April 2005

Taking into : A Practitioner’s Research into Balance-Sheet 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 are a powerful indicator turn on 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 com- tool has a very low correlation with our 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 , 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 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 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 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

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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 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. Richardson et al. found that when applied to a large Th ere are numerous events in the life of a corporation data set, a broad measure of accruals encompassing that span multiple accounting periods, which can give both short- and long-term accounts, scaled to the size a distorted impression of earnings under a cash-based of the balance sheet, was most eff ective in estimating accounting system. For example, a fi rm that spent a lot stock returns. In our reconstruction of their results, the of cash building in one year that isn’t sold until quintile of low-accrual stocks beat the market by 2.9% a the next would report earnings that look misleadingly year on average, and the quintile of high-accrual stocks bad in the fi rst year and misleadingly good the next. lagged by 5.3%. Th at is, low accruals beat high accruals by 8.2%. Accrual accounting attempts to make reported earnings more meaningful by better matching costs with related Making the Tool Practical . In this system, earnings are the sum of the cash Th e Richardson et al. study relied on annual balance- fl ows and the changes in balance-sheet accrual accounts. sheet data and excluded fi nancial stocks, which the Th is attempt to make the data more meaningful intro- authors thought might not be comparable to non- duces subjective judgments and assumptions. Hence, fi nancial stocks, given the diff erent balance-sheet accrual accounts are prone to error—both uninten- structure of fi nancial companies. As practitioners—not tional and deliberate—and studying changes in accrual academics—we were uncomfortable with the idea of accounts can be rewarding. waiting for a full year to get new balance-sheet infor- mation, when an updated balance-sheet scorecard Most oft en, investors think of accruals in terms of current is available quarterly. It would also limit the tool’s operating and liabilities, such as and usefulness to exclude the fi nancial sector, which makes . But accruals can be defi ned more up 20% to 30% of the capitalization of various broad US broadly. Th ere are also non-current operating accruals, market indexes and an even greater share of many other such as physical plant and equipment and deferred taxes. markets. Together, current and non-current operating accruals make up net operating accruals. If you add in fi nancial So, we looked for ways to make the tool more practical for accruals, you get total accruals, which encompass use in our investment process. We tested its eff ectiveness all balance-sheet accounts other than cash and share- by industry and found that, like most quantitative tools, holder equity. it produced positive results for virtually all industries.

Research by Professors Scott Richardson, Richard Sloan, Th e results varied by industry, of course. Th e spread Mark Soliman and Irem Tuna2 tested several defi nitions between high and low BSA stocks within the three major of accruals ranging from very narrow metrics focusing fi nancial industries (insurance, banking and investment on single balance-sheet accounts to more compre- banking/brokerage) was near average. Results for the hensive measures. Prior academic research had shown data-processing and leisure industries proved to be that, broadly speaking, the more a balance-sheet accrual above average historically. Results for steel and airlines account is subject to estimation, the more changes were below average. Statistically speaking, however, the in this account will forecast future stock performance. dispersion was not signifi cant enough to bias our expec-

2 Scott A. Richardson, Richard G. Sloan, Mark T. Soliman and Irem Tuna, “Ac- tations about the future. crual Reliability, Earnings Persistence and Stock Prices,” July 2003

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Th e academics, using annual data, chose to exclude Display 3 changes in long-term assets, perhaps because this We Enhanced the Efficacy of the Academics’ Tool accrual account is relatively stable and not highly subject to estimation. Th e quarterly data Compustat provides, Annualized Return vs. Market 1978–2003 however, lumps long-term assets in with other data Academics’ Net Bernstein Net more prone to estimation. In order to use quarterly Quintile Operating Accruals Operating Accruals balance-sheet information, we included changes in long- Low Accruals 2.9% 4.7% term assets in our defi nition of net operating accruals. High Accruals (5.3) (4.6) Nonetheless, when we applied the Bernstein defi nition Outperformance of net operating accruals—based on quarterly data—to Low vs. High +8.2% +9.3% the full universe of large-cap stocks, we found it even Past valuations are no indication of future results. more eff ective than the academic version (Display 3). Annualized quarterly return versus equal-weighted US large-cap market uni- verse. Quintiles for academics’ net operating accruals were formed annually It is this defi nition of balance-sheet accruals that we use based on annual data and exclude financial stocks. Quintiles for Bernstein net operating accruals were formed quarterly using Bernstein’s definition of net ■ in the rest of this paper, except when stated otherwise. operating accruals based on quarterly data and include financial stocks. Source: Compustat and Bernstein

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THE FUNDAMENTAL VARIABLES THAT DRIVE BSAs

Th e tool’s forecasting power certainly got our attention, Sloan’s data also suggest that the speed of this reversion but we would never adopt a quantitative tool simply was fastest in the component and return on assets related because it performed well in back tests. We have to be to changes in balance-sheet accruals; the cash component satisfi ed that the tool’s power is likely to persist because was more stable. In eff ect, this says that if you see rapid it captures important information about company accrual growth, be skeptical about the likely persistence fundamentals not already captured elsewhere in our of company profi tability. Th e opposite pattern played investment process. Our research has convinced us that out with the lowest accrual stocks: Th e return on assets this tool meets these criteria. recovered in the period ahead, as the depressing eff ect from the change in accruals reversed. The Superiority of Cash Earnings Several academic research studies suggest that the Why should this be? Aft er testing hundreds of samples, balance-sheet accrual tool captures information about we concluded that balance-sheet accruals capture four fundamental themes: unduly pessimistic or the likelihood that current-year earnings will persist optimistic accounting assumptions; deliberate earnings into the future. Although investors tend to take earnings management; capital management; and the mean reports literally and treat all sources of earnings as equal, reversion of sales and earnings. We’ll discuss each of the accrual component of earnings is less reliable then these ideas in turn. the cash component.

