What explains this dynamic? Part of the answer is that some segment of the investment public appears to be too focused on the “bottom line” results of the companies they are invested in. As is the case with a range of investor biases these investors do not fully incorporate the fact that the composition of those earnings make a difference in how stable future earnings will be. In short, some investors may buy companies whose earnings growth is being driven by large accruals only to be surprised in future earnings announcements to learn that the non-cash component of those earnings was not as stable as they expected. An investment strategy that overweights low-accrual companies and underweights high-accrual companies can seek to take advantage of this effect.

The concept of a “quality” company can be fuzzy and difficult to pin down. But the upshot for investors is that a more focused definition of quality based on an analysis of a company’s composition of earnings can be a useful tool for selecting securities or evaluating fund manager’s strategies.

Daniel Morillo, PhD, is the iShares Head of Investment Research.

[1] Data is from Bloomberg. Only equity-focused funds and only the primary listing is counted, so funds with multiple share classes or listing exchanges are counted only once.
[2] See, for example, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings” by Richard Sloan, 1996. The Accounting Review Vol 71.
[3] See, for example, “Earnings Quality and Stock Returns” by Chan et. Al, 2006. Journal of Business.