Corporations around the globe are constantly under pressure to meet sales expectations, which makes it very important when looking for investment opportunities 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).
AFG's Earnings Quality variable helps investors identify companies that are likely to miss earnings 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.
Because companies with poor Earnings Quality are more likely to have negative earnings surprises, you may want to avoid firms with this characteristic. Our back-tests indicate that the EQ variable developed by The Applied Finance Group (AFG) works well at eliminating firms likely to suffer earnings reversals in the future. The chart below depicts the annualized returns of companies based on their Earnings Quality Score. The returns shown are of Russell 1000 companies sorted into quintile buckets based on EQ Score relative to the Russell 1000 universe (blue bar). Companies that fall into the bottom quintile (poorest EQ rank) have underperformed the Russell 1000 universe by over 6% on an annualized basis since 1998.
Today we have put this variable to work for you, screening the Russell 1000 to identify the firms with the worst Earnings Quality (EQ) score that also rank poorly according to AFG's overall Investment Grade rankings which also take into account factors such as valuation attractiveness and momentum. (Note: Financial companies are not included in any EQ analysis as a good portion of their business is accrual based). In the section below you will find 15 companies from the Russell 1000 that have a high level of accruals (poor Earnings Quality) and also rank poorly according to AFG's overall Investment Grade, therefore these firms appear to be unattractive investment opportunities that should be avoided.
The 15 companies listed below have poor Earnings Quality based on AFG's Earnings Quality metric and also rank poorly according to AFG's overall Investment Grade. These companies contain many characteristics of a potential torpedo stock that could blow up a portfolio. We recommend reviewing these firms closely when considering adding or owning them in a client's portfolio.