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There is no guarantee that any forecast or opinions in this material will be realized. Information should not be construed as investment advice.
April 2005
Taking Earnings Quality into Account: A Practitioner’s Research into
Balance-Sheet Accruals
Key Issues and Investment Implications
■ Do balance-sheet accruals signal futureearnings and stock prices?
■ Does the BSA tool have fundamental underpinnings?
■ Can the BSA tool be used outside the US?
■ How can BSAs be used to enhance research and stock selection in growth and value portfolios?
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■ Building upon academic studies, our research has
found that changes in balance-sheet accruals scaled to
the size of the balance sheet are a powerful indicator
of future earnings and stock prices. Within the large-
cap US market, for example, low BSA stocks outper-
formed high BSA stocks by 9.3% a year on average from
1978 to 2003.
■ Our BSA tool captures the risk that the accrual com-
ponent of earnings is not reliable and thus will not
persist. Th e unreliability typically stems from the way
management optimism or pessimism infl uences the
assumptions used in estimating accrual accounts, as
well as earnings management, capital management
and the mean reversion of earnings and sales.
■ Th e BSA tool appears to be eff ective for large-cap
and small-cap stocks and within the growth and val-
ue realms in the US and in major markets around
the world. Diff erences in accounting rules (most of
which have been eliminated) made it less useful in
the UK and Japan until just a few years ago.
■ Th e BSA tool could help growth investors by
underlining the risk that trailing sales growth and re-
turn on equity will rapidly revert to the mean.
■ We have integrated the tool into Bernstein’s risk-
adjusted return model for US value portfolios and
hope to introduce it into all of the Bernstein value
portfolios in 2005. Our research shows the BSA
tool has a very low correlation with our valuation
metrics and thus is picking up diff erent information.
We have also found that the tool enhances our
fundamental research by providing a disciplined,
quantitative framework for comparing company
balance sheets.
About the Author
John P. MahedyCo-Chief Investment Offi cer and Director of Research—Bernstein US Value EquitiesMr. Mahedy was named Co-CIO—US Value Equities in 2003. He continues to serve as Director of Research—US Value
Equities, a position he has held since 2001.
Previously, Mr. Mahedy was a senior research analyst in Bernstein’s institutional research and brokerage unit, covering
the domestic and international energy industry from 1995 to 2001 and the oil-services industry from 1988 to 1991. He
also covered oil services at Morgan Stanley in the early 1990s. Mr. Mahedy was ranked among the top-fi ve oil analysts
in the Reuters and Greenwich Associates polls in 1999 and 2000, and he was named to Institutional Investor magazine’s
All-America Research Team in 1993, 1994 and 1995.
Mr. Mahedy, a CPA, began his career as a senior auditor with Peat Marwick Main. He earned a BS and an MBA from New
York University. ■
Executive Summary
TAKING EARNINGS QUALITY INTO ACCOUNT
Executive Summary Inside Front Cover
Introduction 2
Defi ning BSAs 4
The Fundamental Variables that Drive BSAs 6
Th e Superiority of Cash Earnings 6
Pessimistic or Optimistic Assumptions 6
Earnings Management 7
Capital Management 8
BSAs: Can You Export the Concept? 10
Mean Reversion of Sales and Earnings 12
BSAs and Growth Investing 14
Is the BSA Tool Biased Against High-Growth Companies? 14
Why BSAs Work Within the Growth Arena 15
Using BSAs in the Growth Arena 15
BSAs and Value Investing 17
Are BSAs Additive to Value? 17
Are BSAs Additive to Earnings Revisions? 17
Putting the BSA Tool to Work 18
Bibliography 20
Table of Contents
TAKING EARNINGS QUALITY INTO ACCOUNT
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Taking Earnings Quality into Account:A Practitioner’s Research into Balance-Sheet Accruals
By John P. MahedyCo-Chief Investment Offi cer and Director of Research—Bernstein US Value Equities
For the fundamental analyst, addressing the quality or
reliability of reported earnings is critical to making an
accurate earnings forecast and estimating a stock’s return
potential; thus, most fundamental investors would argue
that they pay attention to earnings quality. Nonetheless,
academic research has shown that an indicator of earnings
reliability in readily available fi nancial reports—the
changes in balance-sheet accruals (BSAs)—is a strong
signal of a company’s future profi tability and stock price.
Th is implies that most investors, in fact, are not paying
suffi cient attention to all of the available information
about earnings quality, thus creating an opportunity for
other investors to exploit.
Our own research has confi rmed the academic fi ndings
and refi ned the BSA tool to make it more powerful and
applicable to all industry sectors. As important, our
research sheds light on the fundamental variables that
make BSAs an eff ective quantitative tool.
Th e BSA tool allows us to systematically compare
changes in balance-sheet information for each company
relative to its peers and to the market as a whole.
Th us, we have integrated this tool into the research
process and risk-adjusted expected return framework
that we use in selecting stocks for Bernstein’s US large-
cap value portfolios, and we are exploring how to use it
in all of our value services globally.
It appears to be quite powerful. Th e quintile of US large-
cap stocks with the lowest balance-sheet accrual growth
outperformed the quintile with the highest BSAs from
1978 through 2003 by 9.3% a year. While the lowest
accrual stocks outperformed the US large-cap market
by 4.7% a year on average, the highest accrual stocks
underperformed by 4.6% (Display 1). Th e tool is also
remarkably consistent, generating a positive return
between the low and high accrual groups in all but three
of the 26 years tested.
Th e tool appears even more powerful for small-cap
stocks. Th e quintile of US small-cap stocks with the
lowest balance-sheet accrual growth outperformed the
quintile with the highest BSAs by more than 18% a year
on average from 1980 through September 2004. Most
quantitative tools, however, deliver more powerful results
in back tests within the small-cap arena than within the
large-cap arena. Our research and experience show that
the added power cannot be fully harnessed in managing
small-cap portfolios, due to the lower liquidity and
higher transaction costs of small-cap stocks. Th us, we
assume that in practice, the tool should deliver similar
results within the US large-cap and small-cap universes.
Display 1BSAs: A Powerful Predictor of Returns
Indexed to 100 on December 31, 1977; return vs. US large-cap universe, defined as
all stocks with more than 2 basis points of total US equity market capitalization.
Source: Compustat and Bernstein
INTRODUCTION
TAKING EARNINGS QUALITY INTO ACCOUNT
3AllianceBernstein |
Th e tool also appears to be eff ective globally, although
diff erences in accounting rules (most of which have
been eliminated) made it less useful in the UK and Japan
until recently.
While some of the tool’s underlying drivers seem to have
a value fl avor, our research shows that the tool should
be valuable to growth investors as well. We divided the
large-cap universe into value stocks and growth stocks
on the basis of trailing price to sales1 and found that the
tool is quite eff ective within both the value domain and
the growth domain (Display 2). In fact, it was somewhat
more eff ective for stock selection within growth, with a
spread between low- and high-accrual stocks of nearly
11% a year, compared to 9% a year for value stocks, with
similar consistency. ■
Display 2BSAs Are Powerful in the Value and Growth Arenas
Annualized Return vs. Style Universe 1978–2003
Quintile US Value US Growth
Low Accruals 3.7% 5.2%
High Accruals (5.3) (5.5)Outperformance
Low vs. High +9.0% +10.7%Past valuations are no indication of future results.
Annualized quarterly return versus equal-weighted style index. Growth index
includes the more expensive half of the US large-cap market universe based
on price/sales; value index includes the less expensive half. BSA quintiles were
formed quarterly using Bernstein definition of net operating accruals within
each style universe, and the performance of the highest and lowest BSA quintiles
was compared to the style index.
