With so much talk about factor investing, in particular the quality and value factors, often lost in the conversation is that a primary tenant of emphasizing quality should be steering clear of the riskiest companies.
Among exchange traded funds, there are examples of overlooked, but straight forward funds that intently focus on keep investors away from debt-laden risky companies that could take investors down a road of ruin. The Forensic Accounting ETF (NYSEArca: FLAG) is one example.
FLAG’s holdings are drawn from a universe of 500 stocks and tracks the Del Vecchio Earnings Quality Index, which assigns 500 large-cap stocks a grade of A through F based on fun manger John Del Vecchio’s “earnings quality” methodology. The index looks for aggressive revenue recognition, inventory issues, reserve concerns, large changes in operation expenses, large changes in operation income and tax issues. The index would then exclude F ranked stocks, instead of shorting them. [FLAG Boots the Weak Links]
Companies ranked the highest in earnings quality make up 40% of the index, whereas rank B, C, D earnings quality firms receive a 20% weighting.
Excluded companies raise red flags by carrying too much debt, using aggressive accounting practices, holding too much inventory and other issues, according to fund data.
FLAG’s focus on companies’ financial statements leads to a group of holdings that “are all solid companies and highly diversified, but it goes one step further and culls out companies that have any kind of issues with earnings or accounting practices,” reports Will Deener for the Dallas Morning News.
As the Morning News notes, one of the big name companies left out of FLAG’s lineup is Dow component International Business Machines (NYSE: IBM). Although IBM is a consistent dividend raiser and one of the largest repurchasers of its own shares among S&P 500 firms, the company has taken advantage of low interest and used debt to fund many of its moves that, on the surface, appear shareholder friendly. [IBM Isn’t a Player in Buyback ETFs]
IBM has $33 billion in debt and would not be able to cover its payout if not for selling corporate bonds, according to the Morning News.
On the other hand, A-rated stocks show strong balance sheets, sold cash flow, sustainable buybacks and dividends, and gross profit and EBITDA margins are rising.
Del Vecchio anticipates FLAG will see higher turnovers, up to 30% annually, due to changes in F-rated stocks, but it is still lower many actively managed ETFs. [A Look at the Forensic Accounting ETF]
FLAG holds an array of familiar stocks, including Warren Buffett’s Berkshire Hathaway (NYSE: BRK-B), Bank of America (NYSE: BAC), Caterpillar (NYSE: CAT), eBay (NasdaqGS: EBAY), Intel (NasdaqGS: INTC) and Microsoft (NasdaqGS: MSFT).
Forensic Accounting ETF
