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April 2005

Taking Earnings Quality into Account: A Practitioner’s Research into

Balance-Sheet Accruals

Key Issues and Investment Implications

■ Do balance-sheet accruals signal futureearnings and stock prices?

■ Does the BSA tool have fundamental underpinnings?

■ Can the BSA tool be used outside the US?

■ How can BSAs be used to enhance research and stock selection in growth and value portfolios?

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• Are Not FDIC Insured • May Lose Value • Are Not Bank Guaranteed

■ Building upon academic studies, our research has

found that changes in balance-sheet accruals scaled to

the size of the balance sheet are a powerful indicator

of future earnings and stock prices. Within the large-

cap US market, for example, low BSA stocks outper-

formed high BSA stocks by 9.3% a year on average from

1978 to 2003.

■ Our BSA tool captures the risk that the accrual com-

ponent of earnings is not reliable and thus will not

persist. Th e unreliability typically stems from the way

management optimism or pessimism infl uences the

assumptions used in estimating accrual accounts, as

well as earnings management, capital management

and the mean reversion of earnings and sales.

■ Th e BSA tool appears to be eff ective for large-cap

and small-cap stocks and within the growth and val-

ue realms in the US and in major markets around

the world. Diff erences in accounting rules (most of

which have been eliminated) made it less useful in

the UK and Japan until just a few years ago.

■ Th e BSA tool could help growth investors by

underlining the risk that trailing sales growth and re-

turn on equity will rapidly revert to the mean.

■ We have integrated the tool into Bernstein’s risk-

adjusted return model for US value portfolios and

hope to introduce it into all of the Bernstein value

portfolios in 2005. Our research shows the BSA

tool has a very low correlation with our valuation

metrics and thus is picking up diff erent information.

We have also found that the tool enhances our

fundamental research by providing a disciplined,

quantitative framework for comparing company

balance sheets.

About the Author

John P. MahedyCo-Chief Investment Offi cer and Director of Research—Bernstein US Value EquitiesMr. Mahedy was named Co-CIO—US Value Equities in 2003. He continues to serve as Director of Research—US Value

Equities, a position he has held since 2001.

Previously, Mr. Mahedy was a senior research analyst in Bernstein’s institutional research and brokerage unit, covering

the domestic and international energy industry from 1995 to 2001 and the oil-services industry from 1988 to 1991. He

also covered oil services at Morgan Stanley in the early 1990s. Mr. Mahedy was ranked among the top-fi ve oil analysts

in the Reuters and Greenwich Associates polls in 1999 and 2000, and he was named to Institutional Investor magazine’s

All-America Research Team in 1993, 1994 and 1995.

Mr. Mahedy, a CPA, began his career as a senior auditor with Peat Marwick Main. He earned a BS and an MBA from New

York University. ■

Executive Summary

TAKING EARNINGS QUALITY INTO ACCOUNT

Executive Summary Inside Front Cover

Introduction 2

Defi ning BSAs 4

The Fundamental Variables that Drive BSAs 6

Th e Superiority of Cash Earnings 6

Pessimistic or Optimistic Assumptions 6

Earnings Management 7

Capital Management 8

BSAs: Can You Export the Concept? 10

Mean Reversion of Sales and Earnings 12

BSAs and Growth Investing 14

Is the BSA Tool Biased Against High-Growth Companies? 14

Why BSAs Work Within the Growth Arena 15

Using BSAs in the Growth Arena 15

BSAs and Value Investing 17

Are BSAs Additive to Value? 17

Are BSAs Additive to Earnings Revisions? 17

Putting the BSA Tool to Work 18

Bibliography 20

Table of Contents


| AllianceBernstein2

Taking Earnings Quality into Account:A Practitioner’s Research into Balance-Sheet Accruals

By John P. MahedyCo-Chief Investment Offi cer and Director of Research—Bernstein US Value Equities

For the fundamental analyst, addressing the quality or

reliability of reported earnings is critical to making an

accurate earnings forecast and estimating a stock’s return

potential; thus, most fundamental investors would argue

that they pay attention to earnings quality. Nonetheless,

academic research has shown that an indicator of earnings

reliability in readily available fi nancial reports—the

changes in balance-sheet accruals (BSAs)—is a strong

signal of a company’s future profi tability and stock price.

Th is implies that most investors, in fact, are not paying

suffi cient attention to all of the available information

about earnings quality, thus creating an opportunity for

other investors to exploit.