Source: Compustat and Bernstein
1 We also divided the universe into value and growth on the basis of price to book, with very similar results—a spread of about 11% on average for growth stocks and about 9% on average for value stocks.
TAKING EARNINGS QUALITY INTO ACCOUNT
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Balance-sheet accruals arise from the attempt to make
reported earnings more meaningful than they are in a
pure and very simplifi ed cash-accounting system. In
the latter, earnings are simply equal to the change in
cash from period to period. Such fi nancial statements
are highly objective and reliable, because they can be
easily audited—but they are almost never meaningful.
Th ere are numerous events in the life of a corporation
that span multiple accounting periods, which can give
a distorted impression of earnings under a cash-based
accounting system. For example, a fi rm that spent a lot
of cash building inventory in one year that isn’t sold until
the next would report earnings that look misleadingly
bad in the fi rst year and misleadingly good the next.
Accrual accounting attempts to make reported earnings
more meaningful by better matching costs with related
revenues. In this system, earnings are the sum of the cash
fl ows and the changes in balance-sheet accrual accounts.
Th is attempt to make the data more meaningful intro-
duces subjective judgments and assumptions. Hence,
accrual accounts are prone to error—both uninten-
tional and deliberate—and studying changes in accrual
accounts can be rewarding.
Most oft en, investors think of accruals in terms of current
operating assets and liabilities, such as inventories and
accounts payable. But accruals can be defi ned more
broadly. Th ere are also non-current operating accruals,
such as physical plant and equipment and deferred taxes.
Together, current and non-current operating accruals
make up net operating accruals. If you add in fi nancial
accruals, you get total accruals, which encompass
all balance-sheet accounts other than cash and share-
holder equity.
Research by Professors Scott Richardson, Richard Sloan,
Mark Soliman and Irem Tuna2 tested several defi nitions
of accruals ranging from very narrow metrics focusing
on single balance-sheet accounts to more compre-
hensive measures. Prior academic research had shown
that, broadly speaking, the more a balance-sheet accrual
account is subject to estimation, the more changes
in this account will forecast future stock performance.
In other words, the more diffi cult it is to precisely defi ne
and audit the exact balance, the more prone to error the
account becomes—and the more changes in earnings
stemming from such accounts should be viewed with
skepticism. Nonetheless, while the forecasting ability
of individual accrual accounts yields impressive results,
Richardson et al. found that when applied to a large
data set, a broad measure of accruals encompassing
both short- and long-term accounts, scaled to the size
of the balance sheet, was most eff ective in estimating
stock returns. In our reconstruction of their results, the
quintile of low-accrual stocks beat the market by 2.9% a
year on average, and the quintile of high-accrual stocks
lagged by 5.3%. Th at is, low accruals beat high accruals
by 8.2%.
Making the Tool PracticalTh e Richardson et al. study relied on annual balance-
sheet data and excluded fi nancial stocks, which the
authors thought might not be comparable to non-
fi nancial stocks, given the diff erent balance-sheet
structure of fi nancial companies. As practitioners—not
academics—we were uncomfortable with the idea of
waiting for a full year to get new balance-sheet infor-
mation, when an updated balance-sheet scorecard
is available quarterly. It would also limit the tool’s
usefulness to exclude the fi nancial sector, which makes
up 20% to 30% of the capitalization of various broad US
market indexes and an even greater share of many other
markets.
So, we looked for ways to make the tool more practical for
use in our investment process. We tested its eff ectiveness
by industry and found that, like most quantitative tools,
it produced positive results for virtually all industries.
Th e results varied by industry, of course. Th e spread
between high and low BSA stocks within the three major
fi nancial industries (insurance, banking and investment
banking/brokerage) was near average. Results for the
data-processing and leisure industries proved to be
above average historically. Results for steel and airlines
were below average. Statistically speaking, however, the
dispersion was not signifi cant enough to bias our expec-
tations about the future. 2 Scott A. Richardson, Richard G. Sloan, Mark T. Soliman and Irem Tuna, “Ac-crual Reliability, Earnings Persistence and Stock Prices,” July 2003
DEFINING BSAs
TAKING EARNINGS QUALITY INTO ACCOUNT
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Th e academics, using annual data, chose to exclude
changes in long-term assets, perhaps because this
accrual account is relatively stable and not highly subject
to estimation. Th e quarterly data Compustat provides,
however, lumps long-term assets in with other data
more prone to estimation. In order to use quarterly
balance-sheet information, we included changes in long-
term assets in our defi nition of net operating accruals.
Nonetheless, when we applied the Bernstein defi nition
of net operating accruals—based on quarterly data—to
the full universe of large-cap stocks, we found it even
more eff ective than the academic version (Display 3).
It is this defi nition of balance-sheet accruals that we use
in the rest of this paper, except when stated otherwise. ■
Display 3We Enhanced the Efficacy of the Academics’ Tool
Annualized Return vs. Market 1978–2003
QuintileAcademics’ Net
Operating AccrualsBernstein Net
Operating Accruals
Low Accruals 2.9% 4.7%
High Accruals (5.3) (4.6)
Outperformance
Low vs. High +8.2% +9.3%Past valuations are no indication of future results.
Annualized quarterly return versus equal-weighted US large-cap market uni-
verse. Quintiles for academics’ net operating accruals were formed annually
based on annual data and exclude financial stocks. Quintiles for Bernstein net
operating accruals were formed quarterly using Bernstein’s definition of net
operating accruals based on quarterly data and include financial stocks.
Source: Compustat and Bernstein
TAKING EARNINGS QUALITY INTO ACCOUNT
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Th e tool’s forecasting power certainly got our attention,
but we would never adopt a quantitative tool simply
because it performed well in back tests. We have to be
satisfi ed that the tool’s power is likely to persist because
it captures important information about company
fundamentals not already captured elsewhere in our
investment process. Our research has convinced us that
this tool meets these criteria.
The Superiority of Cash EarningsSeveral academic research studies suggest that the
balance-sheet accrual tool captures information about
the likelihood that current-year earnings will persist
into the future. Although investors tend to take earnings
reports literally and treat all sources of earnings as equal,
the accrual component of earnings is less reliable then
the cash component.
Research published in 1996 by Professor Richard Sloan3
illustrates this point clearly. Sloan separated companies
into categories of high current accruals and low current
accruals and observed the changes in their return on
assets in the fi ve years before and aft er the measurement
date (Display 4). On average, reported earnings
and return on assets for the decile of companies with
the highest accrual growth increased rapidly prior to
the measurement date—but tended to reverse sharply
soon thereaft er.
Display 4Extreme BSAs Rapidly Revert to the Mean
Highest and lowest deciles of accruals each event year. Accruals defined as change
in non-cash current assets, less the change in current liabilities, excluding short-
term debt and taxes payable, minus depreciation expenses, and divided by average
total assets. Universe included about 2,000 US stocks per year, on average.
Source: Sloan, 1996
Sloan’s data also suggest that the speed of this reversion
was fastest in the component and return on assets related
to changes in balance-sheet accruals; the cash component
was more stable. In eff ect, this says that if you see rapid
accrual growth, be skeptical about the likely persistence
of company profi tability. Th e opposite pattern played
out with the lowest accrual stocks: Th e return on assets
recovered in the period ahead, as the depressing eff ect
from the change in accruals reversed.
Why should this be? Aft er testing hundreds of samples,
we concluded that balance-sheet accruals capture
four fundamental themes: unduly pessimistic or
optimistic accounting assumptions; deliberate earnings
management; capital management; and the mean
reversion of sales and earnings. We’ll discuss each of
these ideas in turn.
Pessimistic or Optimistic Assumptions Since accrual accounting entails subjective judgments,
reported earnings in this system frequently refl ect
management’s pessimism or optimism. Th us, two
management teams reviewing the same set of facts might
come to very diff erent conclusions about the appropriate
level of current-period earnings.
