Corporate Management Quality & Earnings Quality Report

Anyone who invests professionally in stocks knows that beating the market requires significant and diligent research. Which often surprises me that investment professionals focus virtually all their time identifying buy ideas, as determining what stocks to sell is just as important for building a portfolio likely to outperform. I believe Charles Ellis applied the term "loser's game" from tennis to investing. His point is an excellent one, which we will modify slightly.

As applied to tennis, a "loser's game" means that for the recreational player trying to win points is really the wrong goal. Unlike professional players which are able to make winning shots, the amateur should focus on one goal - getting the ball back over the net. The reason is really simple; amateurs usually make mistakes and thus getting the ball over the net one more time will likely result in the other player making a mistake. In tennis, Pros make shots while amateurs make mistakes and that should dictate appropriate strategy for tennis players. As applied in the Ellis view, markets are very efficient; therefore anything which increases the costs of maintaining a portfolio will be a drag on performance that will be very difficult to overcome given how hard it is to pick stocks that outperform. The Ellis view is a smart one indeed; if you cannot "make shots", so to speak, as an investor then you should focus on getting the ball back over the net "one more time" via cost management.

We believe what Ellis says makes a great deal of sense, except our research has consistently shown an ability to "make shots" across time, sectors and countries. Therefore, the question is how we can maximize our ability to generate excess returns on the portfolios we construct. We will borrow Ellis' concept of a "loser's game" to broaden our portfolio management scope and tool kit. Specifically, we examine if there are certain characteristics that consistently define stocks likely to underperform the market, that we should avoid buying or consider selling from our holdings.

We explore two concepts to help us sharpen our stock picking toolkit -whether a company's management is creating or destroying value and whether a company's reported earnings is likely to contain elements leading to future earnings declines.

Management Quality

Finance 101 is fairly clear that when investments earn more than the cost of the capital required to fund them, the result is value creation. Conversely, investments that do not earn their cost of capital destroy wealth. The Applied Finance Group (AFG) has systematically applied this concept to score company management teams on whether they are creating or destroying shareholder value. For our purposes today, we will focus on a specific group of firms, those that AFG defines as wealth destroyers - companies that are investing in their business, but failing to earn their cost of capital and as a result destroying shareholder wealth. Table 1 depicts the annual returns to firms AFG classifies as Wealth Destroyers, versus the overall universe of stocks in the AFG database. On average, these firms under-performed the overall market by 7.22% annually.

Earnings Quality

What if you could identify companies that are likely to show future earnings declines by studying the components of their current earnings? Professor Richard Sloan pioneered this research, and concluded that companies whose earnings consists of a disproportionally high percentage of accounting accrual rather than cash flow are likely to suffer earnings reversals in the future. Table 2, depicts the annual returns to firm's scoring in the bottom 20% of AFG's earnings quality metric. On average, these firms underperform the overall market by 11% annually.

9-25-98 to 9-24-10

Every week, Investment Advisor Ideas provides dozens of stocks having characteristics that over time have tended to beat their respective index benchmarks and thus warrant consideration if you make stock selections for your clients.

Management Quality & Earnings Quality Report

Most of the articles that we provide in the Investment Advisor Ideas Newsletter tend to focus on helping our readers identify high quality companies that are attractively priced, however a large part of that process begins with eliminating companies from our focus lists that look likely to underperform index and sector peers. Two metrics that we commonly use to identify potential torpedo stocks, developed by The Applied Finance Group (AFG), are Management Quality and Earnings Quality. Our goal in this report is to share some insight with our readers what these metrics are, benefits of using these strategies in your stock selection process and the value added to your performance when using these variables coupled with AFG valuation and Economic Margin (EM) methodologies. These 2 exclusionary metrics have proven to consistently identify stocks that underperform and help our readers avoid companies that will torpedo their portfolio returns.

Management Quality

AFG's Management Quality score enables investors to grade management's ability to eliminate wealth destroying firms from your list of constituents. AFG's Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses even when they are not profitable (generating negative Economic Margin).

When companies are unproductive and destroying wealth, management teams should not be looking to grow that business. Instead, management needs to improve profitability by either divesting it unprofitable units and/or restructuring the units to make them profitable before they earn the right to expand. The alternative is also true, just as investors do not like to see management grow a unprofitable business, investors do like to see management grow a profitable business (generating positive EMs) to maximize its profitability. The bottom line is that companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

The chart below highlights the performance of firms that were flagged as following a negative management strategy (Red Bar) vs. firms that were not flagged as "wealth-destroyers" (green bar) over the last 12 years. This variable works quite well at identifying firms that are poised to underperform across all sectors, sizes and style categories.

On a stand-alone basis the metric, management quality, is a valuable asset to advisors by helping you avoid firms likely to underperform, however when you couple this metric with AFG valuation techniques the results are even more impressive.

The companies listed below have been flagged as following a poor management strategy of not earning back its true economic cost of capital and still growing its asset base despite not being profitable. These firms also are all currently trading at a premium to their default intrinsic value (bottom half of valuation rank) making these companies look like poor investment opportunities and should be closely reviewed when performing your due diligence on these companies.

Management Quality Score Insights:

·Measures a company's Economic Margin (EM+1) and LFY Asset Growth.

·Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

·Un-biased quantitative way to analyze a company

·Holds management teams accountable for unprofitable growth

Management Quality - Evaluating Management:

· Assess companies' Economic Margins.

· Evaluate the ability of companies to sustain Economic Margins based on historical performance.

· Build out companies' future cash flows to better evaluate expected future performance relative to their peer group.

· Look at companies' investment prospects, and review how they are growing or shrinking their business.

Earnings Quality

AFG's Earnings Quality variable is a proven indicator of companies that are more likely to have negative earnings surprises, and therefore underperform due to high amounts of accruals (difference in net income vs cash flow) . Corporations are constantly under pressure to meet sales expectations so it is very important to watch out for those companies that may be trying to pad their sales numbers in various ways, ie. Channel-stuffing (sending excess inventory to stores that will not be able to sell their products).

Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you will probably want to avoid these firms. Our back-tests indicate that the EQ variable works especially well when coupled with AFG's valuation model (see charts below). The first chart highlights the performance of companies when you separate the top half (best earnings quality companies) from the bottom half (worst earnings quality companies) across all sector size and style categories.


The next chart illustrates the value added to your stock selection process when you combine AFG Earnings Quality score with valuation. The red and green bars represent the performance of the top half most attractive valuation companies and the red bars represent the bottom half unattractive firms. The red and green dots represent the value added performance when you add EQ to the equation. Firms in the top half of valuation attractiveness and top half of EQ tend to outperform more often than not while the opposite is true for firms that land in the bottom half of both categories in most sectors, sizes and styles. (Note: Financial companies are not included in any EQ analysis as a good portion of their business is accrual based)


We have put this variable to work for you, screening the S&P500 to identify the firms with the worst Earnings Quality (EQ) score that also rank poorly according to AFG's default valuation ranking (bottom half of valuation rank). (Note: Financial companies are not included in any EQ analysis as a good portion of their business is accrual based).


Earnings Quality Score Insights:


·An accrual is the difference between Cash Flow and Net Income.

·Net Income = Cash Flow + Accruals

·Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement
·Difference between Net Income and Cash Flow

2. Balance Sheet
·Change in Net Operating Assets from Period t-1 to t
·Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.