Morningstar Advisor - December/January 2010 - 24

Gray Matters Exhibit 3 Least Stable Because Distance to Default uses market-based inputs, its ratings are more volatile than those of Z-Score and TLTA, which rely more on accounting-based inputs. Weighted Average Drift Distance 3 Distance to Default Z-Score TLTA a bankruptcy event was 91. The high average means that there was a lower occurrence of the Distance to Default model classifying future bankrupt companies as safe compared with the Z-Score and TLTA. In addition, Distance to Default had the lowest occurrence of bankruptcies in its best-rated quintile of companies. The Z-Score placed second in both measures, followed by TLTA. Summarizing the Study 1 Years Durability Results The ordinal-ranking ability of any bankruptcy prediction model would presumably decay as the time horizon for bankruptcy lengthens. Exhibit 2 shows the ordinal predictive capability of all three models over one- to 10-year bankruptcy time horizons. Distance to Default’s predictive ability is superior to the other two models over all bankruptcy time horizons. The widening spread between Distance to Default and the other two models also demonstrates that the decay of its predictive ability is less than that of the other two, meaning Distance to Default produces a more durable signal. Stability Results Exhibit 3 shows Distance to Default is the least-stable rating system, followed by the Z-Score and then the TLTA. This is expected, because market-based model inputs are typically more volatile than accounting-based inputs. Distance to Default relies more on the former, and TLTA and Z-Score rely primarily on the latter. Cardinal Results Distance to Default, which is the basis of Morningstar’s Financial Health Grades for companies, outperformed the Z-Score and our univariate TLTA model in both ordinal and cardinal bankruptcy prediction. Curiously, the Z-Score’s predictive ability is nearly equal to the other two models when ranking relatively safe companies but performs worse in situations when the bankruptcy probability is high. Compared with the other two models, Distance to Default also had a higher average rating just before bankruptcy and a lower bankruptcy rate for companies it had categorized as safe. If a bankruptcy signal is not durable and decays too rapidly to act on, then a predictive model will prove useless in practice. We found that all three models produced actionable scores. Distance to Default, however, generated more durable ratings, as its ordinal ability decayed at a slower rate than either of the other two models. It also displayed more volatile ratings than both the Z-Score and the TLTA model. This is intuitive, because Distance to Default relies more on marketbased inputs than accounting-based inputs. One final note: When valuing a business as a going concern, a firm is assumed to continue operations into the indefinite future. Does this mean that investors need to remove distressed companies from publiccompany risk premiums when applying the latter to the valuation of healthy, goingconcern private entities? It does not. Although the firm is presumed to be a going concern, predictive ability is never 100%. Our secondary performance tests gauged each model’s cardinal ability to predict bankruptcy. The table examines the default rates of the companies to which the models assigned the lowest risk. Average Rating Before Default Default Rate of Top Quintile Rating stability can determine the potential applications of a credit-scoring system. In most models, ordinal and cardinal accuracy are at odds with rating stability; that is, accuracy must be sacrificed for stability, and vice versa. Drift distance is a measure of how each model’s ratings vary from period to period, from 0 (maximum stability) to 9 (minimal stability). Distance to Default Z-Score TLTA 91 83 82 0.5% 0.6% 0.8% Of the three models, Distance to Default proved to be most predictive of bankruptcy in absolute terms. On average, the most recent Distance to Default percentile before 24 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2010

Morningstar Advisor - December/January 2010
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
How Big a Role Do Alternative Investments Play in Your Practice?
In for the Long Term: Dana Emery
It's All About the Plan
Investment Briefs
A More Powerful Bankruptcy Prediction Model
This Time It’s Personal
Alternative Investments Go Mainstream
After Meltdown, More Advisors Turn to Alternatives
Where to Find Low Correlation
Commodities Are a Rock in a Hard Place
How Alternatives Protect Portfolios
Shipshape
Slow Scrutiny
Four Picks for the Present
Are Utilities’ Dividends Worth the Worry?
High-Confidence Stock Picks
Long-Short Funds That Pass a Simple Stress Test
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
VA Sales See Some Recovery
New at Morningstar
I Read the News Today, Oh Boy
Morningstar Advisor - December/January 2010 - Morningstar Advisor - December/January 2010
Morningstar Advisor - December/January 2010 - Cover2
Morningstar Advisor - December/January 2010 - Contents
Morningstar Advisor - December/January 2010 - 2
Morningstar Advisor - December/January 2010 - 3
Morningstar Advisor - December/January 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - December/January 2010 - 5
Morningstar Advisor - December/January 2010 - 6
Morningstar Advisor - December/January 2010 - Letter from the Editor
Morningstar Advisor - December/January 2010 - Contributors
Morningstar Advisor - December/January 2010 - 9
Morningstar Advisor - December/January 2010 - How Big a Role Do Alternative Investments Play in Your Practice?
