We offer a number of academically proven screens for selecting baskets of stocks that are either overvalued or undervalued. We recently ran our Percent Accruals screen, which is typically used as a screen for selecting short candidates (the alpha driver on this system is derived from the well-documented accrual anomaly).
The screen looks for stocks that have net income that has exceeded cash flow, and is then scaled by total earnings. The research shows that companies with high accruals tend to underperform those with low accruals. You can visit us for additional discussion of the academic research underlying this fascinating strategy and a detailed review of the system.
Running the short-side screen, we see the following output for the top 10 names:
(Click charts to enlarge)
In reviewing the results, I am reminded of the famous Sesame Street song, “One of these things is not like the others.” Take a look down the Market Cap column. Allergan Inc. (NYSE:AGN) exceeds the next highest in market capitalization by a factor of over 6X.
Allergan is a $25 billion market capitalization healthcare company focused on researching, developing and manufacturing pharmaceuticals, biologics, and medical devices, and additional over-the-counter products in numerous specialty markets, including eye care, skin care, and medical aesthetics. Many are familiar with the company’s popular Botox product. The company serves markets in over 100 countries around the world.
If we click through to the Company Overview output, we see the following:
AGN is showing a composite Turnkey Score of 47.3%, consisting of the average of a Quality Measures score of 72% and a Pricing Measures score of 22.8%. So overall, the fundamental review is telling us that while the company is high quality, the price is high, at least statistically. Before moving onto additional areas of consideration, let's focus in on the Accrual issue, and see what the output is telling us.
Reviewing the company's Earning Quality scorecard, we see that the overall quality is 42.6%. At the bottom of the output, you can see the telltale operating accruals / net income statistic that drove the company into the top 10 within our Percent Accruals screen. Additionally, the operating accruals / assets result of -4.3% places the company in the 55th percentile, which demonstrates that the accruals as scaled by assets also do not compare especially favorably with our universe. Clearly, the accruals issue is one that merits some additional fundamental legwork.
Now we want to see if there are any other areas that might be worth additional analytical focus.
Moving on from our preliminary fundamental and earnings quality scoring to a review of additional quantitative factors, we can see above how the company stacks up versus seven different quantitative screens. Since we generated this name on the short side of our Percent Accruals screen, you can see that, as you would expect, the company was in the very bottom percentile of our long Percent Accruals screen. But wait. There's that Sesame Street song again, "One of these outputs is not like the others." Goodwill Gone Bad.
Within the Goodwill Gone Bad output, the company has scored in the 6th percentile of our universe. In a nutshell, our Goodwill Gone Bad screen calculates four variables for the company: goodwill scaled by assets and return on assets. On the short side, the test identifies companies that have extensive goodwill and low return on assets. These factors have been shown to be predictive of unanticiapated goodwill impairment (Details can be found here. The Goodwill Gone Bad screen suggest that, statistically, the company is likely to see an unanticipated goodwill impairment charge that could have a significant effect on its perceived value.
Now we turn to our quality output in order to see what factors are driving the high quality score discussed above. Our overall Economic Moat score, above, which is the primary driver of our quality score, is 74.8%. This is a result of several factors. The company has not lost money in any of the past 8 years. Normalized (8-year average) cash from operations - capex / assets yield is 56.8%, placing the company in the 83rd percentile of our output. Normalized (8-year avrage) returns on assets and capital look strong at 6.6% and 7.7%, respectively, and put the company in roughly the top third of our universe. Finally, Margin Strength is very solid at 50.1%, placing it in the 93rd percentile (margins are very stable over time). The company is showing multiple characteristic signs of a company with a wide economic moat.
Next we review our Shareholder Yields output, above, which allows us to look at several valuation benchmark yields and compare them with our universe. Overall, the company looks pricey, with a Valuation score of 22.7%. The company's TTM EBIT/TEV yield of 1.2%, book-to-market value of 19.8%, and net-income-to-market cap yield of essentially 0%, all leave the company in roughly the bottom 6th of our universe. Normalized (8-year average) net-income-to-market cap is not much better at 1.4%, and normalized (8-year average) EBIT/TEV yield of 2.3% is also low; both of these outputs leave the company in the bottom quartile. Finally, TTM FCF/TEV yield of 2.1%, and normalized (8-year average) FCF/TEV yield of 2.7% are the best relative yields we can see, although these still leave the company in the bottom third of our universe. Even given the superior Economic Moat scores, it would be difficult to argue that the company is cheap at these prices.
How can we interpret these results? In general, the company is exhibiting output you would expect from a high-quality business. The Economic Moat scores are strong, which indicate the company's competitive position is defensible, based on traditional metrics. But there are some accounting questions that need to be analyzed. The company accruals are practically off the charts. It is very strange to see such a large capitalization company with such significant accruals. We ran our short Percent Accruals screen out to 100 companies, and AGN was still the largest by a significant margin. This statistical relationship between net income and cash flow cannot be sustained over the long run (even if this is only a temporary blip on the radar).
Additionally, the company is scoring poorly on our Goodwill Gone Bad measures. If management is failing to write down goodwill on a orderly basis, reflecting accurate periodic assessments, there could be a nasty surprise when any accumulating goodwill impairment is finally recognized. Finally, the company is priced for perfection. Interestingly, the company's put/call ratio has increased recently. Perahaps option traders are expecting a negative event? Regardless, at these prices, there is not much margin for error. If these accounting issues start to cause problems, it is hard to see how the company could maintain its lofty valuation.
In the end, our quant measures are not a replacement for good-old fashioned fundamental legwork; however, our tools allow us to efficiently and intelligently identify problem areas for further investigation.