Our own research has confi rmed the academic fi ndings

and refi ned the BSA tool to make it more powerful and

applicable to all industry sectors. As important, our

research sheds light on the fundamental variables that

make BSAs an eff ective quantitative tool.

Th e BSA tool allows us to systematically compare

changes in balance-sheet information for each company

relative to its peers and to the market as a whole.

Th us, we have integrated this tool into the research

process and risk-adjusted expected return framework

that we use in selecting stocks for Bernstein’s US large-

cap value portfolios, and we are exploring how to use it

in all of our value services globally.

It appears to be quite powerful. Th e quintile of US large-

cap stocks with the lowest balance-sheet accrual growth

outperformed the quintile with the highest BSAs from

1978 through 2003 by 9.3% a year. While the lowest

accrual stocks outperformed the US large-cap market

by 4.7% a year on average, the highest accrual stocks

underperformed by 4.6% (Display 1). Th e tool is also

remarkably consistent, generating a positive return

between the low and high accrual groups in all but three

of the 26 years tested.

Th e tool appears even more powerful for small-cap

stocks. Th e quintile of US small-cap stocks with the

lowest balance-sheet accrual growth outperformed the

quintile with the highest BSAs by more than 18% a year

on average from 1980 through September 2004. Most

quantitative tools, however, deliver more powerful results

in back tests within the small-cap arena than within the

large-cap arena. Our research and experience show that

the added power cannot be fully harnessed in managing

small-cap portfolios, due to the lower liquidity and

higher transaction costs of small-cap stocks. Th us, we

assume that in practice, the tool should deliver similar

results within the US large-cap and small-cap universes.

Display 1BSAs: A Powerful Predictor of Returns

Indexed to 100 on December 31, 1977; return vs. US large-cap universe, defined as

all stocks with more than 2 basis points of total US equity market capitalization.

Source: Compustat and Bernstein

INTRODUCTION


3AllianceBernstein |

Th e tool also appears to be eff ective globally, although

diff erences in accounting rules (most of which have

been eliminated) made it less useful in the UK and Japan

until recently.

While some of the tool’s underlying drivers seem to have

a value fl avor, our research shows that the tool should

be valuable to growth investors as well. We divided the

large-cap universe into value stocks and growth stocks

on the basis of trailing price to sales1 and found that the

tool is quite eff ective within both the value domain and

the growth domain (Display 2). In fact, it was somewhat

more eff ective for stock selection within growth, with a

spread between low- and high-accrual stocks of nearly

11% a year, compared to 9% a year for value stocks, with

similar consistency. ■

Display 2BSAs Are Powerful in the Value and Growth Arenas

Annualized Return vs. Style Universe 1978–2003

Quintile US Value US Growth

Low Accruals 3.7% 5.2%

High Accruals (5.3) (5.5)Outperformance

Low vs. High +9.0% +10.7%Past valuations are no indication of future results.

Annualized quarterly return versus equal-weighted style index. Growth index

includes the more expensive half of the US large-cap market universe based

on price/sales; value index includes the less expensive half. BSA quintiles were

formed quarterly using Bernstein definition of net operating accruals within

each style universe, and the performance of the highest and lowest BSA quintiles

was compared to the style index.


1 We also divided the universe into value and growth on the basis of price to book, with very similar results—a spread of about 11% on average for growth stocks and about 9% on average for value stocks.



Balance-sheet accruals arise from the attempt to make

reported earnings more meaningful than they are in a

pure and very simplifi ed cash-accounting system. In

the latter, earnings are simply equal to the change in

cash from period to period. Such fi nancial statements

are highly objective and reliable, because they can be

easily audited—but they are almost never meaningful.

Th ere are numerous events in the life of a corporation

that span multiple accounting periods, which can give

a distorted impression of earnings under a cash-based

accounting system. For example, a fi rm that spent a lot

of cash building inventory in one year that isn’t sold until

the next would report earnings that look misleadingly

bad in the fi rst year and misleadingly good the next.

Accrual accounting attempts to make reported earnings

more meaningful by better matching costs with related

revenues. In this system, earnings are the sum of the cash

fl ows and the changes in balance-sheet accrual accounts.

Th is attempt to make the data more meaningful intro-

duces subjective judgments and assumptions. Hence,

accrual accounts are prone to error—both uninten-

tional and deliberate—and studying changes in accrual

accounts can be rewarding.