Morningstar Advisor - December/January 2010 - 11
Morningstar Advisor - December/January 2010 - In for the Long Term: Dana Emery
Morningstar Advisor - December/January 2010 - 13
Morningstar Advisor - December/January 2010 - It's All About the Plan
Morningstar Advisor - December/January 2010 - 15
Morningstar Advisor - December/January 2010 - Investment Briefs
Morningstar Advisor - December/January 2010 - 17
Morningstar Advisor - December/January 2010 - 18
Morningstar Advisor - December/January 2010 - 19
Morningstar Advisor - December/January 2010 - A More Powerful Bankruptcy Prediction Model
Morningstar Advisor - December/January 2010 - 21
Morningstar Advisor - December/January 2010 - 22
Morningstar Advisor - December/January 2010 - 23
Morningstar Advisor - December/January 2010 - 24
Morningstar Advisor - December/January 2010 - 25
Morningstar Advisor - December/January 2010 - This Time It’s Personal
Morningstar Advisor - December/January 2010 - 27
Morningstar Advisor - December/January 2010 - 28
Morningstar Advisor - December/January 2010 - 29
Morningstar Advisor - December/January 2010 - 30
Morningstar Advisor - December/January 2010 - 31
Morningstar Advisor - December/January 2010 - Alternative Investments Go Mainstream
Morningstar Advisor - December/January 2010 - 33
Morningstar Advisor - December/January 2010 - 34
Morningstar Advisor - December/January 2010 - 35
Morningstar Advisor - December/January 2010 - After Meltdown, More Advisors Turn to Alternatives
Morningstar Advisor - December/January 2010 - 37
Morningstar Advisor - December/January 2010 - Where to Find Low Correlation
Morningstar Advisor - December/January 2010 - 39
Morningstar Advisor - December/January 2010 - Commodities Are a Rock in a Hard Place
Morningstar Advisor - December/January 2010 - 41
Morningstar Advisor - December/January 2010 - How Alternatives Protect Portfolios
Morningstar Advisor - December/January 2010 - 43
Morningstar Advisor - December/January 2010 - 44
Morningstar Advisor - December/January 2010 - 45
Morningstar Advisor - December/January 2010 - 46
Morningstar Advisor - December/January 2010 - 47
Morningstar Advisor - December/January 2010 - Shipshape
Morningstar Advisor - December/January 2010 - 49
Morningstar Advisor - December/January 2010 - 50
Morningstar Advisor - December/January 2010 - 51
Morningstar Advisor - December/January 2010 - Slow Scrutiny
Morningstar Advisor - December/January 2010 - 53
Morningstar Advisor - December/January 2010 - 54
Morningstar Advisor - December/January 2010 - 55
Morningstar Advisor - December/January 2010 - Four Picks for the Present
Morningstar Advisor - December/January 2010 - 57
Morningstar Advisor - December/January 2010 - 58
Morningstar Advisor - December/January 2010 - Are Utilities’ Dividends Worth the Worry?
Morningstar Advisor - December/January 2010 - 60
Morningstar Advisor - December/January 2010 - 61
Morningstar Advisor - December/January 2010 - High-Confidence Stock Picks
Morningstar Advisor - December/January 2010 - 63
Morningstar Advisor - December/January 2010 - Long-Short Funds That Pass a Simple Stress Test
Morningstar Advisor - December/January 2010 - 65
Morningstar Advisor - December/January 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - December/January 2010 - 67
Morningstar Advisor - December/January 2010 - 68
Morningstar Advisor - December/January 2010 - 69
Morningstar Advisor - December/January 2010 - 50 Most Popular Equity ETFs
Morningstar Advisor - December/January 2010 - 71
Morningstar Advisor - December/January 2010 - 72
Morningstar Advisor - December/January 2010 - Undervalued Stocks
Morningstar Advisor - December/January 2010 - 74
Morningstar Advisor - December/January 2010 - 75
Morningstar Advisor - December/January 2010 - VA Sales See Some Recovery
Morningstar Advisor - December/January 2010 - 77
Morningstar Advisor - December/January 2010 - 78
Morningstar Advisor - December/January 2010 - New at Morningstar
Morningstar Advisor - December/January 2010 - I Read the News Today, Oh Boy
Morningstar Advisor - December/January 2010 - Cover3
Morningstar Advisor - December/January 2010 - Cover4
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