We can illustrate this with a hypothetical example of two
companies that start to see modest slowdowns in current
sales during a quarter. One company has a pessimistic
management team; the other, an optimistic management
team. Both end up with the same level of sales at the end
of the quarter.
Th e pessimistic management team might assume that the
disappointing sales indicate that a sustained downward
trend has begun. Th us, it might reduce its estimate of the
value of inventory in the warehouse and of the likelihood
of collecting on outstanding receivables. Th ese decisions
would reduce both current earnings and balance-sheet
accruals. Th e pessimistic management team might also
cut production to limit any further growth in inven-
tories from weaker sales. Again, this would hurt current
earnings as fi xed overhead costs were applied to fewer
units of output, while also reducing accrual growth. Th is
company would end up with an attractive BSA score.
THE FUNDAMENTAL VARIABLES THAT DRIVE BSAs
3 Richard G. Sloan, “Do Stock Prices Fully Refl ect Information in Accruals and Cash Flows About Future Earnings?” Th e Accounting Review, July 1996, vol. 71, no. 3
TAKING EARNINGS QUALITY INTO ACCOUNT
7AllianceBernstein |
By contrast, the company with the optimistic manage-
ment team assumes that sales growth will bounce back
quickly. Th us, it sees little need to lower inventories
or reassess receivables, and it maintains production
levels that build inventories and increase accruals. Th is
company would end up with a less attractive BSA score.
Although both companies fi nish the quarter with the
same level of sales, the pessimistic company would
report lower margins and earnings. Th e market would
probably react more negatively to this earnings report
than to the more optimistic company’s report.
At this stage, it’s impossible to know which management
is correct in the accounting assumptions that underpin
its earnings report. Th e balance-sheet accrual tool,
however, suggests that we should not be indiff erent. It
suggests that we would increase our chances of success
by investing in the company with the more pessi-
mistic (or conservative) management. Th is refl ects the
skewed market reactions to the possible outcomes for
each company.
If management at either company is ultimately proved
correct, there would be no earnings surprise and thus
no market reaction. If they are proved wrong, however,
the two managements would have to adjust their accrual
accounts or reverse them through earnings, creating
earnings surprises that would probably cause very
diff erent market reactions.
If the optimistic management that built inventories is
proved wrong, it would have to write down inventories
or cut production sharply in the future. Th e resulting
earnings shortfall would likely produce a big negative
surprise relative to investor expectations, with negative
implications for the stock price.
If the pessimistic management that had decided to
slow production is proved wrong, it would have to
increase production above normal levels, resulting
in higher margins as fi xed costs are spread over the
larger number of units of output. Furthermore, the
value of existing inventories and receivables would
be understated, and this extra value would have to
be reversed back into income in the period ahead.
In this case, there would be a positive surprise in
earnings, with positive implications for the stock price.
Display 5Earnings Surprise Is Skewed to Favor Low BSA Stocks
Optimistic Forecast Pessimistic Forecast
If Proved Correct No Surprise No Surprise
If Proved Wrong Negative Surprise Positive Surprise
Th us, in this example, the best outcome when investing
in the company with the optimistic management is
neutral; the worst outcome is potentially very negative.
Conversely, the worst outcome with the conservative
management is neutral, but the best outcome is very
positive (Display 5).
Earnings ManagementIn the example above, both management teams were
doing their best to be objective. At other times, the desire
to meet certain performance thresholds may aff ect their
judgment in making assumptions: Th is is oft en called
earnings management. Earnings management can range
from mild manipulation within the bounds of generally
accepted accounting principles to more severe distor-
tions and even outright fraud. While it is hard to measure
earnings management directly, there is indirect evidence
that it exists.
Several academic studies have demonstrated that earnings
reports cluster around certain thresholds: reporting
breakeven results, earning as much as in the prior period
and reaching consensus estimates. Degeorge et al.4 for
example, examined year-on-year changes in earnings
growth and found a sharp break in the bell curve at no
growth (Display 6, next page). Th ere are abnormally few
reports of a small decline in growth and an abnormally
large number of reports at—or just above—the previous
year’s earnings. Similar patterns of discontinuity can be
found at other break points, such as reporting positive
earnings and reporting earnings that match or exceed
the consensus.
Earnings management may play a large role in the
accrual reversal pattern that we saw in Sloan’s work on
the mean reversion of earnings and returns for high-
and low-accrual stocks. To the extent that a company
borrows from the future to meet today’s threshold, it
4 François Degeorge, Jayendu Patel and Richard Zeckhauser, “Earnings Manage-ment to Exceed Th resholds,” Journal of Business, 1999, vol. 72, no. 1
TAKING EARNINGS QUALITY INTO ACCOUNT
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Display 6Companies Manage Earnings to Meet or Beat Thresholds
Past valuations are no indication of future results.
Percentage change in reported earnings from four quarters earlier, based on quar-
terly data on 5,387 firms
Source: Degeorge, Patel and Zeckhauser, Journal of Business, 1999
will have a harder time meeting a future threshold—
with adverse implications for the stock price. Th is
pattern of borrowing simply cannot be sustained.
Th ere are many ways that companies can manage
earnings. In one famous example that the SEC called a
case of massive fraud, Sunbeam executives met earnings
targets by such techniques as shipping barbecue grills to
stores in the Northeast of the US—in December. While
the company met its sales targets for that year, it fell
short the next year because the stores either returned the
grills or ordered fewer than usual for the next season.
Th is method of earnings management is oft en referred
to as channel stuffi ng.
Another, more subtle technique involves timing the
recognition of gains on fi nancial contracts. If an insurance
company holds an investment in a bond yielding 5%
and rates drop to 4%, management could choose to
hold the bond to maturity, recognizing the extra yield
into earnings over the bond’s remaining life. Or, it could
sell the bond and replace it with a similar bond yielding
the market rate of 4%, realizing the earnings benefi t
immediately at the expense of future periods. Manage-
ments could defend either action as being in pursuit
of their long-term strategies. But the diff erence in how
generally accepted accounting principles treat the timing
of income recognition from the gain on sale versus the
higher interest income can allow managements to meet
thresholds by deciding to recognize more or fewer gains
on sale.
Sometimes, earnings management entails trying to
increase the odds that the company can meet a future
threshold. Oft en, this is done by taking one-time charges,
such as those related to a restructuring. For example, if a
restructuring entails closing a plant and laying off a large
number of workers, the company might take a charge
to earnings for writing off a multiyear lease on the
plant and paying various severance costs. Th ese charges
appear on the income statement immediately, but the
impact on current-year profi tability is generally ignored
by the market as a one-time event that is not relevant
to long-term earnings potential. Th ese expenses will
be paid from cash in future periods; thus, a liability is
established on the balance sheet.
When done correctly, accruing these types of charges may
fairly represent the company’s fi nancial performance. But
these types of accruals are very diffi cult to monitor from
the outside; thus, they are vulnerable to abuse. Manage-
ments can deliberately overestimate this type of reserve,
creating a “cookie jar” on the balance sheet that it can
raid in the future to fatten earnings: Management may
start to pay current-period costs out of the previously
established liability account, artifi cially raising current
earnings. Eventually, the reserve will be exhausted
and the ongoing costs will once again show up as
current-period costs in the P&L, potentially creating a
nasty surprise for investors.
It is almost never possible to know with certainty whether
management is manipulating such reserve or liability
accounts, so the reduction in these accrual accounts
should always be viewed with skepticism. Our BSA
tool captures this risk as the liability account declines,
because the change produces a relatively unattractive
BSA score. Th e tool is telling us that earnings appear to
be low quality, because the cash component of earnings
is low, refl ecting the use of balance-sheet cash to pay
costs that have not run through the current-period
earnings statement.
