Measuring the quality aspects of a firm is very subjective and often cumbersome to come to any meaningful conclusions on large pools of stocks. The Applied Finance Group has developed some metrics that provide an objective approach to measuring management’s ability to create wealth for its shareholders as well as a firm’s ability to continue to generate solid and repeatable earnings that are an accurate representation of the company’s operations. Our Earnings Quality and Management Quality metrics have proven to consistently identify companies that have management teams that are unable to create wealth for their shareholders as well as companies with the highest levels of accruals or poorest Earnings Quality.
To better understand the value that each of these variables adds to a portfolio management process we will explain briefly each metric and how it has performed over the past 3 years.
Management Quality from an AFG viewpoint, essentially creates an unbiased approach to gauging management teams on their ability to create wealth for shareholders. We first start by understanding how profitable the firm really is from an economic cash flow perspective utilizing AFG’s Economic Margin methodology. Economic Margin essentially cleans up many of the distortions in traditional GAAP accounting metrics and provides a more complete view of a company’s economic health. Once we have a better grasp of how profitable a firm is we compare the firm’s strategy for asset growth in relation to its EM levels. We believe that firms that continue to grow their assets when they are not profitable are effectively destroying wealth for shareholders and are likely to underperform. We would like to see a firm in this position potentially divesting the losing parts of their business and focusing on improving EMs to earn the right to grow again.
Utilizing the MQ metric alone as an exclusionary screening tool can help money managers avoid potential torpedo stocks and firms that are following “wealth destroying” growth strategies. In the chart below you can see that over the last 3 years (1-31-2014 to 1-31-2017), Russell 1000 firms that earned a Management Quality grade of “F” have underperformed the overall index by 4%. Filtering out these poor companies from your initial pool of investable stocks using AFG MQ Grade provides a meaningful and efficient approach to grading the “Quality” aspects of a firm and avoiding potential headaches.
Another valuable “Quality” aspect that often goes overlooked and is difficult to assess is the quality of a firm’s earnings. It is important for investors to see a company grow earnings, but it is just as important to not get caught by a company that could be misrepresenting those earnings with “creative accounting” techniques. By focusing on a firm’s accrual levels and flagging firms with the highest levels of accruals, we are able to flush out the firms from our constituent lists that are the likeliest companies to encounter negative earnings surprises and underperform. 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.
This accrual based method of grading the quality of a firm’s earnings, pioneered by Richard Sloan, has proven through vigorous tests and in use in multiple model portfolios to add significant value by excluding potential torpedo stocks from focus lists. This allows for more time and effort to focus on stocks with earnings that investors can have confidence in and that accurately represent the firm’s operations. Over the last 3 years (1-31-2014 to 1-31-2017), Russell 1000 firms that earned an Earnings Quality grade of “F” have underperformed the overall index by 5.1% and a significant spread is achieved between “A” and “F” graded companies. Avoiding high accrual companies can help investors to avoid companies likely to encounter a negative earnings surprises and underperform.
We have rounded up a list of 10 companies from within the Russell 1000 index that are currently flagged by both EQ & MQ metrics as companies to avoid as they both earn “F” grades in both categories. These companies should be reviewed carefully if you own them and avoided if possible as they all have characteristics that our model “red-flags” as companies likely to underperform.
Russell 1000 Companies with Poor Management/Earnings Quality