Asset Managers Focus on Earnings Quality

Terry Flanagan

Since the 2008 stock market crash, investment managers have placed a heavy emphasis on earnings quality and accounting-related risk management.

“The markets tend not to price earnings that are significantly accounting-driven,” said Nick Gibbons, senior analyst and associate director of research at Gradient Analytics. “For example, an unusual increase in receivables relative to revenue may suggest a risk to persistence of earnings going forward.”

Gradient Analytics, a global equities research firm, has launched Earnings Quality Rank (EQR), a quantitative tool for the asset management industry.

EQR aims to provide an objective and unbiased assessment of a company’s relative potential risk due to accrual accounting practices as reflected in key relationships among information contained in the firm’s income statement, balance sheet, and cash flow statement.

“We were founded on academic principles of observing accounting anomalies,” said Gibbons. “Investment managers want a standard to evaluate earnings quality-related risks, and EQR serves as the latest quantitative tool in addressing this need.”

Sabrient Systems, an independent equity research firm, acquired Gradient Analytics in 2011 to aid clients in alpha extraction through quantitative and qualitative analysis.

The combined core knowledge from has enabled Sabrient to develop an exclusive ranking methodology that can detect early warnings of accounting irregularities that can negatively impact corporate earnings.

“Academia has taken a stab at applying earnings quality to create alpha but has fallen short,” said Scott Brown, president of Sabrient Systems. “Even the largest funds lack in-house forensic accounting expertise. “We’ve taken the core methodology on determining earnings quality developed by Gradient and applied it to our quantitative models so that fund managers can better manage risk.”

The variables used to construct EQR include evolved calculations of accruals and other unique earnings quality risk assessment factors developed by Gradient Analytics.

Moreover, EQR features assessments of earnings quality of companies within the financial industry, which often is not offered by competing solutions.

“In addition to our regular coverage of non-financial companies exhibiting unusual earnings quality-related risks, our analysts played a vital role during and after the 2008 economic crisis in assisting clients when assessing the earnings quality of financial institutions,” said Gibbons. “We were able to assemble factors, such as loan-loss revisions, that could predict earnings quality.”

To develop the EQR model, Gradient’s research team selected the most salient accounting factors associated with a firm’s future returns. The Gradient variables were then quantified and backtested by Sabrient’s research team to find those with the highest correlation among financial statements and negative events. The final variables were sized and scaled and, as a result, the most correlated ones became the foundation for EQR.

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