In order to help investors gain confidence that a company’s reported earnings are not only repeatable, but also an accurate representation of its operations, we must remove human biases and view a firm’s earnings in an objective, unbiased and systematic way. A reliance on future earnings performance based on misrepresentations of reality and/or “creative accounting” can leave investment firms vulnerable to encountering negative earnings surprises in their portfolios.
We believe that the best way to assess the quality of a firm’s earnings is to start by clearly understanding a firm’s accrual levels. Our Earnings Quality metric flags companies with the highest levels of accruals as these firms have proven to encounter negative earnings surprises more frequently and subsequently tend to underperform companies with lower accrual levels. Accruals, or the difference between Cash Flow and Net Income, or essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. Most investors like to see a company grow earnings, but it is vital that the earnings that are reported are an accurate representation of operations. This accrual based method of gauging Earnings Quality, pioneered by Richard Sloan, is an important tool in helping investors identify potential torpedoes in their portfolio.
By flushing out the companies from your constituent list that carry the highest levels of accruals and spending more time and focus on stocks more likely to deliver on their future earnings expectations and protect your portfolio from potential torpedoes. Over the last 3 years (April 2014-2017), within the Russell 1000 Index, companies that earn an “F” Grade for Earnings Quality have underperformed the benchmark by 3.9% and underperformed the “A” Graded firms by over 8%.
Avoiding firms with the highest levels of accruals is an unbiased way to eliminate potential torpedo stocks from your portfolios. These firms tend to have more negative earnings surprises and have proven through countless backtests to underperform low accrual firms. The 12 firms listed below all earn an “F” Earnings Quality Grade according to AFG’s Investment Grade model. If you would like to gain access to the list of R1000 companies that have “A” Graded Earnings Quality and also look attractive from a valuation standpoint, email us at Sales@afgltd.com.
Russell 1000 – Poor Earnings Quality Companies
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