When narrowing down a list of potential portfolio constituents, it is beneficial to eliminate companies with characteristics that tend to lead to underperformance. One metric that helps us to eliminate potential torpedo stocks from our pool of potential companies to own is Earnings Quality, or the amount of accruals a company has on its books.
Accruals are the difference between Cash Flow and Net Income, essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. Being that companies have an astounding amount of leeway in preparing their financial statements, a dollar of net income often times does not represent a dollar of cash flow.
The Applied Finance Group (AFG) score’s the quality of each company’s earnings to determine which are or are not sustainable into the future. If a company has an extremely high level of accruals relative to its industry peers, it is likely that the company will not receive full payment from all customers, which leads to potential poor earnings quality. Whether it is stuffing channels with excess inventory, delaying bill payments or other “creative” accounting techniques to manipulate earnings, companies with a high amount of accruals have proven to encounter far more negative earnings surprises and inferior returns than firms with lower levels of accruals.
As you can see in the charts below, we have broken down the Russell 1000 Index into quintile buckets based on accrual levels. The F rated firms have the highest level of accruals (lowest quality of earnings) and the A rated firms have the lowest level of accruals (highest quality of earnings). Both Year to Date (12-27-13 to 9-26-14) and since we began tracking the performance of this metric (1998-2014), you can notice a distinct trend that by avoiding the companies with the highest level of accruals you will avoid many torpedo stocks. This metric helps investors avoid companies that are the most likely to encounter negative earnings surprises and most likely to underperform peers with higher quality earnings.
A company with poor EQ does not necessarily mean a company is not an attractive investment opportunity as other metrics such as valuation, momentum and other quality metrics need to be taken into account. This list does serve, however, as a list of companies that contain characteristics found in companies that tend to underperform.