Research published in 1996 by Professor Richard Sloan3 Pessimistic or Optimistic Assumptions illustrates this point clearly. Sloan separated companies Since accrual accounting entails subjective judgments, into categories of high current accruals and low current reported earnings in this system frequently refl ect accruals and observed the changes in their return on management’s pessimism or optimism. Th us, two assets in the fi ve years before and aft er the measurement management teams reviewing the same set of facts might date (Display 4). On average, reported earnings come to very diff erent conclusions about the appropriate and return on assets for the decile of companies with level of current-period earnings. the highest accrual growth increased rapidly prior to We can illustrate this with a hypothetical example of two the measurement date—but tended to reverse sharply companies that start to see modest slowdowns in current soon thereaft er. sales during a quarter. One company has a pessimistic Display 4 management team; the other, an optimistic management Extreme BSAs Rapidly Revert to the Mean 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- 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- tories from weaker sales. Again, this would hurt current term and taxes payable, minus , and divided by average earnings as fi xed overhead costs were applied to fewer total assets. Universe included about 2,000 US stocks per year, on average. Source: Sloan, 1996 units of output, while also reducing accrual growth. Th is 3 Richard G. Sloan, “Do Stock Prices Fully Refl ect Information in Accruals company would end up with an attractive BSA score. and Cash Flows About Future Earnings?” Th e Accounting Review, July 1996, vol. 71, no. 3

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By contrast, the company with the optimistic manage- Display 5 ment team assumes that sales growth will bounce back Is Skewed to Favor Low BSA Stocks quickly. Th us, it sees little need to lower inventories Optimistic Forecast Pessimistic Forecast or reassess receivables, and it maintains production levels that build inventories and increase accruals. Th is If Proved Correct No Surprise No Surprise company would end up with a less attractive BSA score. If Proved Wrong Negative Surprise Positive Surprise

Although both companies fi nish the quarter with the Th us, in this example, the best outcome when investing same level of sales, the pessimistic company would in the company with the optimistic management is report lower margins and earnings. Th e market would neutral; the worst outcome is potentially very negative. probably react more negatively to this earnings report Conversely, the worst outcome with the conservative than to the more optimistic company’s report. management is neutral, but the best outcome is very positive (Display 5). 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, Earnings Management however, suggests that we should not be indiff erent. It In the example above, both management teams were suggests that we would increase our chances of success doing their best to be objective. At other times, the desire by investing in the company with the more pessi- to meet certain performance thresholds may aff ect their mistic (or conservative) management. Th is refl ects the judgment in making assumptions: Th is is oft en called skewed market reactions to the possible outcomes for earnings management. Earnings management can range each company. from mild manipulation within the bounds of generally accepted accounting principles to more severe distor- If management at either company is ultimately proved tions and even outright fraud. While it is hard to measure correct, there would be no earnings surprise and thus earnings management directly, there is indirect evidence no market reaction. If they are proved wrong, however, that it exists. the two managements would have to adjust their accrual accounts or reverse them through earnings, creating Several academic studies have demonstrated that earnings earnings surprises that would probably cause very reports cluster around certain thresholds: reporting diff erent market reactions. breakeven results, earning as much as in the prior period and reaching consensus estimates. Degeorge et al.4 for If the optimistic management that built inventories is example, examined year-on-year changes in earnings proved wrong, it would have to write down inventories growth and found a sharp break in the bell curve at no or cut production sharply in the future. Th e resulting growth (Display 6, next page). Th ere are abnormally few earnings shortfall would likely produce a big negative reports of a small decline in growth and an abnormally surprise relative to investor expectations, with negative large number of reports at—or just above—the previous implications for the stock price. year’s earnings. Similar patterns of discontinuity can be found at other break points, such as reporting positive If the pessimistic management that had decided to earnings and reporting earnings that match or exceed slow production is proved wrong, it would have to the consensus. increase production above normal levels, resulting in higher margins as fi xed costs are spread over the Earnings management may play a large role in the larger number of units of output. Furthermore, the accrual reversal pattern that we saw in Sloan’s work on value of existing inventories and receivables would the mean reversion of earnings and returns for high- be understated, and this extra value would have to and low-accrual stocks. To the extent that a company be reversed back into income in the period ahead. borrows from the future to meet today’s threshold, it In this case, there would be a positive surprise in 4 François Degeorge, Jayendu Patel and Richard Zeckhauser, “Earnings Manage- earnings, with positive implications for the stock price. ment to Exceed Th resholds,” Journal of Business, 1999, vol. 72, no. 1