Capital ManagementTh e BSA tool always gives a poor rating to companies
that have completed large acquisitions because it
compares the pre-merger balance sheet of the acquirer
to the combined company’s post-acquisition balance
sheet. Th is may appear to be an unfair comparison of
apples and oranges, but we have found that dismissing
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9AllianceBernstein |
Display 7Acquirers Perform Worse than High-BSA Group Overall
Past valuations are no indication of future results.
Large acquisition or share issue inferred by an increase in market capitalization
over the prior year of 10% more than the stock-price appreciation would explain.
Annualized quarterly returns versus the equal-weighted US large-cap universe;
Bernstein BSA quintiles reformed quarterly.
Source: Center for Research in Security Prices (CRSP), Compustat and Bernstein
the negative signifi cance it imputes to these corporate
events would be a mistake. When we screened our large-
cap universe for acquirers, we found that the acquirers
underperformed the market by 5.6%, worse than the
4.6% average underperformance for the high-accrual
group (Display 7).
Th e accrual tool may simply be highlighting what we
have all come to know from experience: More oft en than
not, acquisitions are bad for the stock of the acquiring
company.5 A clash of cultures makes many deals fail; the
Time Warner/AOL combination is a classic example.
Th e tendency of acquirers to overpay at moments of
exuberance damages other deals. Corning, for one, paid
$4 billion in cash in late 1999 to buy Pirelli’s fi ber opera-
tions, which had sales of less then $40 million; it later
had to write off virtually the entire purchase price.
Mergers also depress stock prices when they are poorly
executed. Th is was vividly demonstrated in the 1990s
by a series of tangled rail mergers, as well as by several
bank deals that led to neglect of the core customer.
Even if the accrual tool simply captures what we already
know about acquisitions, it forces us to confront the
issue systematically. A more surprising part of the tool’s
effi cacy with regard to acquirers is how long the
performance penalty for acquisitions lasts. Th e BSA
tool captures an acquisition only aft er it has closed and
the combined balance sheet has been measured, oft en
many quarters aft er the announcement of the deal.
Although the market has had an extended period to
fi gure out the merits of the deal, acquirers on average
still underperform.
Th e mirror image of this phenomenon is found in
the quintile of low accruals, where restructurers
abound. Th e restructuring subset of the low-accrual
group outperformed the market by 7.8%, signifi cantly
more than the 4.7% average for all low-accrual stocks
(Display 8). Conceptually, the balance-sheet accrual tool
may be signaling that management is ridding itself of a
distraction. It may also be signaling that returning money
to shareholders instead of making potentially low-return
investments oft en turns out to be a good thing.
It may be tempting to shrug and dismiss write-off s as
no more then a pen stroke with little economic impact,
but this, too, would oft en turn out to be a mistake.
When we screened for companies that had taken large
write-off s and then measured their performance in
the subsequent period, we found that on average they
outperformed the market by 5.9%, better than the 4.7%
average for low-accrual stocks. Sometimes, write-off s
signal the beginning of the end of a large retrenchment.
Oft en, the underlying business is close to stabilizing
and improving.
Display 8Restructurers Outperform Low-BSA Group Overall
Past valuations are no indication of future results.
Large disposals or share buybacks inferred by a decrease in market capitalization
over the prior year of at least 10% more than stock-price change would explain.
Large write-offs defined as net income at least 20% lower than income before
extraordinary items, with a difference of at least $5 million. Group with
disposals/buybacks and group with write-offs may overlap. Annualized quarterly
returns versus the equal-weighted US large-cap universe; Bernstein BSA quintiles
formed quarterly.
Source: CRSP, Compustat and Bernstein
5 Of course, not all acquisitions destroy shareholder value. Vadim Zlotnikov, my colleague at Sanford C. Bernstein & Co. LLC, a unit of Alliance Capital, recently showed that accretive acquisitions tend to be of smaller companies with transparent business models, which were purchased with cash for a price justifi able without claiming synergies. Acquisitions within a company’s cur-rent line of business are more likely to be good for the acquirer’s future stock performance than diversifying acquisitions. More surprisingly, paying a pre-mium to the last trading price of the acquired companies’ stock tends not to be a signal of future underperformance. Th e key price issue is whether the price paid is consistent with current industry valuations. See Vadim Zlotnikov, “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” Bernstein Research Call, January 24, 2005.
(Continued on page 12)
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| AllianceBernstein10
When we fi nd an investment tool that works in
one market, we always see if we can use it in other
markets as well. Usually, our research shows that we
can; this reinforces our belief that investor behavior
is the same the world over.
Studying the usefulness of our BSA tool worldwide,
however, presented some stiff challenges. Th ere is
virtually no literature available on its use outside
the US,* perhaps in part because the signifi cant
variations in accounting from country to country
make comparisons between accounting-based tools
diffi cult. Th e gradual adoption of International
Accounting Standards around the world will make
accounting in many countries more similar to that of
the US in ways that are promising for the effi cacy of
the BSA tool. However, it also creates discontinuous
balance sheets that could distort the results of a
historical study.
Lastly, there is the perennial problem that the data
set for markets outside the US is neither as long-
Display ABSA Tool Works Well Around the World
Return vs. Market 1991–2003
USEuropeex UK UK Japan Canada Australia
Lowest BSAs 3.0% 3.0% 1.7% 0.9% 0.7% 4.3%
Highest BSAs (3.3) (2.8) (1.2) 0.1 (4.7) (4.6)
Spread 6.3 5.8 2.9 0.8 5.4 8.9Bernstein investment universe for each country or region, excluding
financials, was divided into balance-sheet accrual quintiles on a quarterly
basis using Bernstein definition of net operating accruals. Highest BSAs
represents the two BSA quintiles with the highest BSAs; lowest BSAs is
the two quintiles with the lowest BSAs. Stock performance evaluated
quarterly relative to equal-weighted universe and then annualized.
Source: Compustat, CRSP, Morgan Stanley Capital International (MSCI),
Worldscope and Bernstein
dated nor as robust as the data set for the US
market, and carving up smaller markets into
quintiles makes the sample sizes very small indeed.
We solved this last problem by using the top and
bottom 40% (two quintiles) rather than the top and
bottom quintile. Sparse data on some balance-sheet
items, meanwhile, forced us to exclude fi nancial
companies from the non-US data.
Despite these diffi culties, our initial results were
encouraging. In each market we examined, low-
accrual stocks beat high-accrual stocks. Th e spreads
for Europe, Canada and Australia were substantial;
those for the UK and Japan, relatively small (Display
A). Th e latter concerned us because Japan and the
UK make up such a large share of the global and
international markets. When we refi ned the data, the
results improved for the UK and Japan (Display B).
For Japan, we substituted data from Nomura
Securities for Worldscope’s data because it included
more companies. We also applied a narrower
defi nition of BSAs that focused on changes in
payables and receivables until 2000, when Japan
began to require consolidated reporting for its
Display BRefining the Tool Improved Effectiveness in UK and Japan
Return vs. Market 1991–2003
USEuropeex UK UK Japan Canada Australia
Lowest BSAs 3.0% 3.0% 2.1% 1.9% 0.7% 4.3%
Highest BSAs (3.3) (2.8) (1.8) (1.9) (4.7) (4.6)
Spread 6.3 5.8 3.9 3.8 5.4 8.9For US, Europe, Canada and Australia, quintiles were formed using
Bernstein definition of net operating accruals. For the UK, universe
excludes companies f lagged for M&A prior to 2000. For Japan, Nomura/
Nikkei data divided into quintiles based on current operating accruals
prior to 2000.