Most oft en, investors think of accruals in terms of current

operating assets and liabilities, such as inventories and

accounts payable. But accruals can be defi ned more

broadly. Th ere are also non-current operating accruals,

such as physical plant and equipment and deferred taxes.

Together, current and non-current operating accruals

make up net operating accruals. If you add in fi nancial

accruals, you get total accruals, which encompass

all balance-sheet accounts other than cash and share-

holder equity.

Research by Professors Scott Richardson, Richard Sloan,

Mark Soliman and Irem Tuna2 tested several defi nitions

of accruals ranging from very narrow metrics focusing

on single balance-sheet accounts to more compre-

hensive measures. Prior academic research had shown

that, broadly speaking, the more a balance-sheet accrual

account is subject to estimation, the more changes

in this account will forecast future stock performance.

In other words, the more diffi cult it is to precisely defi ne

and audit the exact balance, the more prone to error the

account becomes—and the more changes in earnings

stemming from such accounts should be viewed with

skepticism. Nonetheless, while the forecasting ability

of individual accrual accounts yields impressive results,

Richardson et al. found that when applied to a large

data set, a broad measure of accruals encompassing

both short- and long-term accounts, scaled to the size

of the balance sheet, was most eff ective in estimating

stock returns. In our reconstruction of their results, the

quintile of low-accrual stocks beat the market by 2.9% a

year on average, and the quintile of high-accrual stocks

lagged by 5.3%. Th at is, low accruals beat high accruals

by 8.2%.

Making the Tool PracticalTh e Richardson et al. study relied on annual balance-

sheet data and excluded fi nancial stocks, which the

authors thought might not be comparable to non-

fi nancial stocks, given the diff erent balance-sheet

structure of fi nancial companies. As practitioners—not

academics—we were uncomfortable with the idea of

waiting for a full year to get new balance-sheet infor-

mation, when an updated balance-sheet scorecard

is available quarterly. It would also limit the tool’s

usefulness to exclude the fi nancial sector, which makes

up 20% to 30% of the capitalization of various broad US

market indexes and an even greater share of many other

markets.

So, we looked for ways to make the tool more practical for

use in our investment process. We tested its eff ectiveness

by industry and found that, like most quantitative tools,

it produced positive results for virtually all industries.

Th e results varied by industry, of course. Th e spread

between high and low BSA stocks within the three major

fi nancial industries (insurance, banking and investment

banking/brokerage) was near average. Results for the

data-processing and leisure industries proved to be

above average historically. Results for steel and airlines

were below average. Statistically speaking, however, the

dispersion was not signifi cant enough to bias our expec-

tations about the future. 2 Scott A. Richardson, Richard G. Sloan, Mark T. Soliman and Irem Tuna, “Ac-crual Reliability, Earnings Persistence and Stock Prices,” July 2003

DEFINING BSAs



Th e academics, using annual data, chose to exclude

changes in long-term assets, perhaps because this

accrual account is relatively stable and not highly subject

to estimation. Th e quarterly data Compustat provides,

however, lumps long-term assets in with other data

more prone to estimation. In order to use quarterly

balance-sheet information, we included changes in long-

term assets in our defi nition of net operating accruals.

Nonetheless, when we applied the Bernstein defi nition

of net operating accruals—based on quarterly data—to

the full universe of large-cap stocks, we found it even

more eff ective than the academic version (Display 3).

It is this defi nition of balance-sheet accruals that we use

in the rest of this paper, except when stated otherwise. ■

Display 3We Enhanced the Efficacy of the Academics’ Tool

Annualized Return vs. Market 1978–2003

QuintileAcademics’ Net

Operating AccrualsBernstein Net

Operating Accruals

Low Accruals 2.9% 4.7%

High Accruals (5.3) (4.6)

Outperformance

Low vs. High +8.2% +9.3%Past valuations are no indication of future results.

Annualized quarterly return versus equal-weighted US large-cap market uni-

verse. Quintiles for academics’ net operating accruals were formed annually

based on annual data and exclude financial stocks. Quintiles for Bernstein net

operating accruals were formed quarterly using Bernstein’s definition of net

operating accruals based on quarterly data and include financial stocks.




Th e tool’s forecasting power certainly got our attention,

but we would never adopt a quantitative tool simply

because it performed well in back tests. We have to be

satisfi ed that the tool’s power is likely to persist because

it captures important information about company

fundamentals not already captured elsewhere in our

investment process. Our research has convinced us that

this tool meets these criteria.

