The third metric, accruals, attempts to capture the historical and well-documented accruals anomaly, which is the negative relationship between accounting accruals and subsequent stock returns. This anomaly relates to the persistence of profitability. Academic evidence (see Sloan 19962) indicates that earnings attributable to accruals (such as accounts receivable) exhibit lower persistence than earnings attributable to cash received. Accruals are an accounting construct that allow companies to keep track of non-cash-based accounts such as accounts receivable. Since they are non-cash, accruals can also serve as a means for earnings manipulation because they are subject to a high level of manager discretion. In other words, misestimating accruals could decrease a company’s earnings quality. Therefore, to identify firms that report high quality earnings and to capture the seemingly persistent accruals anomaly, the quality factor underweights companies that exhibit higher levels of accruals.
Beyond profitability, the second component of the quality factor is leverage. Leverage is calculated by dividing operating cash flow by total debt. Historically, low levels of cash flow to debt have been shown to be related to the likelihood of business failure. Logically, companies that have higher leverage face a higher risk of default. In addition, historical data indicate that increased leverage is typically associated with lower future profitability. Accordingly, the quality factor tilts portfolios towards investing in companies that have lower levels of leverage.
Overall, he quality factor captures detailed information about companies and aims to enhance investor returns by tilting portfolios towards stocks that rank well from both a profitability and leverage standpoint. We seek out companies that earn more dollars of net income per dollar of assets, squeeze more sales from their assets this year than last, report high quality earnings, and use relatively less leverage. We hope that by digging deeper into how the quality factor works, this blog gives investors a better understanding of why they might choose a factor investing strategy that systematically seeks companies that score well on quality. More on factor investing can be found on our dedicated factor investing website: dws.com.
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1. Normally, we would expect quality to be a defensive factor that performs well during market downturns, but this recent trend merely evidences that long-run relationships do not necessarily hold in the short-run.
2. Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? Richard G. Sloan, The Accounting Review, Vol. 71, No. 3. (Jul., 1996).