A Downside of Using Stops

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Oct 26, 2010
Two ways I try to improve as an investor are reviewing past investing decisions and reviewing constructive criticism. I’ll be doing some of both below.


Back in January, I placed an Altman Z”-Score pairs trade, shorting Trico Marine Services (TRMA, Financial) and buying an equivalent amount of Oceaneering International (OII, Financial). I had found TRMA on Short Screen’s screener, where it was listed at the time as one of the 25 most financially distressed companies among those with a share price above $5.


As we noted in a recent Seeking Alpha article, Short Screen uses the Altman Z”-Score to rank the non-manufacturing stocks in its database, and the original Altman Z-Score to rank the manufacturing stocks; then Short Screen combines the results into one list, ranking stocks according to their distance from their respective distress thresholds. That article stated the original Altman Z-Score Model:
The Altman Z-Score Model: Z = 1.2X1 + 1.4X2 + 3.3X3 + .6X4 + 1X5


Where,


X1 = Working Capital / Total Assets


X2 = Retained Earnings / Total Assets


X3 = Earnings Before Interest and Taxes / Total Assets


X4 = Market Value of Equity / Total Liabilities


X5 = Sales/ Total Assets


Scores below 1.81 indicate risk of bankruptcy within the next two years; scores from 1.81 to 2.99 are a gray area; and scores of 3 or higher indicate an absence of financial distress.
The problem with applying the original Altman Z-Score model to non-manufacturing companies is that the fifth term, Sales/Total assets, tends to vary widely among non-manufacturing companies. Because of this, the Altman Z”-Score model eliminates the fifth term. It also weights the first four terms differently:
Altman Z”-Score Bankruptcy Model:


Z” = 6.56X1 + 3.26X2+ 6.72X3 + 1.05X4


Where,


X1 = Working Capital / Total Assets


X2 = Retained Earnings / Total Assets


X3 = Earnings Before Interest and Taxes / Total Assets


X4 = Market Value of Equity / Total Liabilities


Scores below 1.1 indicate risk of bankruptcy within the next two years; scores from 1.1 to 2.6 are a gray area; and scores greater than 2.6 indicate an absence of financial distress.
On Short Screen’s screener back in January, TRMA showed a distance from distress of -1.23, consistent with its Altman Z”-Score at the time of -0.13. Looking for stronger companies in its industry (offshore oil field services), I found Oceaneering International (OII), which had an impressive Altman Z”-Score of 9. I shorted TRMA at $5.31 per share and bought an equivalent amount of OII at $64.70. I set 9.5% trailing stops on both sides. A couple of weeks later, I was stopped out of OII for a loss of 9.5%. TRMA was down 16% at the time, and I decided to cover it there, closing out the trade for a modest 6.5% gain.


A couple of days ago, I looked at a blog post of mine where I had embedded a chart of TRMA versus OII. I noticed that the chart for TRMA stopped abruptly in September:


z?s=TRMA&t=3m&q=l&l=on&z=m&c=OII&a=v&p=s


The chart ended abruptly in September because the stock symbol for Trico Marine Services is no longer TRMA, but TRAMQ.PK, the “Q” indicating that the company is in bankruptcy. This chart uses the new symbol:


z?s=TRMAQ.PK&t=1y&q=l&l=on&z=l&c=OII&p=s&a=v&p=s&lang=en-US&region=US


In hindsight, I made two mistakes there. The first was in using stops. The reason I did was that I knew expert short sellers such as Tim Knight and William O’Neil tended to use tight stops. But as short sellers, those investors are driven mainly by technical analysis. I do take basic technical analysis into account when I invest, but the Altman models are primarily based on fundamentals (save for the numerator in the fourth term of both models, market value of equity).


Dr. Paul Price noted that and offered this constructive criticism: since I was shorting companies based primarily on their fundamentals, and since fundamental factors can take several months or to play out, it didn’t make sense to get stopped out of a position based on short-term share price fluctuations. Seeing the gains I left on the table by closing out this Altman Z”-Score pairs trade too soon underlines Paul’s point. Going forward, I won’t be using mechanical stops on these trades.