The Superiority of Cash EarningsSeveral academic research studies suggest that the

balance-sheet accrual tool captures information about

the likelihood that current-year earnings will persist

into the future. Although investors tend to take earnings

reports literally and treat all sources of earnings as equal,

the accrual component of earnings is less reliable then

the cash component.

Research published in 1996 by Professor Richard Sloan3

illustrates this point clearly. Sloan separated companies

into categories of high current accruals and low current

accruals and observed the changes in their return on

assets in the fi ve years before and aft er the measurement

date (Display 4). On average, reported earnings

and return on assets for the decile of companies with

the highest accrual growth increased rapidly prior to

the measurement date—but tended to reverse sharply

soon thereaft er.

Display 4Extreme BSAs Rapidly Revert to the Mean

Highest and lowest deciles of accruals each event year. Accruals defined as change

in non-cash current assets, less the change in current liabilities, excluding short-

term debt and taxes payable, minus depreciation expenses, and divided by average

total assets. Universe included about 2,000 US stocks per year, on average.

Source: Sloan, 1996

Sloan’s data also suggest that the speed of this reversion

was fastest in the component and return on assets related

to changes in balance-sheet accruals; the cash component

was more stable. In eff ect, this says that if you see rapid

accrual growth, be skeptical about the likely persistence

of company profi tability. Th e opposite pattern played

out with the lowest accrual stocks: Th e return on assets

recovered in the period ahead, as the depressing eff ect

from the change in accruals reversed.

Why should this be? Aft er testing hundreds of samples,

we concluded that balance-sheet accruals capture

four fundamental themes: unduly pessimistic or

optimistic accounting assumptions; deliberate earnings

management; capital management; and the mean

reversion of sales and earnings. We’ll discuss each of

these ideas in turn.

Pessimistic or Optimistic Assumptions Since accrual accounting entails subjective judgments,

reported earnings in this system frequently refl ect

management’s pessimism or optimism. Th us, two

management teams reviewing the same set of facts might

come to very diff erent conclusions about the appropriate

level of current-period earnings.

We can illustrate this with a hypothetical example of two

companies that start to see modest slowdowns in current

sales during a quarter. One company has a pessimistic

management team; the other, an optimistic management

team. Both end up with the same level of sales at the end

of the quarter.

Th e pessimistic management team might assume that the

disappointing sales indicate that a sustained downward

trend has begun. Th us, it might reduce its estimate of the

value of inventory in the warehouse and of the likelihood

of collecting on outstanding receivables. Th ese decisions

would reduce both current earnings and balance-sheet

accruals. Th e pessimistic management team might also

cut production to limit any further growth in inven-

tories from weaker sales. Again, this would hurt current

earnings as fi xed overhead costs were applied to fewer

units of output, while also reducing accrual growth. Th is

company would end up with an attractive BSA score.

THE FUNDAMENTAL VARIABLES THAT DRIVE BSAs

3 Richard G. Sloan, “Do Stock Prices Fully Refl ect Information in Accruals and Cash Flows About Future Earnings?” Th e Accounting Review, July 1996, vol. 71, no. 3



By contrast, the company with the optimistic manage-

ment team assumes that sales growth will bounce back

quickly. Th us, it sees little need to lower inventories

or reassess receivables, and it maintains production

levels that build inventories and increase accruals. Th is

company would end up with a less attractive BSA score.

Although both companies fi nish the quarter with the

same level of sales, the pessimistic company would

report lower margins and earnings. Th e market would

probably react more negatively to this earnings report

than to the more optimistic company’s report.

At this stage, it’s impossible to know which management

is correct in the accounting assumptions that underpin

its earnings report. Th e balance-sheet accrual tool,

however, suggests that we should not be indiff erent. It

suggests that we would increase our chances of success

by investing in the company with the more pessi-

mistic (or conservative) management. Th is refl ects the

skewed market reactions to the possible outcomes for

each company.

If management at either company is ultimately proved

correct, there would be no earnings surprise and thus

no market reaction. If they are proved wrong, however,

the two managements would have to adjust their accrual

accounts or reverse them through earnings, creating

earnings surprises that would probably cause very

diff erent market reactions.