Source: Compustat, CRSP, MSCI, Nikkei Financial, Nomura Securities,
Worldscope and Bernstein
* Th e articles we found were Morton Pincus, Shivaram Rajgopal and Mo-han Venkatachalam, “Th e Accrual Anomaly: International Evidence,” March 2003; and H. Otani, “Discretionary Accruals: Th e Impact of Earnings Management on Stock Price,” Nomura Global Quantitative Research, February 27, 2004 (English translation).
BSAs: CAN YOU EXPORT THE CONCEPT?
TAKING EARNINGS QUALITY INTO ACCOUNT
11AllianceBernstein |
companies and disclosure of cash fl ows. Aft er
that, we switched to the broad defi nition we
used elsewhere.
For the UK, we excluded acquirers from the
universe because until 1998, purchase accounting
was handled quite diff erently in the UK than in
the US and elsewhere. In the US and elsewhere,
an acquirer’s balance sheet increases with an
acquisition. Under the old UK rules, however, the
acquirer immediately wrote off all goodwill related
to the transaction, so the balance-sheet increase was
much smaller—and sometimes even negative.
You can see this in the case of Vodafone (Display
C). Its balance sheet in March 1998 showed net
assets declining by more than 50% over the prior
year, even though it had made large acquisitions in
the French and Dutch telecom markets during that
period. Only if you read the footnotes and adjusted
for the full value of the acquisitions—including the
associated goodwill—would you have discovered
that its net assets actually grew by more than 20%. In
other words, Vodafone’s true BSAs were expanding
rapidly rather than shrinking.
Display CUnder Old UK Rules, Acquisitions Could Shrink a Firm
Vodafone 1998 As ReportedPro Forma for Rule Change
Beginning Net Assets £829 Mil. £829 Mil.
Change in Assets ex Goodwill 186 186
Goodwill Acquired in 1998 (635) —
Ending Total Net Assets 380 1,015
Change –54% +22%Source: Company reports and Bernstein estimates
Display DBSAs Worked Much Better in UK After Accounting Change
Return vs. UK Market
1991–1999 2000–2003
Lowest BSAs 1.2% 2.6%
Highest BSAs (0.1) (3.7)
Spread 1.3 6.3Bernstein investment universe for UK, excluding financials, divided
into BSA quintiles annually using Bernstein definition of net operating
accruals; quarterly performance annualized.
Source: MSCI, Worldscope and Bernstein
Because of this accounting treatment, the BSA tool
has been less eff ective in the UK historically. Since
the UK adopted purchase accounting rules more
similar to those in the US, however, it has become
dramatically more eff ective. Th e spread increased
from a little over 1% to in excess of 6% (Display D).
Of course, it’s not safe to generalize too much from
four years of data, but given what we know about
how the tool works elsewhere—and why—we are
confi dent that it should work well in the UK.
We are continuing to improve our research on the
effi cacy of using BSAs in other markets, and we hope
to introduce the tool into the investment process for
our non-US portfolios sometime in 2005. ■Please note: Past valuations are no indication of future results.
TAKING EARNINGS QUALITY INTO ACCOUNT
| AllianceBernstein12
But the write-off subset of low accruals is tricky. It
includes some spectacular turnarounds, such as Chrysler
in the early 1990s, Applied Materials just before a big
run-up in the semiconductor sector in 1999 and, more
recently, the upturn at Xerox (Display 9, top). It also
includes some spectacular fl ameouts: companies that
never recovered, such as Woolworth and Fruit of the
Loom, and companies, such as Circuit City Stores and
LSI Logic, that got worse before they got better (Display
9, bottom). Indeed, seven of the 10 big bankruptcies of
recent years passed through the fi rst quintile of BSAs.
Th us, research judgment is crucial to making successful
investments in these situations. Earnings revisions data
may also help to separate the wheat from the chaff , as we
will later show.
Display 9Some Restructurings Succeed…
Company NameFlagged for Write-Off
Relative Return Next 12 Months
Applied Materials April 1999 190%
Chrysler January 1992 165
Phelps Dodge January 2003 102
Kroger April 1990 82
Xerox October 2002 76
…While Other Restructurings Fail
Company NameFlagged for Write-Off
Relative Return Next 12 Months
Fruit of the Loom July 1998 –89
Circuit City Stores April 2000 –87%
Kmart October 1999 –65
Woolworth October 1997 –60
LSI Logic January 2000 –59Past valuations are no indication of future results.
Total returns relative to the S&P 500 for select companies with large write-offs
in the most attractive quintile of BSAs. Large write-offs defined as net income at
least 20% lower than income before extraordinary items, with a difference of at
least $5 million.
Source: Compustat and Bernstein
Mean Reversion of Sales and EarningsOur examination of high-accrual stocks produced
another surprising fi nding: From a sales and a return-
on-equity perspective, on average these stocks had been
very successful in the recent past. From 1978 to 2003, the
companies with the highest accrual growth on average had
17.5% sales growth in the previous year—far better than
the 2.7% average for low-accrual companies (Display 10).
Th e high-accrual stocks were also more profi table, with
an average ROE 1.2 percentage points above the market
average, while the low-accrual companies’ average ROE
was 2.2 percentage points below the market average.
Taken at face value, this would imply that the BSA tool
is somehow unfairly penalizing companies that have
recently been successful and that have been growing
quickly. Th is implication, however, confl icts with our
fi nding that the tool is actually quite eff ective when
applied to a universe of growth stocks.
Our research suggests that some of the diff erence in
stock performance between high- and low-accrual
stocks relates to the diffi culty of sustaining above-market
sales growth and profi tability. When companies are
successful in these ways, their managements, anchored
in recent experience, typically become optimistic:
Th ey order more inventory, plant and equipment, or
distribution outlets—or perhaps pay a high price for
an acquisition—because they expect their success
to continue.
Display 10Success Can Lead to High BSAs
Past valuations are no indication of future results.
Average trailing one-year sales growth for BSA quintiles reformed quarterly
Source: Compustat and Bernstein
(Continued from page 9)
TAKING EARNINGS QUALITY INTO ACCOUNT
13AllianceBernstein |
But success is notoriously diffi cult to sustain for long
periods. Successful companies attract competition,
and fads fade. As a result, growth oft en decelerates
and profi tability declines. Th us, optimistic manage-
ments frequently fi nd themselves with excess inventory
they need to discount or write off , plants they need to
shutter, employees they must lay off and goodwill from
high-priced acquisitions they must write off . Such stocks
oft en sell at loft y valuations because the market oft en
shares management’s optimism. Th us, they oft en under-
perform massively when investors recognize that the
company’s growth prospects are decelerating and that
management has overbuilt capacity in the expectation of
continued growth.
Th e market tendency to extrapolate—oft en incor-
rectly—from recent success or failure can be seen clearly
by looking at consensus forecasts and returns for high-
and low-accrual stocks. On average, the highest-accrual
companies had trailing return on equity 1.2% above the
market average, and as a group, sell-side analysts—as
measured by I/B/E/S—have expected them not only
to sustain their above-average ROE, but to improve it
(Display 11, top). Instead, their ROE declined: Although
the high-accrual companies maintained an above-
average ROE, they failed to match both expectations and
their own prior performance.
Th e pattern played out again the following year: Analysts
lowered their ROE expectations yet still expected the
high-accrual companies to be above average, but the
group failed to match the lowered expectations. Aft er
just two years, the high-accrual companies on average
had slightly below-average ROE.
Th e low-accrual stocks, by contrast, started out less
profi table than the market (Display 11, bottom). Analysts
predicted improvement, forecasting an ROE defi cit that
narrows to about 1% less than the market. Manage-
ments, however, adapted to the challenges they faced,
and on average they succeeded, delivering a better-than-
expected ROE.
