Measuring Company Quality

Abstract

Over the last decade the accruals phenomenon has garnered much attention in the U.S. and increasingly worldwide. In particular, academic and industry research in the U.S. has found that accruals are an effective contrarian signal because they measure the extent to which earnings do not reflect operating fundamentals, but which the market in turn seems to ignore. In the Australian context we find total accruals, as opposed to simple accruals, add the most consistent value through time. Alternately, back tests across the Australian equity market found the Altman Z-score (originally developed to help distinguish between healthy companies and those likely to go bankrupt) had strong predictive power, but disaggregation into its underlying components showed only two out of its five ratios were effective at detecting relative levels of quality across the entire equity market spectrum. These components are retained earnings to total assets and EBIT to total assets (ROA). Combining total accruals and the two relevant Z-score components together into one quality indicator creates a generalized metric that added value across different size dimensions and when sector neutralized. It was particularly powerful within a growth universe, although it still added value for cheap stocks.

TOPICS: Portfolio construction, information providers/credit ratings, risk management