Credit score

SMACOM’s Risk-Linked “Credit Score” Predicts Management Failure

Figure 1) Renown Credit Rating Trends

The SMACOM Credit Score, developed by Nikkei FTRI, is used to quantify a company’s credit risk, indicating the one-year probability of default.

TOKYO, JAPAN, June 29, 2022 / — To achieve outstanding performance in equity-focused asset management, it is necessary to take proportionate risks. Thus, a high-risk, high-return investment is often the basic principle at work in this business. These investors take on two types of risk: the risk of falling stock prices and credit risk, which is associated with the possible bankruptcy of a company that is an investment target. The first risk has an element of uncertainty because it is affected by the actions of an indeterminate number of investors. However, credit risk can be improved to a great extent by using a rating model that demonstrates a high degree of reliability.

SMACOM, provided by Nikkei Financial Technology Research Institute (or Nikkei FTRI), has three scores that can be used to assess risk. In this article, we look at screening investment targets using the Nikkei FTRI’s “Credit Score” risk assessment model.

Credit score is a numerical value used to quantify a company’s credit risk, indicating the likelihood of default within a year. The scores vary from 1 to 100, the higher the score, the lower the probability of default. Nikkei FTRI initially developed this form of measurement based on its expertise in risk models used for credit management by banks.

The default discrimination ability of a credit risk model is assessed using a number between 0 and 1 called the AR value, which is used to judge the effectiveness of a model in determining default. Usually models with AR values ​​of 0.6 or more are used, but if the number exceeds 0.9 for a given model, it is only sensitive to faults occurring under the same conditions as those used for the create, which makes it difficult for the model to predict flaws that have never been experienced. The AR value of SMACOM’s credit score is 0.8281, which is considered to represent an ideal default discrimination ability.

In some cases, credit risk increases in the short term, even when stock prices are strong. In this situation, the difficulty of selecting stocks to invest surfaces. When the stock price does not take into account the credit risk, and if the company suddenly goes bankrupt, the stock price crashes without giving investors the opportunity to sell the shares held. To avoid such a situation, it is advisable to use the credit score effectively.

To determine whether the default can actually be predicted in this way, an instructive case is provided by the Credit Score business of Renown Inc. (3606), a Japanese manufacturer that went out of business in 2020.

(Figure 1)

Founded in 1902, Renown was a long-standing clothing company in Japan. indeed, in the 1990s, it was one of the largest such companies in the world. However, its business model relied primarily on department store sales, and this strategy had become increasingly untenable over the years with the rise of internet shopping and fast fashion. After two consecutive fiscal years of losses, Renown entered default. Due to the spread of the coronavirus, department stores with tenant stores have been forced to suspend operations, leading to a sharp drop in clothing sales. Faced with a shortage of cash, the company filed for bankruptcy on May 15, 2020.

Credit score trends accurately indicated Renown’s increased default risk, as can be seen in the chart above.

Around October 2017, when performance improved, Renown’s credit rating increased, with the probability of default decreasing accordingly. The situation suddenly changed in January 2019, when the credit score dropped from the 50s to the 40s. After that, there were no more signs of improvement and the score had fallen to the low of 30 in April. 2019. Renown then launched a voluntary retirement program among its employees in August 2019, and in February 2020 the company issued a going concern note. . The sharp drop in the company’s credit score six months earlier had raised alarms about the possibility of future defaults. Renown’s failure happened in May 2020, nearly a year after his credit score fell to 30.

As noted, SMACOM’s credit score can serve as a valid predictor of a company’s default a year in advance, and Renown’s example is a perfect example. The use of credit rating in stock selection clearly helps to seek stronger and more stable investment performance.

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