When Choosing Companies, Go for Quality Earnings


Posted by Vident Financial on 8/29/22 12:56 PM

Basic financial theory teaches that the value of an investment is the value of the future cash flow from that investment, but with an adjustment downward because investors must wait for those future cash flows. All other things being equal, a dollar now is preferable to a dollar 10 years from now. The number used to calculate that downward adjustment is called the discount rate. Future cash flows minus that discount amount is the present value of an investment. Companies pay these cash flows out of future earnings, therefore earnings are important when it comes to determining the present value of an investment, which makes the quality of earnings also important.

The Vident Core U.S. Stock IndexTM (VCUSX) uses a set of factors to create an “Earnings Quality Grouping” which is based chiefly on categories we call “Profitability” and “Growth in Profitability” factors, though it also uses other factors to calculate a “Risk” category, including factors like volatility and risk of default. The premise is that companies with a high degree of earnings quality in the present may be more likely to maintain and perhaps grow earnings in the future.

Click here for a refresher on quintiles, one of our favorite ways of performing this kind of factor analysis.

Starting with an approximation of the VCUSX investable universe of companies, here's our historic analysis of the Earnings Quality Grouping based on the Profitability and Growth in Profitability factors compared to subsequent performance:

(Source: Bowyer Research, 1-1-1993 - 12-31-2021. Performance is gross of fees as VCUSX does incur any management fees. Returns include the reinvestment of dividends. Past performance is not indicative of future results. You cannot invest directly in an index or the Earnings Quality Grouping.)

Since high earnings quality is generally accepted as a good thing, then the top quintile (quintile 1) is the most desirable. It represents the top 1/5th best Earnings Quality Grouping companies in any given time period. So, the leftmost bars are the highest quality companies, and the rightmost are the lowest quality. The height of the bar is the average percent return of the companies in each bucket in the year following the calculation of their earnings quality. It's important to look at the return after the earnings quality score is given, because that’s the way investment has to happen in the real world. You have to act on the knowledge you have before adding a stock to the index, and any returns come after.

We see that, in general, the better Earnings Quality Grouping quintiles have, in the past, been rewarded with higher subsequent returns. The exception is that the worst quintile did a little better than the second-worst quintile. It's impossible to know from this data alone why that is, but one possible explanation is that companies with very bad earnings quality perhaps fall into such disfavor that they end up being very attractively-priced and therefore create the possibility of some advantage arising from a value factor.

This grouping is not as consistent when applied only to large cap companies:

(Source: Bowyer Research, 1-1-1993 - 12-31-2021. Performance is gross of fees as VCUSX does incur any management fees. Returns include the reinvestment of dividends. Past performance is not indicative of future results. You cannot invest directly in an index or the Earnings Quality Grouping.)

Clearly the best quintile has historically outperformed the worst quintile. However, the relationship is more muddled in the middle quintiles. It is important to remember, however, that VCUSX underweights large cap stocks compared to the well-known cap-weighted funds, and has more “smid” cap (small and mid cap) companies than it does large cap ones. Accordingly, it is more important to see how the Earnings Quality Grouping has historically performed in the smid bucket:

(Source: Bowyer Research, 1-1-1993 - 12-31-2021. Performance is gross of fees as VCUSX does incur any management fees. Returns include the reinvestment of dividends. Past performance is not indicative of future results. You cannot invest directly in an index or the Earnings Quality Grouping.)

But since this Earnings Quality Grouping is, well, a grouping, it may be worth zooming in to the components of that grouping to find out which types of factors and which individual factors are most additive. We'll look at that in future articles in this series on earnings quality and investment performance.



The opinions expressed herein are those of Vident Financial at the time of publication and are subject to change. This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the information described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. Recipients should not rely on this material in making any future investment decision.

Investors cannot invest directly in an index. Indexes are not managed and do not reflect management fees and transaction costs that are associated with some investments. Past performance does not guarantee future results.