Look under the hood of exchange-traded funds (ETFs) incorporating a quality factor and you will often find accruals being used. An accrual is an accounting entry recorded at the time a transaction occurs, regardless of whether not payment has been made. Accrual accounting allows businesses to report their sales and earnings performance without being beholden to the timing of transaction-related cash flows.
The downside of accrual accounting is the risk of those transactions not being completed in the future. Customers may not pay their bills or may push to renegotiate contracts. Inventories may be sold at lower-than-anticipated prices or even written down. There are certainly other examples, but one of the risks with accruals is too much optimism on the part of management. This excessive optimism can lead to lower future stock returns.
This was the conclusion reached by Richard Sloan in “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” (The Accounting Review, July 1996). In this oft-cited analysis, Sloan found that stocks with the lowest levels of accruals experienced abnormal returns of 4.9%. Stocks with the highest levels of accruals experienced abnormal returns of -5.5% over the following 12 months after being included in a portfolio. (An abnormal return is a return that is different than would be expected.) Subsequent studies confirmed the existence of an accrual anomaly. ETFs using an earnings quality component consider accruals.
There are different ways for calculating accruals, but the math is straightforward. The only thing you need is financial statements for the two most recently completed fiscal years and either a spreadsheet or a calculator, pencil and paper. Stock Investor Pro users can also create custom fields in the program to automate the calculations.
Using “Δ” to imply the year-over-year change, Sloan listed accruals in his 1996 study as equaling:
(ΔCurrent Assets – ΔCash/Cash Equivalents) – (ΔCurrent Liabilities – ΔShort-Term Debt Included in Current Liabilities– ΔTaxes Payable) – Depreciation and Amortization Expense
The accruals calculated by the above equation should be scaled (meaning divided by) the average total assets for the most recently completed fiscal year and the year prior. Doing so allows an apples-to-apples comparison between companies of different sizes to be made. Depending on the formula, accruals may be scaled to net operating assets at the start of the fiscal year instead.
Low levels of accruals are good and high levels of accruals are bad. The problem with calculating the data for just one company is relative context. There is no measurement of all companies to compare it against. Rather, the math must be repeated for all companies, with results ranked from lowest (good) to highest (bad). Index providers who do this winsorize the data. Winsorization reduces the impact on statistical analysis that outliers with extraordinary high or low values have. This might not be a daunting task for those who have mathematical backgrounds and are comfortable with spreadsheets, but it’s certainly not something most others desire to get involved with. (Index providers and quantitatively-oriented investment firms rank stocks based on specified criteria to ensure that a sufficient number of stocks can always be found. Using absolute instead of ranked values has the advantage of finding more stocks when conditions are favorable and less when conditions are unfavorable.)
Those of you seeking a shortcut can similarly look for negative values. An alternative is to avoid stocks whose net income exceeds free cash flow (cash from operating activities less capital expenditures). Another option is to determine how the asset turnover ratio (sales/assets) has changed on a year-over-year basis. An increase in this ratio shows that a company is more efficiently turning its assets into sales; a decrease shows lower efficiency. Scott Richardson, in a 2001 paper co-authored by Sloan and two others, suggested using net operating assets (NOA) instead of reported total assets in the denominator of the assert turnover ratio. NOA is:
(Total Assets – Cash and Short-term Investments) – (Total Assets – Short-term Debt – Long-term Debt – Common and Preferred Equity – Minority Interest)
- The Cash Flow Statement: Tracing the Sources and Uses of Cash – Whereas accrual accounting causes opaqueness between the balance sheet and the income statement, the cash flow statement reveals how much cash is actually flowing into and out of the business.
- CFOs Identify Financial Statement Red Flags – Lots of accruals and/or large changes in accruals warrant suspicion, say chief financial officers.
- Why Value Beats Growth: A Brief Explanation – Peter Berezin explains why value stocks perform better, and shares other traits associated with better-performing stocks.
- Value Stocks With Upward Momentum – This month’s First Cut lists 16 profitable value stocks with rising earnings estimates.
Following his September quarterly portfolio review, James Cloonan unveiled several new portfolio rules for the Model Shadow Stock Portfolio. These new rules came about from changes in market conditions as well as Cloonan’s research for his book, Investing at Level3. The specific changes are:
- The maximum market capitalization was raised from $300 million to $400 million. This also means that the new sell threshold for stocks in the portfolio will now be $1.2 billion.
- Stocks in the rental & leasing industry classification of Thomson Reuters have been eliminated from the portfolio and will no longer be considered for purchase.
- Stocks in the utility sector classification of Thomson Reuters will no longer be considered for purchase.
- In order to be considered for the Model Shadow Stock Portfolio, a stock must have relative price strength over the last 26 weeks that ranks in the top half of the stock universe. In other words, the stock’s price must have increased more (or decreased less) relative to the market than the majority of stocks in our database over the last 26 weeks.
In addition, Cloonan has adjusted the portfolio management rules to permit holding more than 5% in cash. This allows for greater flexibility and patience when making buy decisions for the portfolio.
As a result of these rule changes, as well as updated quarterly earnings, three stocks were removed from the portfolio:
- CDI Corp. (CDI) and LMI Aerospace (LMIA) were sold because they violated their earnings probation for consecutive quarters.
- Willis Lease Finance Corp. (WLFC) was sold because it is in the rental & leasing industry, violating the new rule implemented this month.
Three companies were added to the Model Shadow Stock Portfolio:
Members were alerted about these changes via a special Model Portfolios Update email on September 1, the day Jim Cloonan placed the buy trades, and a posted notice at the Model Portfolios area of AAII.com. In the future, we will inform members of changes to the AAII model portfolios via special email alerts and website notices. Be sure you are signed up to receive these free notices by going to www.aaii.com/email and selecting the Model Portfolios Update email.