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Display 6 Sometimes, earnings management entails trying to Companies Manage Earnings to Meet or Beat Thresholds 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 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. 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 When done correctly, accruing these types of charges may Source: Degeorge, Patel and Zeckhauser, Journal of Business, 1999 fairly represent the company’s fi nancial performance. But will have a harder time meeting a future threshold— these types of accruals are very diffi cult to monitor from with adverse implications for the stock price. Th is the outside; thus, they are vulnerable to abuse. Manage- pattern of borrowing simply cannot be sustained. ments can deliberately overestimate this type of , creating a “cookie jar” on the balance sheet that it can Th ere are many ways that companies can manage raid in the future to fatten earnings: Management may earnings. In one famous example that the SEC called a start to pay current-period costs out of the previously case of massive fraud, Sunbeam executives met earnings established liability account, artifi cially raising current targets by such techniques as shipping barbecue grills to earnings. Eventually, the reserve will be exhausted stores in the Northeast of the US—in December. While and the ongoing costs will once again show up as the company met its sales targets for that year, it fell current-period costs in the P&L, potentially creating a short the next year because the stores either returned the nasty surprise for investors. grills or ordered fewer than usual for the next season. Th is method of earnings management is oft en referred It is almost never possible to know with certainty whether to as channel stuffi ng. management is manipulating such reserve or liability accounts, so the reduction in these accrual accounts Another, more subtle technique involves timing the should always be viewed with skepticism. Our BSA recognition of gains on fi nancial contracts. If an insurance tool captures this risk as the liability account declines, company holds an investment in a bond yielding 5% because the change produces a relatively unattractive and rates drop to 4%, management could choose to BSA score. Th e tool is telling us that earnings appear to hold the bond to maturity, recognizing the extra yield be low quality, because the cash component of earnings into earnings over the bond’s remaining life. Or, it could is low, refl ecting the use of balance-sheet cash to pay sell the bond and replace it with a similar bond yielding costs that have not run through the current-period the market rate of 4%, realizing the earnings benefi t earnings statement. immediately at the of future periods. Manage- ments could defend either action as being in pursuit Capital Management of their long-term strategies. But the diff erence in how Th e BSA tool always gives a poor rating to companies generally accepted accounting principles treat the timing that have completed large acquisitions because it of income recognition from the gain on sale versus the compares the pre-merger balance sheet of the acquirer higher interest income can allow managements to meet to the combined company’s post-acquisition balance thresholds by deciding to recognize more or fewer gains sheet. Th is may appear to be an unfair comparison of on sale. apples and oranges, but we have found that dismissing

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Display 7 effi cacy with regard to acquirers is how long the Acquirers Perform Worse than High-BSA Group Overall 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 Past valuations are no indication of future results. Large acquisition or share issue inferred by an increase in market capitalization the quintile of low accruals, where restructurers over the prior year of 10% more than the stock-price appreciation would explain. abound. Th e restructuring subset of the low-accrual Annualized quarterly returns versus the equal-weighted US large-cap universe; Bernstein BSA quintiles reformed quarterly. group outperformed the market by 7.8%, signifi cantly Source: Center for Research in Security Prices (CRSP), Compustat and Bernstein more than the 4.7% average for all low-accrual stocks (Display 8). Conceptually, the balance-sheet accrual tool the negative signifi cance it imputes to these corporate may be signaling that management is ridding itself of a events would be a mistake. When we screened our large- distraction. It may also be signaling that returning money cap universe for acquirers, we found that the acquirers to shareholders instead of making potentially low-return underperformed the market by 5.6%, worse than the investments oft en turns out to be a good thing. 4.6% average underperformance for the high-accrual group (Display 7). It may be tempting to shrug and dismiss write-off s as no more then a pen stroke with little economic impact, Th e accrual tool may simply be highlighting what we but this, too, would oft en turn out to be a mistake. have all come to know from experience: More oft en than When we screened for companies that had taken large not, acquisitions are bad for the stock of the acquiring write-off s and then measured their performance in company.5 A clash of cultures makes many deals fail; the the subsequent period, we found that on average they Time Warner/AOL combination is a classic example. outperformed the market by 5.9%, better than the 4.7% Th e tendency of acquirers to overpay at moments of average for low-accrual stocks. Sometimes, write-off s exuberance damages other deals. Corning, for one, paid signal the beginning of the end of a large retrenchment. $4 billion in cash in late 1999 to buy Pirelli’s fi ber opera- Oft en, the underlying business is close to stabilizing tions, which had sales of less then $40 million; it later and improving. had to write off virtually the entire purchase price. (Continued on page 12) Display 8 Mergers also depress stock prices when they are poorly Restructurers Outperform Low-BSA Group Overall 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

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 Past valuations are no indication of future results. justifi able without claiming synergies. Acquisitions within a company’s cur- Large disposals or share buybacks inferred by a decrease in market capitalization rent line of business are more likely to be good for the acquirer’s future stock over the prior year of at least 10% more than stock-price change would explain. performance than diversifying acquisitions. More surprisingly, paying a pre- Large write-offs defined as at least 20% lower than income before mium to the last trading price of the acquired companies’ stock tends not to be extraordinary items, with a difference of at least $5 million. Group with a signal of future underperformance. Th e key price issue is whether the price disposals/buybacks and group with write-offs may overlap. Annualized quarterly paid is consistent with current industry valuations. See Vadim Zlotnikov, returns versus the equal-weighted US large-cap universe; Bernstein BSA quintiles “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” formed quarterly. Bernstein Research Call, January 24, 2005. Source: CRSP, Compustat and Bernstein

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BSAs: CAN YOU EXPORT THE CONCEPT? When we fi nd an investment tool that works in dated nor as robust as the data set for the US one market, we always see if we can use it in other market, and carving up smaller markets into markets as well. Usually, our research shows that we quintiles makes the sample sizes very small indeed. can; this reinforces our belief that investor behavior We solved this last problem by using the top and is the same the world over. bottom 40% (two quintiles) rather than the top and bottom quintile. Sparse data on some balance-sheet Studying the usefulness of our BSA tool worldwide, items, meanwhile, forced us to exclude fi nancial however, presented some stiff challenges. Th ere is companies from the non-US data. virtually no literature available on its use outside the US,* perhaps in part because the signifi cant Despite these diffi culties, our initial results were variations in accounting from country to country encouraging. In each market we examined, low- make comparisons between accounting-based tools accrual stocks beat high-accrual stocks. Th e spreads diffi cult. Th e gradual adoption of International for Europe, Canada and Australia were substantial; Accounting Standards around the world will make those for the UK and Japan, relatively small (Display accounting in many countries more similar to that of A). Th e latter concerned us because Japan and the the US in ways that are promising for the effi cacy of UK make up such a large share of the global and the BSA tool. However, it also creates discontinuous international markets. When we refi ned the data, the balance sheets that could distort the results of a results improved for the UK and Japan (Display B). historical study. For Japan, we substituted data from Nomura Lastly, there is the perennial problem that the data Securities for Worldscope’s data because it included set for markets outside the US is neither as long- more companies. We also applied a narrower defi nition of BSAs that focused on changes in Display A BSA Tool Works Well Around the World payables and receivables until 2000, when Japan began to require consolidated reporting for its Return vs. Market 1991–2003 Display B Europe Refining the Tool Improved Effectiveness in UK and Japan US ex UK UK Japan Canada Australia

