New York – Last summer, Richard Sloan-a leading expert in the field of earnings quality analysis-took leave from his tenured position at the University of Michigan business school to join Barclay’s Global Investors (BGI). This move indicates that demand for earnings quality analysis continues to grow, even in the post-SOX world.
Richard Sloan and Earnings Quality
Sloan first received recognition for discovering the so-called “accruals anomaly” in the early 1990s. Then an assistant professor of accounting at Wharton, Sloan showed that companies with higher levels of accruals tend to fare worse over time than companies with lower levels of accruals. According to Sloan’s analysis, an investment strategy that included buying companies with the highest earnings quality (lowest level of accruals) and shorting companies with the lowest earnings quality (highest level of accruals) could have produced excess returns of roughly 20%. In an investing world of increasingly elusive alpha, this was a monumental finding.
Sloan developed these insights during his tenure as an accounting professor at Wharton and the University of Michigan. Recently, however, Sloan has decided to take his work to the private sector. As a recent article in BusinessWeek reported, his decision to leave Michigan for BGI was not entirely for the money. “I just felt that BGI was getting ahead of me,” Sloan remarked. “I came here because this is where the leading edge of my research is now.”
BGI searches constantly for new quantitative “signals” to enhance its own proprietary quantitative models. Despite the changes imposed by Sarbanes Oxley, BGI says that earnings quality analysis remains a powerful input for their quantitative models. Even as individual signals have come and gone, the BusinessWeek article reports, earnings quality has been BGI’s single richest source of alpha over the last decade.
The Competitive Earnings Quality Research Market
While BGI has chosen to in-source its earnings quality research, many independent research providers have made good business of analyzing financial statements for the investment community. Some of these providers-such as Criterion (recently acquired by CFRA)-use quantitative processes to rate companies on the basis of earnings quality. By quantifying accruals and adjusting for factors that impact the quality of accruals, the Criterion/CFRA model works to single out companies with a high prospect for under- and over-performing the market. Criterion’s white papers indicate that its accrual model was developed with assistance from three Wharton accounting professors, though it is unclear if Sloan had a direct role in developing it.
Other research providers-such as RateFinancials-use methodologies that go beyond quantitative assessments of earnings quality, incorporating qualitative assessments into their rating systems. In addition to performing standard measurements of earnings quality (measurements that look at levels and quality of accruals), RateFinancials also performs qualitative assessments to determine the accuracy, reliability and completeness of a company’s footnotes, management discussion/analysis and corporate governance practices.
Integrity Research: Monitoring the Earnings Quality Research Providers
RateFinancials and CFRA are just two of the earnings quality research providers that Integrity research tracks. In the next month, Integrity will be putting out a comprehensive review of these providers to highlight the top players with the freshest ideas and most innovative product offerings. For more information about our upcoming ResearchInsight review, please contact Matt Bannister at (212)-845-9088 x6851
Comment by Jack Zwingli:
I am surprised that the blog posted by Integrity Research last week drew a parallel between earnings quality and accruals. The accrual anomaly has been known in the market for a decade or more, and has been incorporated into pretty much every quant model that looks at accounting. In short, if there’s still an anomaly left, it’s small and shrinking.
The broader category of earnings quality is less well defined, and much more important, than simplistic accruals models. There are many important non-accruals factors that corporations use to make financials look better. Identifying these earnings quality risk factors is what BGI is spending their research millions on, not comparing cash flow to net income.
If accruals are a subset of earnings quality, then earnings quality in turn is a subset of the ultimate measure of risk – corporate integrity. Quantitative and qualitative approaches looking to achieve alpha will focus on the reliability of the numbers AND the management. Companies that lack integrity, which must be measured by both financial and non-financial factors, blow up more often – if you want to improve portfolio performance, avoid them (or short them.)
In your upcoming review I hope that you start out by defining the different measures of earnings quality, and try to address the real drivers of successful quant models – here’s a clue, it’s not accruals. In the interests of self disclosure, that’s what my company – Audit Integrity – tries to do. It would be helpful to all interested parties to move away from the fixation on accruals – as it looks like Richard Sloan did, literally and figuratively.
Comment by Bill George:
While reading this article I couldn’t help but think about some of its implications and how the article, perhaps unwittingly, lends support to the one of the basic rational for the Efficient Market Hypothesis (EMH). That rational: in efficient markets widely known and publicly available information on value discrepancies will cause market forces to re-price these value discrepancies to accurately reflect values (fleeting alpha?).
It would be very interesting to run a new “back test” using securities price data from after the publication of Professor Sloan’s earnings accrual model and his long / short straddle disintermediation strategy. I imagine the results might be less rewarding than the effort required performing the back-test. Perhaps the increasing elusiveness of alpha is a consequence of the ever increasing sophistication of analytic techniques, and the ever increasing speed of data processing.
Mr. Sloan’s decision to move from an academic institution, which values publishing research findings, to a private entity, which values maintaining proprietary confidentiality, may have been partially motivated by the realization that the “half-life” of the value of an investment strategy is lengthened by the ability to maintain its “proprietary-ness”.
For those who are unfamiliar with Barclays Global Advisors, BGI has a strong investment in the Efficient Market Hypothesis; years ago Barclays acquired Wells Fargo Investment Advisors. Wells Fargo was a very early pioneer in indexing and by the time Barclays acquired the business WFIA had become the largest institutional asset indexer. Nowadays, BGI runs many other institutional quantitative investment strategies; however I believe their indexed strategies are still their most popular products.
Tongue in cheek:
Where the article says, “As a recent article in BusinessWeek reported, his decision to leave Michigan, for BGI was not entirely for the money”. . . .
I thought it was going to say weather was a contributing factor in the decision. BGI’s is headquartered in San Francisco, California.