Th e next year, analysts raised their ROE estimates for this
group to about equal to the market average, but again,
they underestimated the magnitude of the change. Th e
group now surpassed the market ROE. ■
Display 11Analysts (Wrongly) Expect High Profitability to Persist…
…and Underestimate Recovery for Low-Profit Companies
Past valuations are no indication of future results.
ROE relative to US large-cap universe and I/B/E/S one-year forecast for highest and
lowest quintiles of BSAs, using Bernstein definition
Source: Compustat, I/B/E/S and Bernstein
TAKING EARNINGS QUALITY INTO ACCOUNT
| AllianceBernstein14
Is the BSA Tool Biased Against High-Growth Companies?When we fi rst began sharing our research on BSAs with
our fi rm’s own analysts, we encountered an immediate
suspicion that the tool was biased against companies with
rapid growth. Th e mean reversion of ROEs shown in the
previous section and the concentration of slow trailing
sales growth in the attractive BSA quintile reinforced
this view.
Isn’t it right and natural for companies with growing
sales to increase their balance sheets? Aft er all, analysts
generally study changes in inventory and receivables
relative to sales. Our fi nding that the tool worked within
the growth domain as well as the market as a whole gave
us some confi dence that the tool wasn’t biased against
growth stocks, but we decided to study the apparent bias
against prior sales growth.
Following a trail blazed by Professor Hong Xie,6 we
tried refi ning the accrual metric to diff erentiate between
“normal” accruals and “excess” accruals. We defi ned
accrual growth equal to sales growth as normal, accrual
growth in excess of sales growth as excessive and accrual
growth slower than sales growth as low. We then tested
whether adding information about trailing sales would
make the tool more indicative of the performance of
growth companies.
First, we deducted sales growth from the unadjusted
growth in accruals. If accruals grew 10% but sales grew
25%, adjusted accrual growth would be negative 15%
(Display 12). In this case, the company would get credit
for restraining accrual growth relative to sales, rather
than a penalty for expanding its balance sheet. We also
tried several other formulations that adjusted accrual
growth for trailing sales growth.
We measured the correlation of each of these formula-
tions to the change in future stock price. Like Professor
Xie, we found that the unadjusted version was a better
signal of future stock performance. Th e more credit we
gave for sales growth as an explanation for the growth in
accruals, the worse the tool performed.
We also measured the performance of the adjusted and
unadjusted tool over time. For the adjusted version
that gives half credit for sales growth (the best of the
modifi ed formulas we tried), low-accrual stocks beat
high-accrual stocks by about 7.2% a year on average—a
nice amount, but about 200 basis points less than our
original unadjusted version (Display 13).
Display 12BSA Tool Can Be Adjusted for Sales Growth…
BSAs Adjusted for Sales GrowthUnadjusted BSAs Total Sales 1/2 Sales
Accrual Growth +10.0% +10.0% +10.0%
– Sales Growth N/A 25.0 12.5
= Adjusted Score +10 (15) (2.5)Trailing one-year sales growth for Bernstein US large-cap growth universe
Display 13…but That Makes It Less Effective…
Indexed to 100 on December 31, 1977; return vs. US large-cap universe. Large-cap
universe divided into balance-sheet accrual quintiles using Bernstein definition
of net operating accruals, based on quarterly data. Trailing one-year sales growth;
quintiles formed monthly. Adjusted version gives half credit for sales growth.
Source: Compustat and Bernstein
Display 14…Because Sales Growth Tends to Revert to the Mean
Past valuations are no indication of future results.
Trailing one-year sales growth for Bernstein US large-cap universe
Source: Compustat and Bernstein
BSAs AND GROWTH INVESTING
(15)
(10)
(5)
0
5
10
15
20
Year 5Year 4Year 3Year 2Year 1Year 0
1972-2003
Company vs. Market Sales Growth
6 Hong Xie, “Th e Mispricing of Abnormal Accruals,” Th e Accounting Review, July 2001, vol. 76., no. 3
TAKING EARNINGS QUALITY INTO ACCOUNT
15AllianceBernstein |
Why BSAs Work Within the Growth ArenaTh e reason that adding trailing sales growth to the
accrual equation diluted, rather than enhanced, the
tool’s effi cacy may be quite simple: Trailing sales growth
is not a good predictor of future sales growth. When we
divided our universe of large-cap US stocks into quintiles
on the basis of trailing sales growth and looked at their
subsequent sales growth, we found that the sales growth
of the fastest and slowest quintiles regressed to the mean
at an astonishing speed (Display 14).
Mean reversion—the value investor’s friend—is the
growth investor’s enemy. As my colleagues in Alliance
Capital’s Growth Equity business say, the challenge for
growth investors is to identify companies that will beat
the odds and sustain their superior growth. Th us, in many
instances, justifying rapid accrual growth by pointing to
trailing sales growth turns out to be a mistake.
If trailing sales growth doesn’t justify fast accrual growth,
does future sales growth? To study this, we fi rst divided
our universe of large-cap US stocks in half on the basis of
actual sales growth over the next 12 months. We found
that the half with above-average sales growth outper-
formed the market by 3.7% a year on average, while the
half with below-average sales growth underperformed by
3.1%. Th us, a hypothetical growth investor with perfect
foresight about future sales growth would do quite well
by focusing his or her portfolio on those stocks with
the highest future sales growth. As Display 15 shows,
companies with above-average growth outperformed all
other companies by about 6.8%.
Display 15BSA Tool Helps Whether or Not Future Sales Growth Is Strong
Annual Returns vs. Market 1978–2003
Next Year Sales Growth1 All Stocks Low BSA2 High BSA2
Above Market Average +3.7% +5.5% +1.7%
Market Average or Below –3.1 –0.6 –8.6
Spread 6.8 6.1 10.3Past valuations are no indication of future results.
One-year forward returns versus equal-weighted US large-cap universe
1Assuming perfect foresight of sales growth over the next year
2Low BSAs defined as Q1–Q3 and represent roughly 50% of stocks in the
above-market sales category. High BSAs defined as Q4–Q5.
Source: Compustat and Bernstein
Our next step was to see whether the BSA tool would
be of any use to the analyst with perfect foresight about
future sales growth. To do so, we divided the stocks with
above-average future sales growth into two groups: the
three quintiles with the lowest (most attractive) BSAs
and the two quintiles with the highest (least attractive)
BSAs. Historically, about half of all fast-growth stocks
fall into the three most attractive BSA quintiles, creating
plenty of fertile ground for the growth investor.
We found that the portfolio of rapid-growth stocks that
also had more attractive BSA scores did better than the
rapid-growth stocks as a whole—it outperformed the
market by 5.5% a year, on average, as Display 15 also
shows. Th e other half of the rapid growth stocks—those
in the highest two quintiles of BSAs—did worse but still
outperformed the overall market. Th us, the rapid accrual
growth was justifi ed by rapid sales growth.
Perhaps the more interesting results came from
looking at the stocks that turned out to have average or
below-market future sales growth. Th e companies
in this group with attractive BSA scores lagged the
market slightly. Th ose with unattractive BSA scores were
severely penalized.
A closer look at the worst-performing segment—stocks
with high BSAs and below-average sales growth—
showed that the vast majority had above-average sales
growth in the prior year. Th is reinforces the view that
their managements may have been growing the balance
sheet because a period of fast growth had made them
optimistic. Disaster struck when the continued growth
they expected failed to materialize.
Using BSAs in the Growth ArenaAnother potential concern about using the BSA tool in
the growth arena is that there may be entire industries
with rapid balance-sheet growth, refl ecting a period of
rapid expansion or innovation. In many cases, it may
be impractical for the growth investor to avoid such
an industry entirely. Furthermore, the analyst may
conclude that the growth in accruals is warranted,
given the analyst’s outlook for the business. Th us, we
examined the eff ectiveness of the BSA tool in forecasting
performance within an industry.