Lowest BSAs 3.0% 3.0% 1.7% 0.9% 0.7% 4.3% Return vs. Market 1991–2003 Highest BSAs (3.3) (2.8) (1.2) 0.1 (4.7) (4.6) Europe Spread 6.3 5.8 2.9 0.8 5.4 8.9 US ex UK UK Japan Canada Australia Bernstein investment universe for each country or region, excluding Lowest BSAs 3.0% 3.0% 2.1% 1.9% 0.7% 4.3% financials, was divided into balance-sheet accrual quintiles on a quarterly basis using Bernstein definition of net operating accruals. Highest BSAs Highest BSAs (3.3) (2.8) (1.8) (1.9) (4.7) (4.6) represents the two BSA quintiles with the highest BSAs; lowest BSAs is the two quintiles with the lowest BSAs. Stock performance evaluated Spread 6.3 5.8 3.9 3.8 5.4 8.9 quarterly relative to equal-weighted universe and then annualized. For US, Europe, Canada and Australia, quintiles were formed using Source: Compustat, CRSP, Morgan Stanley Capital International (MSCI), Bernstein definition of net operating accruals. For the UK, universe Worldscope and Bernstein excludes companies flagged for M&A prior to 2000. For Japan, Nomura/ Nikkei data divided into quintiles based on current operating accruals *Th e articles we found were Morton Pincus, Shivaram Rajgopal and Mo- prior to 2000. han Venkatachalam, “Th e Accrual Anomaly: International Evidence,” Source: Compustat, CRSP, MSCI, Nikkei Financial, Nomura Securities, March 2003; and H. Otani, “Discretionary Accruals: Th e Impact of Worldscope and Bernstein Earnings Management on Stock Price,” Nomura Global Quantitative Research, February 27, 2004 (English translation).

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companies and disclosure of cash fl ows. Aft er Display D that, we switched to the broad defi nition we BSAs Worked Much Better in UK After Accounting Change used elsewhere. Return vs. UK Market For the UK, we excluded acquirers from the 1991–1999 2000–2003 universe because until 1998, purchase accounting Lowest BSAs 1.2% 2.6% was handled quite diff erently in the UK than in Highest BSAs (0.1) (3.7) the US and elsewhere. In the US and elsewhere, Spread 1.3 6.3 an acquirer’s balance sheet increases with an Bernstein investment universe for UK, excluding financials, divided into BSA quintiles annually using Bernstein definition of net operating acquisition. Under the old UK rules, however, the accruals; quarterly performance annualized. acquirer immediately wrote off all related Source: MSCI, Worldscope and Bernstein to the transaction, so the balance-sheet increase was Because of this accounting treatment, the BSA tool much smaller—and sometimes even negative. has been less eff ective in the UK historically. Since You can s ee this in the case of Vodafone (Display the UK adopted purchase accounting rules more C). Its balance sheet in March 1998 showed net similar to those in the US, however, it has become assets declining by more than 50% over the prior dramatically more eff ective. Th e spread increased year, even though it had made large acquisitions in from a little over 1% to in excess of 6% (Display D). the French and Dutch telecom markets during that Of course, it’s not safe to generalize too much from period. Only if you read the footnotes and adjusted four years of data, but given what we know about for the full value of the acquisitions—including the how the tool works elsewhere—and why—we are associated goodwill—would you have discovered confi dent that it should work well in the UK. that its net assets actually grew by more than 20%. In We are continuing to improve our research on the other words, Vodafone’s true BSAs were expanding effi cacy of using BSAs in other markets, and we hope rapidly rather than shrinking. to introduce the tool into the investment process for Display C our non-US portfolios sometime in 2005. ■ Under Old UK Rules, Acquisitions Could Shrink a Firm Please note: Past valuations are no indication of future results.

Pro Forma for Vodafone 1998 As Reported 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