If the optimistic management that built inventories is

proved wrong, it would have to write down inventories

or cut production sharply in the future. Th e resulting

earnings shortfall would likely produce a big negative

surprise relative to investor expectations, with negative

implications for the stock price.

If the pessimistic management that had decided to

slow production is proved wrong, it would have to

increase production above normal levels, resulting

in higher margins as fi xed costs are spread over the

larger number of units of output. Furthermore, the

value of existing inventories and receivables would

be understated, and this extra value would have to

be reversed back into income in the period ahead.

In this case, there would be a positive surprise in

earnings, with positive implications for the stock price.

Display 5Earnings Surprise Is Skewed to Favor Low BSA Stocks

Optimistic Forecast Pessimistic Forecast

If Proved Correct No Surprise No Surprise

If Proved Wrong Negative Surprise Positive Surprise

Th us, in this example, the best outcome when investing

in the company with the optimistic management is

neutral; the worst outcome is potentially very negative.

Conversely, the worst outcome with the conservative

management is neutral, but the best outcome is very

positive (Display 5).

Earnings ManagementIn the example above, both management teams were

doing their best to be objective. At other times, the desire

to meet certain performance thresholds may aff ect their

judgment in making assumptions: Th is is oft en called

earnings management. Earnings management can range

from mild manipulation within the bounds of generally

accepted accounting principles to more severe distor-

tions and even outright fraud. While it is hard to measure

earnings management directly, there is indirect evidence

that it exists.

Several academic studies have demonstrated that earnings

reports cluster around certain thresholds: reporting

breakeven results, earning as much as in the prior period

and reaching consensus estimates. Degeorge et al.4 for

example, examined year-on-year changes in earnings

growth and found a sharp break in the bell curve at no

growth (Display 6, next page). Th ere are abnormally few

reports of a small decline in growth and an abnormally

large number of reports at—or just above—the previous

year’s earnings. Similar patterns of discontinuity can be

found at other break points, such as reporting positive

earnings and reporting earnings that match or exceed

the consensus.

Earnings management may play a large role in the

accrual reversal pattern that we saw in Sloan’s work on

the mean reversion of earnings and returns for high-

and low-accrual stocks. To the extent that a company

borrows from the future to meet today’s threshold, it

4 François Degeorge, Jayendu Patel and Richard Zeckhauser, “Earnings Manage-ment to Exceed Th resholds,” Journal of Business, 1999, vol. 72, no. 1



Display 6Companies Manage Earnings to Meet or Beat Thresholds

Past valuations are no indication of future results.

Percentage change in reported earnings from four quarters earlier, based on quar-

terly data on 5,387 firms

Source: Degeorge, Patel and Zeckhauser, Journal of Business, 1999

will have a harder time meeting a future threshold—

with adverse implications for the stock price. Th is

pattern of borrowing simply cannot be sustained.

Th ere are many ways that companies can manage

earnings. In one famous example that the SEC called a

case of massive fraud, Sunbeam executives met earnings

targets by such techniques as shipping barbecue grills to

stores in the Northeast of the US—in December. While

the company met its sales targets for that year, it fell

short the next year because the stores either returned the

grills or ordered fewer than usual for the next season.

Th is method of earnings management is oft en referred

to as channel stuffi ng.

Another, more subtle technique involves timing the

recognition of gains on fi nancial contracts. If an insurance

company holds an investment in a bond yielding 5%

and rates drop to 4%, management could choose to

hold the bond to maturity, recognizing the extra yield

into earnings over the bond’s remaining life. Or, it could

sell the bond and replace it with a similar bond yielding

the market rate of 4%, realizing the earnings benefi t

immediately at the expense of future periods. Manage-

ments could defend either action as being in pursuit

of their long-term strategies. But the diff erence in how

generally accepted accounting principles treat the timing

of income recognition from the gain on sale versus the

higher interest income can allow managements to meet

thresholds by deciding to recognize more or fewer gains

on sale.

Sometimes, earnings management entails trying to

increase the odds that the company can meet a future

threshold. Oft en, this is done by taking one-time charges,

such as those related to a restructuring. For example, if a

restructuring entails closing a plant and laying off a large

number of workers, the company might take a charge

to earnings for writing off a multiyear lease on the

plant and paying various severance costs. Th ese charges

appear on the income statement immediately, but the

impact on current-year profi tability is generally ignored

by the market as a one-time event that is not relevant

to long-term earnings potential. Th ese expenses will

be paid from cash in future periods; thus, a liability is

established on the balance sheet.