The Model Shadow Stock Portfolio climbed 2.2% in August. Overall, the Model Shadow Stock Portfolio outperformed the DFA U.S. Micro Cap Fund (DFSCX), which was up 1.6% in August. Year-to-date, the AAII Model Shadow Stock Portfolio is up 11.8%, compared to the S&P 500 large-cap index, as represented by the Vanguard S&P 500 index fund (VFINX), which is up 7.7%. The DFA U.S. Micro Cap Fund (DFSCX) is up 9.8% for the year through the end of August.
No changes were made to the AAII Model Fund Portfolio. The Model Fund Portfolio lost 0.26% in August, compared to a 0.13% total return for the SPDR S&P 500 ETF (SPY). The Model Fund Portfolio has gained 8.8% year to date, while the SPDR S&P 500 ETF is up 7.7%.
Two of my colleagues will be speaking. This Saturday, September 17, Wayne Thorp will give our Puget Sound chapter suggestions on how to find good stocks. Then on Tuesday, Jaclyn McClellan shares the findings from her latest analysis of robo-advisers with our Eastern Michigan chapter.
We’ll see the first batch of third-quarter early reporters next week. Announcing earnings will be S&P 500 members Adobe Systems (ADBE), FedEx Corp. (FDX) and Lennar Corp. (LEN) on Tuesday; Bed Bath & Beyond (BBBY), CarMax (KMX), General Mills (GIS) and Red Hat (RHT) on Wednesday; and AutoZone (AZO) on Thursday.
The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. The meeting announcement and updated committee member forecasts will be released at 2:00 p.m. ET on Wednesday. Fed chair Janet Yellen will hold a quarterly press conference at 2:30 p.m. ET. The CME’s FedWatch Tool shows an 88% chance of rates staying unchanged. The odds for no change occurring at the December meeting are currently at 53.8%. The December odds are very much subject to change.
Elsewhere on the economic calendar, the National Association of Home Builders’ September housing market index will be released on Monday. Tuesday will feature August housing starts. August existing home sales will be released on Thursday. Friday will feature the September purchasing managers’ manufacturing index (PMI) flash.
In addition to Janet Yellen’s press conference on Wednesday, three Federal Reserve officials will speak on a panel on Friday: Philadelphia president Patrick Harker, Atlanta president Dennis Lockhart and Cleveland president Loretta Mester.
The Treasury Department will auction $11 billion of 10-year Treasury inflation-indexed securities (TIPS) on Thursday.
- From Saver to Spender: Managing Your Money in Retirement
- The Truth About Top-Performing Mutual Fund Managers
- Why Buy Bonds If Interest Rates Will Rise?
Pessimism jumped to a three-month high as more than one out of three individual investors described their short-term outlook as "bearish" in the latest AAII Sentiment Survey. At the same time, neutral sentiment fell to its lowest level since February. Bullish sentiment is also lower.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 1.8 percentage points to 27.9%. The decline puts optimism at its lowest level since June 22, 2016 (22.0%). The decline also keeps bullish sentiment below its historical average of 38.5% for the 78th week out of the past 80.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, plunged 5.6 percentage points to 36.1%. Neutral sentiment was last lower on February 17, 2016 (32.1%). Nonetheless, neutral sentiment remains above its historical average of 31.0% for the 33rd consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 7.4 percentage points to 35.9%. Pessimism was last higher on July 15, 2016 (37.5%). This week’s rise puts bearish sentiment above its historical average of 30.5% for the second time in three weeks.
Though this week’s neutral and bearish sentiment readings are well within their typical historical ranges, both are unusual relative to what we’ve seen throughout this calendar year. This week’s neutral sentiment is the fifth-lowest reading recorded this year, and pessimism is at its eighth-highest level for the year. The four lower neutral sentiment readings and six of the seven higher pessimism readings occurred near the start of this year, in January and February.
The shift in sentiment occurred as both large-cap and small-cap stocks experienced recent downward volatility. Some AAII members have previously expressed concern about valuations or the potential for a decline occurring. Also keeping some individual investors bearish, or at least giving them reason to be cautious, are global economic uncertainty and disappointment with corporate earnings growth. The presidential election continues to be brought up in responses to our weekly special questions. Giving other individual investors reason for optimism are this summer’s rise in stock prices, the perceived lack of investment alternatives, corporate earnings and sustained, albeit slow, economic growth.
This week’s special question asked AAII members what they thought about the NASDAQ setting a record high last week. Responses were mixed. About 21% thought the new record high was a positive event. Another 5% said the record high was expected to eventually occur. On the other side of the spectrum, 21% of respondents described the record as a sign that the market has risen too much, is overvalued or is otherwise due for a decline. An additional 5% of expressed cautiousness about the stock market. Nearly 13% said the record high has not impacted their outlook or investing strategy.
Here is a sampling of the responses:
- "Money is flowing to technology for growth.”
- "It was inevitable. I’m fine with it.”
- "Another indicator that the equity market is very expensive.”
- "Disconnect between stock values and the real economy. There is no other place to put your money.”
- "It doesn’t affect my thinking about investing.”
Bullish: 27.9%, down 1.8 points
Neutral: 36.1%, down 5.6 points
Bearish: 35.9%, up 7.4 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Local Chapter Meetings
September 8, 2016 Jeopardy! Shows Humans Don’t Maximize Profits
September 1, 2016 The Impact Returns Have on How Much You Should Save
August 25, 2016 Taking on Risk and Hoping the Strategy Doesn't Backfire
August 18, 2016 A Request to Parents of Gen Xers and Baby Boomers