AllianceBernstein | 11 TAKING EARNINGS QUALITY INTO ACCOUNT

(Continued from page 9) But the write-off subset of low accruals is tricky. It Mean Reversion of Sales and Earnings includes some spectacular turnarounds, such as Chrysler Our examination of high-accrual stocks produced in the early 1990s, Applied Materials just before a big another surprising fi nding: From a sales and a return- run-up in the semiconductor sector in 1999 and, more on-equity perspective, on average these stocks had been recently, the upturn at Xerox (Display 9, top). It also very successful in the recent past. From 1978 to 2003, the includes some spectacular fl ameouts: companies that companies with the highest accrual growth on average had never recovered, such as Woolworth and Fruit of the 17.5% sales growth in the previous year—far better than Loom, and companies, such as Circuit City Stores and the 2.7% average for low-accrual companies (Display 10). LSI Logic, that got worse before they got better (Display Th e high-accrual stocks were also more profi table, with 9, bottom). Indeed, seven of the 10 big bankruptcies of an average ROE 1.2 percentage points above the market recent years passed through the fi rst quintile of BSAs. average, while the low-accrual companies’ average ROE was 2.2 percentage points below the market average. Th us, research judgment is crucial to making successful investments in these situations. Earnings revisions data Taken at face value, this would imply that the BSA tool may also help to separate the wheat from the chaff , as we is somehow unfairly penalizing companies that have will later show. recently been successful and that have been growing quickly. Th is implication, however, confl icts with our Display 9 Some Restructurings Succeed… fi nding that the tool is actually quite eff ective when applied to a universe of growth stocks. Flagged for Relative Return Company Name Write-Off Next 12 Months Our research suggests that some of the diff erence in Applied Materials April 1999 190% stock performance between high- and low-accrual Chrysler January 1992 165 stocks relates to the diffi culty of sustaining above-market sales growth and profi tability. When companies are Phelps Dodge January 2003 102 successful in these ways, their managements, anchored Kroger April 1990 82 in recent experience, typically become optimistic: Xerox October 2002 76 Th ey order more inventory, plant and equipment, or distribution outlets—or perhaps pay a high price for …While Other Restructurings Fail an acquisition—because they expect their success to continue. Flagged for Relative Return Company Name Write-Off Next 12 Months Display 10 Fruit of the Loom July 1998 –89 Success Can Lead to High BSAs Circuit City Stores April 2000–87% Kmart October 1999 –65 Woolworth October 1997 –60 LSI Logic January 2000 –59

Past 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

Past valuations are no indication of future results. Average trailing one-year sales growth for BSA quintiles reformed quarterly Source: Compustat and Bernstein

12 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT

But success is notoriously diffi cult to sustain for long Display 11 periods. Successful companies attract competition, Analysts (Wrongly) Expect High Profitability to Persist… 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- …and Underestimate Recovery for Low-Profit Companies 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.

Past valuations are no indication of future results. Th e pattern played out again the following year: Analysts 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 lowered their ROE expectations yet still expected the Source: Compustat, I/B/E/S and Bernstein 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. ■

AllianceBernstein | 13 TAKING EARNINGS QUALITY INTO ACCOUNT

BSAs AND GROWTH INVESTING

Is the BSA Tool Biased Against High-Growth Companies? We also measured the performance of the adjusted and When we fi rst began sharing our research on BSAs with unadjusted tool over time. For the adjusted version our fi rm’s own analysts, we encountered an immediate that gives half credit for sales growth (the best of the suspicion that the tool was biased against companies with modifi ed formulas we tried), low-accrual stocks beat rapid growth. Th e mean reversion of ROEs shown in the high-accrual stocks by about 7.2% a year on average—a previous section and the concentration of slow trailing nice amount, but about 200 basis points less than our sales growth in the attractive BSA quintile reinforced original unadjusted version (Display 13). this view. Display 12 Isn’t it right and natural for companies with growing BSA Tool Can Be Adjusted for Sales Growth… sales to increase their balance sheets? Aft er all, analysts BSAs Adjusted for Sales Growth generally study changes in inventory and receivables relative to sales. Our fi nding that the tool worked within Unadjusted BSAs Total Sales 1/2 Sales the growth domain as well as the market as a whole gave Accrual Growth +10.0% +10.0% +10.0% us some confi dence that the tool wasn’t biased against – Sales Growth N/A 25.0 12.5 growth stocks, but we decided to study the apparent bias = Adjusted Score +10 (15) (2.5) against prior sales growth. Trailing one-year sales growth for Bernstein US large-cap growth universe

Following a trail blazed by Professor Hong Xie,6 we Display 13 …but That Makes It Less Effective… 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 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 for restraining accrual growth relative to sales, rather of net operating accruals, based on quarterly data. Trailing one-year sales growth; quintiles formed monthly. Adjusted version gives half credit for sales growth. than a penalty for expanding its balance sheet. We also Source: Compustat and Bernstein tried several other formulations that adjusted accrual growth for trailing sales growth. Display 14 …Because Sales Growth Tends to Revert to the Mean

We measured the correlation of each of these formula- 20 1972-2003 tions to the change in future stock price. Like Professor 15 Xie, we found that the unadjusted version was a better 10 Company vs. Market Sales Growth signal of future stock performance. Th e more credit we 5 0 gave for sales growth as an explanation for the growth in (5) accruals, the worse the tool performed. (10) (15) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Past valuations are no indication of future results. 6 Hong Xie, “Th e Mispricing of Abnormal Accruals,” Th e Accounting Review, Trailing one-year sales growth for Bernstein US large-cap universe July 2001, vol. 76., no. 3 Source: Compustat and Bernstein

14 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT

Why BSAs Work Within the Growth Arena Our next step was to see whether the BSA tool would Th e reason that adding trailing sales growth to the be of any use to the analyst with perfect foresight about accrual equation diluted, rather than enhanced, the future sales growth. To do so, we divided the stocks with tool’s effi cacy may be quite simple: Trailing sales growth above-average future sales growth into two groups: the is not a good predictor of future sales growth. When we three quintiles with the lowest (most attractive) BSAs divided our universe of large-cap US stocks into quintiles and the two quintiles with the highest (least attractive) on the basis of trailing sales growth and looked at their BSAs. Historically, about half of all fast-growth stocks subsequent sales growth, we found that the sales growth fall into the three most attractive BSA quintiles, creating of the fastest and slowest quintiles regressed to the mean plenty of fertile ground for the growth investor. at an astonishing speed (Display 14). We found that the portfolio of rapid-growth stocks that Mean reversion—the value investor’s friend—is the also had more attractive BSA scores did better than the growth investor’s enemy. As my colleagues in Alliance rapid-growth stocks as a whole—it outperformed the Capital’s Growth Equity business say, the challenge for market by 5.5% a year, on average, as Display 15 also growth investors is to identify companies that will beat shows. Th e other half of the rapid growth stocks—those the odds and sustain their superior growth. Th us, in many in the highest two quintiles of BSAs—did worse but still instances, justifying rapid accrual growth by pointing to outperformed the overall market. Th us, the rapid accrual trailing sales growth turns out to be a mistake. growth was justifi ed by rapid sales growth.