TAKING EARNINGS QUALITY INTO ACCOUNT
| AllianceBernstein16
Th e results of this work were quite encouraging. In
decomposing the overall benefi t of the BSA tool, we
found that the quintile of stocks with the lowest balance-
sheet accruals relative to the industry outperformed
their industry by 3.8%, while the quintile with the
highest accruals underperformed their industry by 4.7%
(Display 16). Th e spread between the two quintiles was
8.5%. Th us, it could be argued that most of the premium
the tool has delivered comes from helping the investor to
select stocks relative to their own industry. Th is suggests
that paying attention to earnings quality as measured
by accrual growth should not disrupt the investment
process within growth industries. When considering
an investment within an industry with rapid accrual
growth, the investor should simply have a bias, all other
things being equal, toward the company or companies
with slower accrual growth.
Display 16BSA Tool Works Well Within Industries
Indexed to 100 on December 31, 1977; return vs. US large-cap universe. Large-cap
universe divided into balance-sheet accrual quintiles monthly using Bernstein defi-
nition of net operating accruals, based on quarterly data.
Source: Compustat and Bernstein
Our conclusion is that the BSA tool should be comple-
mentary to a growth investment process. Although
the most attractive BSA quintile has historically had
slow trailing sales growth, the population of stocks
with fast future sales growth and above-average BSA
scores is actually quite large. Historically, growth
investors would have improved their performance by
focusing on the intersection of the two variables. When
expectations of future rapid sales growth have been
met, the slower-accrual growth subset has outper-
formed. More importantly, when stocks fail to meet
expectations of future rapid sales growth—and especially
when they have failed to match the market average—the
high-accrual growth subset has underperformed by a
wide margin. Avoiding this downside has been quite
rewarding. In this sense, the BSA tool can be seen
as valuable protection against forecast risk for the
growth investor. ■
TAKING EARNINGS QUALITY INTO ACCOUNT
17AllianceBernstein |
Our understanding of the fundamentals behind the BSA
tool gave us the confi dence to begin using it as part of
the fundamental research process in our US large-cap
value portfolios. Although our analysts already paid
close attention to cash fl ows and balance-sheet issues, we
have found that the BSA tool provides a helpful disci-
pline: It focuses our analysts’ attention on subtle signals
of incipient changes in earnings quality. In addition, by
quantifying companies’ accruals relative to the market,
the BSA tool gives our analysts a way to compare all the
companies they cover, regardless of size, growth rate or
other characteristics.
At the same time, we turned our quantitative research
eff ort to seeing whether the information the tool captured
was additive to the information captured by other tools
used in our value investment process. We found that it
was: Th e tools work better in combination than alone.
Are BSAs Additive to Value?We fi rst looked at how the BSA tool interacted with our
dividend discount model (DDM), our primary measure
of value. As we have described, the accrual tool simply
measures changes in accruals relative to the balance
sheet; it does not take into consideration how much we
are paying for high- or low-accrual growth. While our
quantitative research had shown that the tool has been
very eff ective within the value domain, defi ned by naive
measures such as price to book or price to sales, it was
possible that our research-driven DDM already captured
the information in the BSA tool. Aft er all, our DDM
links the share price to our analysts’ forecasts of long-
term earnings power, and our analysts have historically
paid close attention to balance sheets and cash fl ows
when generating their forecasts.
Th e results from combining the BSA tool with our
DDM were quite encouraging. On its own, the cheapest
quintile of our DDM has outperformed the market by 4.4
percentage points on average from 1980 to 2003 (Display
17). But within that group, the stocks with low balance-
sheet accruals did much better: they outperformed the
market by more than 10%.
Display 17BSAs Enhance the DDM
Past valuations are no indication of future results.
Average forward-quarter return relative to equal-weighted US large-cap universe
for intersection of cheapest quintile of Bernstein dividend discount model with
each Bernstein BSA quintile.
Source: Bernstein
Cheapness, however, was not adequate protection
against high-accrual growth. Th e stocks in the cheapest
quintile of our DDM with high accruals underperformed
the market slightly. Th is implies that our view of what is
attractively valued should be tempered when accruals
have grown rapidly. Because a company’s reported
fi nancial history is oft en a factor in setting our forecast,
a high BSA score may imply that this starting point is
too high.
Are BSAs Additive to Earnings Revisions?Next, we looked at how BSAs work in conjunction with
earnings revisions, which have historically been eff ective
at gauging stock returns in the short term. Stocks with
upward earnings revisions relative to the market tend
to outperform in the near term, while stocks with
negative revisions underperform. We think the effi cacy
of earnings revisions is a result of anchoring: People tend
to be mired in their current reality, and when confronted
with new but confl icting information, they tend to
change their outlooks incrementally. Analysts’ earnings
revisions thus tend to go up and down incrementally,
and stock prices tend to move with them.
Our research shows this holds true within BSA quintiles
as well. When we isolated stocks with very positive
earnings revisions versus the market and measured their
forward monthly returns (the revision tool is a short-term
indicator), we found that low BSA stocks with positive
revisions did very well, outperforming by 1.8% a month,
much better than the 0.5% average outperformance of
the total low-accrual group (Display 18, next page).
BSAs AND VALUE INVESTING
TAKING EARNINGS QUALITY INTO ACCOUNT
| AllianceBernstein18
Display 18BSAs Complement Earnings Revision Tool When BSAs Are Low…
Large positive revisions are stocks with I/B/E/S 1-month revision index at least
0.4% above market. Monthly performance versus equal-weighted US large-cap
universe; Bernstein BSA quintiles reformed quarterly.
Source: Compustat, I/B/E/S and Bernstein
Th is makes sense when we remember that the low-BSA
category has a relatively large share of companies that
were growing slowly or restructuring: Th e biggest risk
of investing in this category is that the restructuring
will persist further into the future, making the invest-
ments premature. Looking at positive revisions adds an
interesting new dimension. Sell-side analysts, who our
BSA research suggests are not suffi ciently focused on
balance sheets, see independent evidence that things are
getting better.
Low-BSA stocks with negative revisions, on the other
hand, underperform the low-accrual group as a whole.
In this case, negative revisions may signal that more bad
news is ahead. Th at is, the BSA tool helps investors to
diff erentiate between the spectacular turnarounds and
fl ameouts in the low-accrual category.
On the other extreme, stocks with high balance-sheet
accruals and negative revisions underperformed the
market by 0.9% per month, worse than the high-accrual
group overall (Display 19). Th is, too, makes sense. Th e
high accruals tell us the company has just expanded
rapidly. Th e negative earnings revisions tell us that
analysts are seeing separate information implying that
growth is not meeting expectations. Th is has been a
pretty good signal to avoid the stock: Investors paying
a high premium for superior growth typically react very
badly to disappointment.
If, however, the expansion is met with continued
earnings estimate increases, the odds are that the
balance-sheet expansion was warranted. However, these
stocks still don’t do signifi cantly better than the market,
implying that the good news may have been largely
discounted in the stock price.
Display 19…and When BSAs Are High
Large negative revisions are stocks with I/B/E/S 1-month revision index at least
0.4% below market. Monthly performance versus equal-weighted US large-cap
universe; Bernstein BSA quintiles reformed quarterly.
Source: Compustat, I/B/E/S and Bernstein
In conclusion, our research implies that adding the BSA
tool to value measures should increase expected returns
for value portfolios. Since value investors are more likely
to look at companies that are growing slowly, restruc-
turing operations or writing off assets, adding earnings
revisions is also important to better judge the timing of
purchases and sales.
Putting the BSA Tool to WorkOur investment process marries our fundamental
insights with quantitative risk control and timing tools.
