With the year drawing to a close, we take a look back at our earnings quality picks through the years. Each quarter we pick three companies in North America that we expect to have strong earnings quality — and pick three that seem to exhibit weak earnings quality. We base these picks on the StarMine Earnings Quality (EQ) model, which ranks companies on a percentile scale from 1-100, with 1 representing companies with the weakest EQ and 100 the strongest EQ. The results tell an interesting story.
Since we started contributing stories for Alpha Now in August 2011, we have had 38 positive EQ stories and 35 negative EQ stories for North America. While the positive EQ picks have had positive returns, the real story is in the negative picks. We see that quite a few of the companies have actually declared bankruptcy and the average returns are negative for a 180 day time frame, despite a healthy bull market. That leads us to believe that EQ is quite an appealing model when trying to find short ideas.
Source : Eikon Add-in for Excel
Model measures
The StarMine Earnings Quality model uses four measures:
Among companies with high accruals, increases in balance sheet line items that reconcile what’s going on in the statement of cash flows vs. what has been recognized as revenues and profits in the income statement tend to reverse fairly rapidly, turning a temporary boost to earnings into a drag on them.
Using the EQ model, we picked companies with strong or weak earnings quality. We see that the negative picks in North America actually had negative returns in the following 180 day period. Given that we have seen a bull market in the past three years, that performance is all the more impressive.
Some Examples
Predicting bankruptcy is no easy task, and over the past few years we have written a few stories that highlighted companies in distress. A few companies that actually went on to declare bankruptcy were Eastman Kodak and Overseas Shipping. In addition to our regular series, we wrote a story on Brazilian oil company OGX Petroleo, identifying it as having bankruptcy risk. That company went on to declare bankruptcy, putting a major dent in the net worth of one of Brazil’s best known billionaires.
One company that we clearly got wrong was Tesla. While the company did have poor earnings quality, the stock has been taken higher by future expectations, and often it’s hard to work against momentum in the market. That being said, if we exclude TSLA and its 300+% return, the rest of the companies saw an average 180 day return of -4.8%. On the positive picks we saw a 4.4% return, giving us a healthy 9.2% spread between the long and shorts.
Other regions
The spread between the long and shorts in Asia was not as large, in part due to the annual reporting cycle, and partly because we only wrote a total of 20 stories based on the EQ model for this region. Europe fared much better. Although there is also a smaller sample size in this region, we notice that of the nine positive EQ examples that we highlighted, only one had a negative return in the 180 day period, while all the others had positive returns. On the negative side, more than half of the 13 picks had a negative return in the 180 day period.
Conclusion
The Earnings Quality model has helped us identify several companies around the world, and our picks have done well, especially the poor earnings quality picks. It looks like the Earnings Quality model could be a powerful ally when investors are searching for short candidates. The demonstration of alpha generation on both the long and short side suggests that our StarMine’s EQ rankings would also make a worthy addition to the tools that long/short equity hedge fund managers use for new idea generation.
Receive stories like this to your inbox as they are published. Subscribehere and follow us @Alpha_Now on Twitter or check out the Eikon blog. If you are looking to access our data or analytics, register for a free trial.