If trailing sales growth doesn’t justify fast accrual growth, Perhaps the more interesting results came from does future sales growth? To study this, we fi rst divided looking at the stocks that turned out to have average or our universe of large-cap US stocks in half on the basis of below-market future sales growth. Th e companies actual sales growth over the next 12 months. We found in this group with attractive BSA scores lagged the that the half with above-average sales growth outper- market slightly. Th ose with unattractive BSA scores were formed the market by 3.7% a year on average, while the severely penalized. half with below-average sales growth underperformed by 3.1%. Th us, a hypothetical growth investor with perfect A closer look at the worst-performing segment—stocks foresight about future sales growth would do quite well with high BSAs and below-average sales growth— by focusing his or her portfolio on those stocks with showed that the vast majority had above-average sales the highest future sales growth. As Display 15 shows, growth in the prior year. Th is reinforces the view that companies with above-average growth outperformed all their managements may have been growing the balance other companies by about 6.8%. sheet because a period of fast growth had made them optimistic. Disaster struck when the continued growth Display 15 they expected failed to materialize. BSA Tool Helps Whether or Not Future Sales Growth Is Strong Using BSAs in the Growth Arena Annual Returns vs. Market 1978–2003 Another potential concern about using the BSA tool in 1 All Stocks Low BSA2 High BSA2 Next Year Sales Growth the growth arena is that there may be entire industries Above Market Average +3.7% +5.5% +1.7% with rapid balance-sheet growth, refl ecting a period of Market Average or Below –3.1 –0.6 –8.6 rapid expansion or innovation. In many cases, it may Spread 6.8 6.1 10.3 be impractical for the growth investor to avoid such Past valuations are no indication of future results. an industry entirely. Furthermore, the analyst may One-year forward returns versus equal-weighted US large-cap universe conclude that the growth in accruals is warranted, 1Assuming perfect foresight of sales growth over the next year given the analyst’s outlook for the business. Th us, we 2Low BSAs defined as Q1–Q3 and represent roughly 50% of stocks in the examined the eff ectiveness of the BSA tool in forecasting above-market sales category. High BSAs defined as Q4–Q5. Source: Compustat and Bernstein performance within an industry.

AllianceBernstein | 15 TAKING EARNINGS QUALITY INTO ACCOUNT

Th e results of this work were quite encouraging. In Our conclusion is that the BSA tool should be comple- decomposing the overall benefi t of the BSA tool, we mentary to a growth investment process. Although found that the quintile of stocks with the lowest balance- the most attractive BSA quintile has historically had sheet accruals relative to the industry outperformed slow trailing sales growth, the population of stocks their industry by 3.8%, while the quintile with the with fast future sales growth and above-average BSA highest accruals underperformed their industry by 4.7% scores is actually quite large. Historically, growth (Display 16). Th e spread between the two quintiles was investors would have improved their performance by 8.5%. Th us, it could be argued that most of the premium focusing on the intersection of the two variables. When the tool has delivered comes from helping the investor to expectations of future rapid sales growth have been select stocks relative to their own industry. Th is suggests met, the slower-accrual growth subset has outper- that paying attention to earnings quality as measured formed. More importantly, when stocks fail to meet by accrual growth should not disrupt the investment expectations of future rapid sales growth—and especially process within growth industries. When considering when they have failed to match the market average—the an investment within an industry with rapid accrual high-accrual growth subset has underperformed by a growth, the investor should simply have a bias, all other wide margin. Avoiding this downside has been quite things being equal, toward the company or companies rewarding. In this sense, the BSA tool can be seen with slower accrual growth. as valuable protection against forecast risk for the growth investor. ■ Display 16 BSA 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

16 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT

BSAs AND VALUE INVESTING

Display 17 Our understanding of the fundamentals behind the BSA BSAs Enhance the DDM 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 Past valuations are no indication of future results. companies they cover, regardless of size, growth rate or Average forward-quarter return relative to equal-weighted US large-cap universe other characteristics. for intersection of cheapest quintile of Bernstein discount model with each Bernstein BSA quintile. Source: Bernstein At the same time, we turned our quantitative research eff ort to seeing whether the information the tool captured Cheapness, however, was not adequate protection was additive to the information captured by other tools against high-accrual growth. Th e stocks in the cheapest used in our value investment process. We found that it quintile of our DDM with high accruals underperformed was: Th e tools work better in combination than alone. the market slightly. Th is implies that our view of what is attractively valued should be tempered when accruals Are BSAs Additive to Value? have grown rapidly. Because a company’s reported We fi rst looked at how the BSA tool interacted with our fi nancial history is oft en a factor in setting our forecast, dividend discount model (DDM), our primary measure a high BSA score may imply that this starting point is of value. As we have described, the accrual tool simply too high. measures changes in accruals relative to the balance sheet; it does not take into consideration how much we Are BSAs Additive to Earnings Revisions? are paying for high- or low-accrual growth. While our Next, we looked at how BSAs work in conjunction with quantitative research had shown that the tool has been earnings revisions, which have historically been eff ective very eff ective within the value domain, defi ned by naive at gauging stock returns in the short term. Stocks with measures such as price to book or price to sales, it was upward earnings revisions relative to the market tend possible that our research-driven DDM already captured to outperform in the near term, while stocks with the information in the BSA tool. Aft er all, our DDM negative revisions underperform. We think the effi cacy links the share price to our analysts’ forecasts of long- of earnings revisions is a result of anchoring: People tend term earnings power, and our analysts have historically to be mired in their current reality, and when confronted paid close attention to balance sheets and cash fl ows with new but confl icting information, they tend to change their outlooks incrementally. Analysts’ earnings when generating their forecasts. revisions thus tend to go up and down incrementally, Th e results from combining the BSA tool with our and stock prices tend to move with them. DDM were quite encouraging. On its own, the cheapest Our research shows this holds true within BSA quintiles quintile of our DDM has outperformed the market by 4.4 as well. When we isolated stocks with very positive percentage points on average from 1980 to 2003 (Display earnings revisions versus the market and measured their 17). But within that group, the stocks with low balance- forward monthly returns (the revision tool is a short-term sheet accruals did much better: they outperformed the indicator), we found that low BSA stocks with positive market by more than 10%. 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).

