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 future earnings 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? www.alliancebernstein.com There is no guarantee that any forecast or opinions in this material will be realized. Information should not be construed as investment advice. Investment Products Offered • Are Not FDIC Insured • May Lose Value • Are Not Bank Guaranteed Executive Summary ■ Building upon academic studies, our research has ■ Th e BSA tool could help growth investors by found that changes in balance-sheet accruals scaled to underlining the risk that trailing sales growth and re- the size of the balance sheet are a powerful indicator turn on equity will rapidly revert to the mean. of future earnings and stock prices. Within the large- cap US market, for example, low BSA stocks outper- ■ We have integrated the tool into Bernstein’s risk- formed high BSA stocks by 9.3% a year on average from adjusted return model for US value portfolios and 1978 to 2003. hope to introduce it into all of the Bernstein value portfolios in 2005. Our research shows the BSA ■ Our BSA tool captures the risk that the accrual com- tool has a very low correlation with our valuation ponent of earnings is not reliable and thus will not metrics and thus is picking up diff erent information. persist. Th e unreliability typically stems from the way We have also found that the tool enhances our management optimism or pessimism infl uences the fundamental research by providing a disciplined, assumptions used in estimating accrual accounts, as quantitative framework for comparing company well as earnings management, capital management balance sheets. 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. About the Author John P. Mahedy Co-Chief Investment Offi cer and Director of Research—Bernstein US Value Equities Mr. 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. ■ TAKING EARNINGS QUALITY INTO ACCOUNT Table of Contents 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 TAKING EARNINGS QUALITY INTO ACCOUNT Taking Earnings Quality into Account: A Practitioner’s Research into Balance-Sheet Accruals By John P. Mahedy Co-Chief Investment Offi cer and Director of Research—Bernstein US Value Equities INTRODUCTION For the fundamental analyst, addressing the quality or by 4.7% a year on average, the highest accrual stocks reliability of reported earnings is critical to making an underperformed by 4.6% (Display 1). Th e tool is also accurate earnings forecast and estimating a stock’s return remarkably consistent, generating a positive return potential; thus, most fundamental investors would argue between the low and high accrual groups in all but three that they pay attention to earnings quality. Nonetheless, of the 26 years tested. academic research has shown that an indicator of earnings reliability in readily available fi nancial reports—the Th e tool appears even more powerful for small-cap changes in balance-sheet accruals (BSAs)—is a strong stocks. Th e quintile of US small-cap stocks with the signal of a company’s future profi tability and stock price. lowest balance-sheet accrual growth outperformed the Th is implies that most investors, in fact, are not paying quintile with the highest BSAs by more than 18% a year suffi cient attention to all of the available information on average from 1980 through September 2004. Most about earnings quality, thus creating an opportunity for quantitative tools, however, deliver more powerful results other investors to exploit. in back tests within the small-cap arena than within the large-cap arena. Our research and experience show that Our own research has confi rmed the academic fi ndings the added power cannot be fully harnessed in managing and refi ned the BSA tool to make it more powerful and small-cap portfolios, due to the lower liquidity and applicable to all industry sectors. As important, our higher transaction costs of small-cap stocks. Th us, we research sheds light on the fundamental variables that assume that in practice, the tool should deliver similar make BSAs an eff ective quantitative tool. results within the US large-cap and small-cap universes. Th e BSA tool allows us to systematically compare Display 1 BSAs: A Powerful Predictor of Returns 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 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. accrual stocks outperformed the US large-cap market Source: Compustat and Bernstein 2 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT Th e tool also appears to be eff ective globally, although Display 2 diff erences in accounting rules (most of which have BSAs Are Powerful in the Value and Growth Arenas been eliminated) made it less useful in the UK and Japan until recently. Annualized Return vs. Style Universe 1978–2003 Quintile US Value US Growth While some of the tool’s underlying drivers seem to have Low Accruals 3.7% 5.2% a value fl avor, our research shows that the tool should High Accruals (5.3) (5.5) be valuable to growth investors as well. We divided the Outperformance large-cap universe into value stocks and growth stocks Low vs. High +9.0% +10.7% 1 on the basis of trailing price to sales and found that the Past valuations are no indication of future results. tool is quite eff ective within both the value domain and Annualized quarterly return versus equal-weighted style index. Growth index includes the more expensive half of the US large-cap market universe based the growth domain (Display 2). In fact, it was somewhat on price/sales; value index includes the less expensive half. BSA quintiles were formed quarterly using Bernstein definition of net operating accruals within more eff ective for stock selection within growth, with a each style universe, and the performance of the highest and lowest BSA quintiles spread between low- and high-accrual stocks of nearly was compared to the style index. Source: Compustat and Bernstein 11% a year, compared to 9% a year for value stocks, with 1 ■ We also divided the universe into value and growth on the basis of price to similar consistency. book, with very similar results—a spread of about 11% on average for growth stocks and about 9% on average for value stocks. AllianceBernstein | 3 TAKING EARNINGS QUALITY INTO ACCOUNT DEFINING BSAs Balance-sheet accruals arise from the attempt to make In other words, the more diffi cult it is to precisely defi ne reported earnings more meaningful than they are in a and audit the exact balance, the more prone to error the pure and very simplifi ed cash-accounting system. In account becomes—and the more changes in earnings the latter, earnings are simply equal to the change in stemming from such accounts should be viewed with cash from period to period. Such fi nancial statements skepticism. Nonetheless, while the forecasting ability are highly objective and reliable, because they can be of individual accrual accounts yields impressive results, easily audited—but they are almost never meaningful.