When done correctly, accruing these types of charges may

fairly represent the company’s fi nancial performance. But

these types of accruals are very diffi cult to monitor from

the outside; thus, they are vulnerable to abuse. Manage-

ments can deliberately overestimate this type of reserve,

creating a “cookie jar” on the balance sheet that it can

raid in the future to fatten earnings: Management may

start to pay current-period costs out of the previously

established liability account, artifi cially raising current

earnings. Eventually, the reserve will be exhausted

and the ongoing costs will once again show up as

current-period costs in the P&L, potentially creating a

nasty surprise for investors.

It is almost never possible to know with certainty whether

management is manipulating such reserve or liability

accounts, so the reduction in these accrual accounts

should always be viewed with skepticism. Our BSA

tool captures this risk as the liability account declines,

because the change produces a relatively unattractive

BSA score. Th e tool is telling us that earnings appear to

be low quality, because the cash component of earnings

is low, refl ecting the use of balance-sheet cash to pay

costs that have not run through the current-period

earnings statement.

Capital ManagementTh e BSA tool always gives a poor rating to companies

that have completed large acquisitions because it

compares the pre-merger balance sheet of the acquirer

to the combined company’s post-acquisition balance

sheet. Th is may appear to be an unfair comparison of

apples and oranges, but we have found that dismissing



Display 7Acquirers Perform Worse than High-BSA Group Overall


Large acquisition or share issue inferred by an increase in market capitalization

over the prior year of 10% more than the stock-price appreciation would explain.

Annualized quarterly returns versus the equal-weighted US large-cap universe;

Bernstein BSA quintiles reformed quarterly.

Source: Center for Research in Security Prices (CRSP), Compustat and Bernstein

the negative signifi cance it imputes to these corporate

events would be a mistake. When we screened our large-

cap universe for acquirers, we found that the acquirers

underperformed the market by 5.6%, worse than the

4.6% average underperformance for the high-accrual

group (Display 7).

Th e accrual tool may simply be highlighting what we

have all come to know from experience: More oft en than

not, acquisitions are bad for the stock of the acquiring

company.5 A clash of cultures makes many deals fail; the

Time Warner/AOL combination is a classic example.

Th e tendency of acquirers to overpay at moments of

exuberance damages other deals. Corning, for one, paid

$4 billion in cash in late 1999 to buy Pirelli’s fi ber opera-

tions, which had sales of less then $40 million; it later

had to write off virtually the entire purchase price.

Mergers also depress stock prices when they are poorly

executed. Th is was vividly demonstrated in the 1990s

by a series of tangled rail mergers, as well as by several

bank deals that led to neglect of the core customer.

Even if the accrual tool simply captures what we already

know about acquisitions, it forces us to confront the

issue systematically. A more surprising part of the tool’s

effi cacy with regard to acquirers is how long the

performance penalty for acquisitions lasts. Th e BSA

tool captures an acquisition only aft er it has closed and

the combined balance sheet has been measured, oft en

many quarters aft er the announcement of the deal.

Although the market has had an extended period to

fi gure out the merits of the deal, acquirers on average

still underperform.

Th e mirror image of this phenomenon is found in

the quintile of low accruals, where restructurers

abound. Th e restructuring subset of the low-accrual

group outperformed the market by 7.8%, signifi cantly

more than the 4.7% average for all low-accrual stocks

(Display 8). Conceptually, the balance-sheet accrual tool

may be signaling that management is ridding itself of a

distraction. It may also be signaling that returning money

to shareholders instead of making potentially low-return

investments oft en turns out to be a good thing.

It may be tempting to shrug and dismiss write-off s as

no more then a pen stroke with little economic impact,

but this, too, would oft en turn out to be a mistake.

When we screened for companies that had taken large

write-off s and then measured their performance in

the subsequent period, we found that on average they

outperformed the market by 5.9%, better than the 4.7%

average for low-accrual stocks. Sometimes, write-off s

signal the beginning of the end of a large retrenchment.

Oft en, the underlying business is close to stabilizing

and improving.

Display 8Restructurers Outperform Low-BSA Group Overall


Large disposals or share buybacks inferred by a decrease in market capitalization

over the prior year of at least 10% more than stock-price change would explain.