AllianceBernstein | 17 TAKING EARNINGS QUALITY INTO ACCOUNT

Display 18 Display 19 BSAs Complement Earnings Revision Tool When BSAs Are Low… …and When BSAs Are High

Large positive revisions are stocks with I/B/E/S 1-month revision index at least Large negative 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 0.4% below market. Monthly performance versus equal-weighted US large-cap universe; Bernstein BSA quintiles reformed quarterly. universe; Bernstein BSA quintiles reformed quarterly. Source: Compustat, I/B/E/S and Bernstein Source: Compustat, I/B/E/S and Bernstein

Th is makes sense when we remember that the low-BSA In conclusion, our research implies that adding the BSA category has a relatively large share of companies that tool to value measures should increase expected returns were growing slowly or restructuring: Th e biggest risk for value portfolios. Since value investors are more likely of investing in this category is that the restructuring to look at companies that are growing slowly, restruc- will persist further into the future, making the invest- turing operations or writing off assets, adding earnings ments premature. Looking at positive revisions adds an revisions is also important to better judge the timing of interesting new dimension. Sell-side analysts, who our purchases and sales. BSA research suggests are not suffi ciently focused on balance sheets, see independent evidence that things are Putting the BSA Tool to Work getting better. Our investment process marries our fundamental insights with quantitative risk control and timing tools. Low-BSA stocks with negative revisions, on the other In Bernstein’s US large-cap value portfolios, we start hand, underperform the low-accrual group as a whole. by using our dividend discount model to determine In this case, negative revisions may signal that more bad the relative attractiveness of each stock by relating its news is ahead. Th at is, the BSA tool helps investors to stock price to our long-term forecast of its earnings and diff erentiate between the spectacular turnarounds and free cash fl ow. We quantify this so we can compute the fl ameouts in the low-accrual category. expected return of each stock relative to the market. Our On the other extreme, stocks with high balance-sheet timing tools—relative stock performance and earnings accruals and negative revisions underperformed the revisions—provide perspective on whether this is the market by 0.9% per month, worse than the high-accrual best time to purchase or sell an individual stock; they group overall (Display 19). Th is, too, makes sense. Th e may add or detract from the expected return. Finally, our factor risk model quantifi es the degree to which a stock high accruals tell us the company has just expanded would diversify the portfolio or add to its concentration rapidly. Th e negative earnings revisions tell us that in terms of sector or traits such as capitalization, value or analysts are seeing separate information implying that earnings variability. Th e combination of all these factors growth is not meeting expectations. Th is has been a gives us a risk-adjusted expected return. pretty good signal to avoid the stock: Investors paying a high premium for superior growth typically react very Aft er studying the linkage between the BSA score and badly to disappointment. subsequent stock performance, we now also quantify If, however, the expansion is met with continued how much the stock’s BSA score would add or subtract earnings estimate increases, the odds are that the from its risk-adjusted expected return. In some cases, balance-sheet expansion was warranted. However, these BSAs might lower our risk-adjusted expected return for stocks still don’t do signifi cantly better than the market, a stock so much that we would decide not to buy the implying that the good news may have been largely stock. In other cases, such as Medco HealthSolutions, discounted in the stock price.

18 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT

the BSA tool has prompted us to accelerate our purchase Display 21 of the stock. Medco’s BSAs Fell with PP&E and Intangibles

Medco HealthSolutions is a pharmaceutical benefi ts $ Millions management fi rm that appeared to be attractively valued Mar 03 Mar 04 Change last summer. It provides a useful example of both the Net Working Capital $515 $583 $68 mechanics of the tool and how it can guide research. In Property, Plant and Equipment 816 718 (98) this case, however, we had to fi rst adjust for some trans- Intangibles and Other Assets 5,834 5,708 (126) actions related to its spin-off from Merck. Operating Liabilities (1,221) (1,215) 6 To analyze Medco’s BSA growth, we divided its adjusted Net Change $(150) net BSA growth over the 12 months ending March 2004 Past valuations are no indication of future results. Source: Company reports and Bernstein by its average balance sheet in that period and compared it to the market average. Medco’s BSA score of negative Together, the accelerated depreciation and 1.5% was much better than the market average of positive made Medco’s reported earnings look worse than the 5.9% (Display 20). company’s true earnings potential. Although the amorti- For our analyst, this was just a starting point. Th e zation of intangibles is purely an accounting matter, shrinkage in Medco’s accruals, he found, had two drivers capital spending had fallen below depreciation—and (Display 21). First, net property, plant and equipment our research indicates that capex could remain low for were down sharply because Medco was closing some many years. Th e BSA tool, we concluded, was telling less-effi cient call centers and mail-order pharmacies and us that the company was doing somewhat better than thus had accelerated its depreciation of those facilities. its recent reported earnings implied (Display 22). Our fundamental research, meanwhile, showed a growing Second, Medco had accelerated the amortization of an trend toward use of mail-order prescriptions and a intangible created when Merck acquired Medco in greater emphasis on generic drugs, both of which are 1993. Merck had attributed part of the price it paid to the positive for Medco’s earnings. When we combined the present value of customer relationships and amortized fundamental information the BSA tool was capturing them over 35 years. Since customer retention has fallen with the positive implications of these industry trends, in the past few years, those assets have shorter lives than we concluded that Medco was priced attractively relative Merck initially assumed; Medco now amortizes them to its earnings potential, and we established a position in over 23 years. the stock. ■

