Investors’ Insight: Fundamental Risk And Stock Returns by Steven De Klerck

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The most important objective for an investor is to protect his stock portfolio against a permanent loss of capital. The two main components underlying the risk of experiencing a permanent loss of capital are valuation risk on the one hand and fundamental risk on the other. Various aspects regarding valuation risk are discussed in the section “Valuations”.

Fundamental risk can be assessed by the use of accounting variables in order to obtain an insight in the financial risk and/or failure risk of companies. Financial risk arises from the increasing volatility in accounting returns resulting from additional debt financing. Failure risk usually is not a big threat for most companies on condition that the use of debt financing is not excessively high.

My interest in fundamental risk is marked in two fields. First, since the exact time of economic recessions and/or financial-economic crises is unpredictable, it should be recommended to protect your stock portfolio in advance of such events. Investors often – mistakenly – pay attention to the fundamental risk of the companies in their stock portfolio when the bear market already had started for quite some time. Secondly, it is important to know which accounting variables can be used in order to obtain a relevant estimation of fundamental risk.

Taking a look at the literature reveals that the number of studies exclusively focusing on accounting variables is rather scarce. I recall the following three studies, in chronological order:

Dichev, “Is the Risk of Bankruptcy a Systematic Risk“, 1998.

Griffin and Lemmon, “Book-to-Market Equity, Distress Risk and Stock Returns“, 2002.

Beaver et al., “Have Financial Statements Become Less Informative? Evidence from the Ability of Financial Ratios to Predict Bankruptcy“, 2005.

More recent (and more complex) studies such as Novy-Marx (2013) focus exclusively on one aspect of fundamental risk such as profitability. Studies such as Campbell et al.(2008) combine both accounting and market-based variables in order to assess failure probability.

The following is an overview of the main findings and conclusions from the three aforementioned studies.

Fundamental Risk And Stock Returns

Dichev (1998) and Griffin and Lemmon (2002) study the relationship between fundamental risk and future stock returns. Fundamental risk is measured using Z-SCORE and O-SCORE. Both scores combine various accounting variables in one score or number. So Z-SCORE takes into account profitability, solvency, liquidity and efficiency. The higher Z-SCORE, the lower the fundamental risk. O-SCORE introduces variables in the field of profitability, solvency and liquidity. The higher O-SCORE, the higher the fundamental risk. Dichev (1998) finds that companies with the highest fundamental risk, measured using both Z-SCORE and O-SCORE, realize the lowest stock returns over the investigated period 1980-1995. This is especially the case with Nasdaq companies with the highest O-SCORE. These companies realize a negative return of 0.06% on a monthly basis.

Griffin and Lemmon (2002) zoom in on companies with the highest O-SCORE, being the fundamentally most risky companies. They state that particularly companies with a high price-to-book ratio (growth stocks) realize inferior stock returns. Griffin and Lemmon (2002) document additional statistics about this kind of firms. Over the previous twelve months, these on average small companies realize a high stock return of 36%, a low and negative return on total assets of 8% as well as – for growth stocks – an inferior growth in revenues. These stocks however have the highest price-to-sales ratio of all studied groups. At the same time, these companies invest a lot in R&D. However, the stock price of these firms systematically comes down upon the publication of the financial results. Otherwise said, here it concerns companies considered by investors to be very promising and for which investors are prepared to pay high valuations. Investors expect that these firms, currently with inferior fundamentals and growth in fundamentals, will manage to convert the extensive R&D investments into very high future revenue and earnings growth. Investors however systematically are disappointed upon the publication of the quarterly results; the stock price of these promising companies systematically comes down sharply. The message is clear. By all means, investors should be extremely careful with promising companies that so to speak have realized very little regarding revenue and/or earnings growth. This message tightly fits with the article “Valuations And Stock Returns: Looking Back on The Dot Com Period” in the section “Valuations”.

A company with an ordinary record cannot, without confusing the term, be called a growth company or a growth stock merely because its proponent expects it to do better than the average in the future. It is just a promising company.

Benjamin Graham, 1949

Which Accounting Variables?

Which accounting variables can we use to quantify fundamental risk? Here, the paper by Beaver et al. (2005) is worth reading. In the introductory paragraphs, they state that more comprehensive scores such as Z-SCORE and O-SCORE can perfectly be reduced to (a combination of) three accounting variables: profitability using the return on total assets (ROA), solvency through total liabilities to total assets (LTA) and the ability to service the principal and interest payments using the ratio of EBITDA to total liabilities (ETL). Failing companies are characterized by a systematic deterioration in these fundamentals in the four years preceding the failure. In the financial year before the failure, Beaver et al. (2005) document the following statistics for the three aforementioned variables: -18% for ROA, 98% for LTA and -5% for ETL.


Based on the aforementioned studies, two major conclusions can be advanced. First, try to avoid companies with a (very) high fundamental risk. Secondly, based on Beaver et al. (2005), fundamental risk can be reduced to a focus on three simple criteria: ROA, LTA and ETL. Otherwise said, these three criteria make it possible for your stock portfolio to focus on fundamentally safe companies.

Fundamental Risk

“Your fundamentally safe equity investments.

The technical insights from the contributions “Valuations” and “Fundamental Risk” are also used in the first equity fund of Pure Value Capital, which will be introduced shortly. The global stock portfolio is directed away from historically expensively valued countries (refer to “Market Valuations And Stock Returns”), is focused on companies that are cheap in the market (refer to “Valuations And Stock Returns: Looking Back on The Dot Com Period ” and “Conclusions”) and that all together form a stock portfolio with a low fundamental risk.

In addition to these more technical insights, we also do need an appropriate “mental approach” (Graham, 1949) in order to deal with price fluctuations in a sensible way. The insights associated to this issue are discussed in the section “Mental approach”.

Investors' Insight: Fundamental Risk And Stock Returns