In Bernstein’s US large-cap value portfolios, we start
by using our dividend discount model to determine
the relative attractiveness of each stock by relating its
stock price to our long-term forecast of its earnings and
free cash fl ow. We quantify this so we can compute the
expected return of each stock relative to the market. Our
timing tools—relative stock performance and earnings
revisions—provide perspective on whether this is the
best time to purchase or sell an individual stock; they
may add or detract from the expected return. Finally, our
factor risk model quantifi es the degree to which a stock
would diversify the portfolio or add to its concentration
in terms of sector or traits such as capitalization, value or
earnings variability. Th e combination of all these factors
gives us a risk-adjusted expected return.
Aft er studying the linkage between the BSA score and
subsequent stock performance, we now also quantify
how much the stock’s BSA score would add or subtract
from its risk-adjusted expected return. In some cases,
BSAs might lower our risk-adjusted expected return for
a stock so much that we would decide not to buy the
stock. In other cases, such as Medco HealthSolutions,
TAKING EARNINGS QUALITY INTO ACCOUNT
19AllianceBernstein |
the BSA tool has prompted us to accelerate our purchase
of the stock.
Medco HealthSolutions is a pharmaceutical benefi ts
management fi rm that appeared to be attractively valued
last summer. It provides a useful example of both the
mechanics of the tool and how it can guide research. In
this case, however, we had to fi rst adjust for some trans-
actions related to its spin-off from Merck.
To analyze Medco’s BSA growth, we divided its adjusted
net BSA growth over the 12 months ending March 2004
by its average balance sheet in that period and compared
it to the market average. Medco’s BSA score of negative
1.5% was much better than the market average of positive
5.9% (Display 20).
For our analyst, this was just a starting point. Th e
shrinkage in Medco’s accruals, he found, had two drivers
(Display 21). First, net property, plant and equipment
were down sharply because Medco was closing some
less-effi cient call centers and mail-order pharmacies and
thus had accelerated its depreciation of those facilities.
Second, Medco had accelerated the amortization of an
intangible asset created when Merck acquired Medco in
1993. Merck had attributed part of the price it paid to the
present value of customer relationships and amortized
them over 35 years. Since customer retention has fallen
in the past few years, those assets have shorter lives than
Merck initially assumed; Medco now amortizes them
over 23 years.
Display 20Applying BSAs: The Medco Example
BSA Score = Net Change/Total Assets
Net Change in Accruals $(150) Mil.
Average Total Assets $10,336 Mil.
Medco BSA Score (1.5)%
Market Average BSA Score 5.9%Past valuations are no indication of future results.
Net change March 2004 vs. March 2003 adjusted for transactions related to its
spin-off from Merck; BSA scores as of early July 2004.
Source: Company reports, FactSet and Bernstein
Display 21Medco’s BSAs Fell with PP&E and Intangibles
$ Millions
Mar 03 Mar 04 Change
Net Working Capital $515 $583 $68
Property, Plant and Equipment 816 718 (98)
Intangibles and Other Assets 5,834 5,708 (126)
Operating Liabilities (1,221) (1,215) 6
Net Change $(150)Past valuations are no indication of future results.
Source: Company reports and Bernstein
Together, the accelerated depreciation and amortization
made Medco’s reported earnings look worse than the
company’s true earnings potential. Although the amorti-
zation of intangibles is purely an accounting matter,
capital spending had fallen below depreciation—and
our research indicates that capex could remain low for
many years. Th e BSA tool, we concluded, was telling
us that the company was doing somewhat better than
its recent reported earnings implied (Display 22). Our
fundamental research, meanwhile, showed a growing
trend toward use of mail-order prescriptions and a
greater emphasis on generic drugs, both of which are
positive for Medco’s earnings. When we combined the
fundamental information the BSA tool was capturing
with the positive implications of these industry trends,
we concluded that Medco was priced attractively relative
to its earnings potential, and we established a position in
the stock. ■
Display 22Medco Earnings Power Is Better Than It Appears
Past valuations are no indication of future results.
Source: Company reports and Bernstein
Please Note: References to Medco HealthSolutions are presented to illustrate the applications of our investment philosophy only and are not to be considered recommendations by AllianceBernstein. Th e specifi c securities identifi ed and described above (and in this report) do not represent the securities purchased, sold or recommended for any AllianceBernstein portfolio, and it should not be assumed that investments in any security identifi ed here will continue to be profi table. We will, upon request, furnish a listing of all investments made during the prior one-year period.
TAKING EARNINGS QUALITY INTO ACCOUNT
| AllianceBernstein20
The following selection of papers informed our research into balance-sheet accruals.
Ahmed, Anwer S., S.M. Khalid Nainar, and X. Frank Zhang. Further Evidence on Analyst and Investor Mis-Weighting of Prior Period Cash Flows and Accruals. May 2003.
Beaver, William H., Maureen F. McNichols, and Karen K. Nelson. An Alternative Interpretation of the Discontinuity in Earnings Distributions. February 2003.
Burgstahler, David. Incentives to Manage Earnings to Avoid Earnings Decreases and Losses: Evidence from Quarterly Earnings. August 1997.
Collins, Daniel W., and Paul Hribar. Errors in Estimating Accruals: Implications for Empirical Research. September 2000.
Degeorge, François, Jayendu Patel and Richard Zeckhauser, “Earnings Management to Exceed Thresholds.” Journal of Business, 1999, vol. 72, no. 1.
Desai, Hemang, Shivaram Rajgopal, and Mohan Venkatachalam. The Relation between Value-Glamour and Accruals Mispricing. July 2003.
Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi Yohn. Accrued Earnings and Growth: Implications for Earnings Persistence and Market Mispricing. November 2001.
Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi Yohn. The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Return on Assets. June 2002.
Frank, Mary Margaret, and Sonja Olhoft Rego. Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets? July 2003.
Louis, Henock. Earnings Management and the Market Performance of Acquiring Firms. October 2002.
Lui, Daphne W. When Accruals Meet Growth: Do Analysts’ Forecasts Fully Reflect the Future Earnings Implications of Accruals and Growth? October 2003.
Nelson, Mark W., John A. Elliott, and Robin L. Tarpley. “How are Earnings Managed? Examples from Auditors.” Accounting Horizons, 2003.
Otani, H. “Discretionary Accruals: The Impact of Earnings Management on Stock Price.” Nomura Global Quantitative Research. February 27, 2004 (Japanese original, December 8, 2003).
Penman, Stephen H., and Xiao-Jun Zhang. Accounting Conservatism, the Quality of Earnings, and Stock Returns. December 1999.
Pincus, Morton, Shivaram Rajgopal, and Mohan Venkatachalam. The Accrual Anomaly: International Evidence. March 2003.
Sloan, Richard G. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” The Accounting Review, July 1996, vol. 71, no. 3.
Richardson, Scott. “Earnings Quality and Short Sellers.” Accounting Horizons, 2003.
Richardson, Scott A., Richard G. Sloan, Mark T. Soliman, and Irem Tuna. Accrual Reliability, Earnings Persistence and Stock Prices. July 2003.
Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Management and the Long-Run Market Performance of Initial Public Offerings.” Journal of Finance, vol. LIII, no. 6, December 1998.
Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Management and the Underperformance of Seasoned Equity Offerings.” Journal of Financial Economics, June 1997.
Thomas, Jacob K., and Huai Zhang. Inventory Changes and Future Returns. December 2001.
Xie, Hong. “The Mispricing of Abnormal Accruals.” The Accounting Review, July 2001, vol. 76, no. 3.
Zach, Tzachi. Inside the “Accrual Anomaly.” June 2003.
Zlotnikov, Vadim. “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” Bernstein Research Call, January 24, 2005.
Bibliography
TAKING EARNINGS QUALITY INTO ACCOUNT
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