Display 20 Display 22 Applying BSAs: The Medco Example Medco Earnings Power Is Better Than It Appears

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 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 Past valuations are no indication of future results. be assumed that investments in any security identifi ed here will continue to Source: Company reports and Bernstein be profi table. We will, upon request, furnish a listing of all investments made during the prior one-year period. AllianceBernstein | 19 TAKING EARNINGS QUALITY INTO ACCOUNT

Bibliography

The following selection of papers informed our research Otani, H. “Discretionary Accruals: The Impact of Earnings into balance-sheet accruals. Management on Stock Price.” Nomura Global Quantitative Research. February 27, 2004 (Japanese original, December 8, Ahmed, Anwer S., S.M. Khalid Nainar, and X. Frank Zhang. 2003). Further Evidence on Analyst and Investor Mis-Weighting of Prior Period Cash Flows and Accruals. May 2003. Penman, Stephen H., and Xiao-Jun Zhang. Accounting Conservatism, the Quality of Earnings, and Stock Returns. Beaver, William H., Maureen F. McNichols, and Karen K. December 1999. Nelson. An Alternative Interpretation of the Discontinuity in Earnings Distributions. February 2003. Pincus, Morton, Shivaram Rajgopal, and Mohan Venkatachalam. The Accrual Anomaly: International Burgstahler, David. Incentives to Manage Earnings to Avoid Evidence. March 2003. Earnings Decreases and Losses: Evidence from Quarterly Earnings. August 1997. Sloan, Richard G. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” The Collins, Daniel W., and Paul Hribar. Errors in Estimating Accounting Review, July 1996, vol. 71, no. 3. Accruals: Implications for Empirical Research. September 2000. Richardson, Scott. “Earnings Quality and Short Sellers.” Accounting Horizons, 2003. Degeorge, François, Jayendu Patel and Richard Zeckhauser, “Earnings Management to Exceed Thresholds.” Journal of Richardson, Scott A., Richard G. Sloan, Mark T. Soliman, Business, 1999, vol. 72, no. 1. and Irem Tuna. Accrual Reliability, Earnings Persistence and Stock Prices. July 2003. Desai, Hemang, Shivaram Rajgopal, and Mohan Venkatachalam. The Relation between Value-Glamour and Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Accruals Mispricing. July 2003. Management and the Long-Run Market Performance of Initial Public Offerings.” Journal of Finance, vol. LIII, Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi no. 6, December 1998. Yohn. Accrued Earnings and Growth: Implications for Earnings Persistence and Market Mispricing. November 2001. Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Management and the Underperformance of Seasoned Equity Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi Offerings.” Journal of Financial , June 1997. Yohn. The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Return on Assets. Thomas, Jacob K., and Huai Zhang. Inventory Changes and June 2002. Future Returns. December 2001.

Frank, Mary Margaret, and Sonja Olhoft Rego. Do Managers Xie, Hong. “The Mispricing of Abnormal Accruals.” The Use the Valuation Allowance Account to Manage Earnings Accounting Review, July 2001, vol. 76, no. 3. Around Certain Earnings Targets? July 2003. Zach, Tzachi. Inside the “Accrual Anomaly.” June 2003. Louis, Henock. Earnings Management and the Market Performance of Acquiring Firms. October 2002. Zlotnikov, Vadim. “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” Bernstein Research Lui, Daphne W. When Accruals Meet Growth: Do Analysts’ Call, January 24, 2005. 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.

20 | AllianceBernstein TAKING EARNINGS QUALITY INTO ACCOUNT

Building and preserving investor wealth through:

■ A sole focus on asset management

Our Firm, ■ Global, innovative research Our Mission ■ Disciplined, principled invest ment processes ■ Invest ment st rategies geared to client needs

■ Competitive performance at a good value

Delivered by our most important asset... Our people

Past performance does not guarantee future results. You should consider the investment objectives, risks and charges and expenses of any AllianceBernstein fund carefully before investing. For free copies of our prospectuses, which contains this and other information, visit our website at www.alliancebernstein.com or call your fi nancial advisor. Please read the prospectus carefully before you invest.

© 2005 AllianceBernstein Investment Research and Management, Inc.

Note to All Readers: Th e information contained herein refl ects, as of the date hereof, the views of AllianceBernstein and sources believed by Alliance- Bernstein to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein. In addition, there can be no guarantee that any projection, forecast or opinion in these materials will be realized. Th e views expressed herein may change at any time subsequent to the date of issue hereof. Th ese materials are provided for informational purposes only and under no circumstances may any information contained herein be construed as investment advice. Neither may any information contained herein be construed as any sales or marketing materials with respect to any fi nancial instrument, product or service sponsored or provided by AllianceBernstein or any affi liate or agent thereof. At any given time, the AllianceBernstein family of funds may or may not have investments in the companies discussed or referenced in this research report. Alliance Capital Management 1345 Avenue of the Americas New York, NY 10105 212.969.1000 www.alliancebernstein.com

AllianceBernstein Investment Research and Management, Inc. is an affi liate of Alliance Capital Management L.P., is a member of the NASD. BALSHEETACC05-RETDOM