Large write-offs defined as net income at least 20% lower than income before

extraordinary items, with a difference of at least $5 million. Group with

disposals/buybacks and group with write-offs may overlap. Annualized quarterly

returns versus the equal-weighted US large-cap universe; Bernstein BSA quintiles

formed quarterly.

Source: CRSP, Compustat and Bernstein

5 Of course, not all acquisitions destroy shareholder value. Vadim Zlotnikov, my colleague at Sanford C. Bernstein & Co. LLC, a unit of Alliance Capital, recently showed that accretive acquisitions tend to be of smaller companies with transparent business models, which were purchased with cash for a price justifi able without claiming synergies. Acquisitions within a company’s cur-rent line of business are more likely to be good for the acquirer’s future stock performance than diversifying acquisitions. More surprisingly, paying a pre-mium to the last trading price of the acquired companies’ stock tends not to be a signal of future underperformance. Th e key price issue is whether the price paid is consistent with current industry valuations. See Vadim Zlotnikov, “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” Bernstein Research Call, January 24, 2005.

(Continued on page 12)



When we fi nd an investment tool that works in

one market, we always see if we can use it in other

markets as well. Usually, our research shows that we

can; this reinforces our belief that investor behavior

is the same the world over.

Studying the usefulness of our BSA tool worldwide,

however, presented some stiff challenges. Th ere is

virtually no literature available on its use outside

the US,* perhaps in part because the signifi cant

variations in accounting from country to country

make comparisons between accounting-based tools

diffi cult. Th e gradual adoption of International

Accounting Standards around the world will make

accounting in many countries more similar to that of

the US in ways that are promising for the effi cacy of

the BSA tool. However, it also creates discontinuous

balance sheets that could distort the results of a

historical study.

Lastly, there is the perennial problem that the data

set for markets outside the US is neither as long-

Display ABSA Tool Works Well Around the World

Return vs. Market 1991–2003

USEuropeex UK UK Japan Canada Australia

Lowest BSAs 3.0% 3.0% 1.7% 0.9% 0.7% 4.3%

Highest BSAs (3.3) (2.8) (1.2) 0.1 (4.7) (4.6)

Spread 6.3 5.8 2.9 0.8 5.4 8.9Bernstein investment universe for each country or region, excluding

financials, was divided into balance-sheet accrual quintiles on a quarterly

basis using Bernstein definition of net operating accruals. Highest BSAs

represents the two BSA quintiles with the highest BSAs; lowest BSAs is

the two quintiles with the lowest BSAs. Stock performance evaluated

quarterly relative to equal-weighted universe and then annualized.

Source: Compustat, CRSP, Morgan Stanley Capital International (MSCI),

Worldscope and Bernstein

dated nor as robust as the data set for the US

market, and carving up smaller markets into

quintiles makes the sample sizes very small indeed.

We solved this last problem by using the top and

bottom 40% (two quintiles) rather than the top and

bottom quintile. Sparse data on some balance-sheet

items, meanwhile, forced us to exclude fi nancial

companies from the non-US data.

Despite these diffi culties, our initial results were

encouraging. In each market we examined, low-

accrual stocks beat high-accrual stocks. Th e spreads

for Europe, Canada and Australia were substantial;

those for the UK and Japan, relatively small (Display

A). Th e latter concerned us because Japan and the

UK make up such a large share of the global and

international markets. When we refi ned the data, the

results improved for the UK and Japan (Display B).

For Japan, we substituted data from Nomura

Securities for Worldscope’s data because it included

more companies. We also applied a narrower

defi nition of BSAs that focused on changes in

payables and receivables until 2000, when Japan

began to require consolidated reporting for its

Display BRefining the Tool Improved Effectiveness in UK and Japan

Return vs. Market 1991–2003

USEuropeex UK UK Japan Canada Australia

Lowest BSAs 3.0% 3.0% 2.1% 1.9% 0.7% 4.3%

Highest BSAs (3.3) (2.8) (1.8) (1.9) (4.7) (4.6)

Spread 6.3 5.8 3.9 3.8 5.4 8.9For US, Europe, Canada and Australia, quintiles were formed using

Bernstein definition of net operating accruals. For the UK, universe

excludes companies f lagged for M&A prior to 2000. For Japan, Nomura/

Nikkei data divided into quintiles based on current operating accruals

prior to 2000.

Source: Compustat, CRSP, MSCI, Nikkei Financial, Nomura Securities,

Worldscope and Bernstein

* Th e articles we found were Morton Pincus, Shivaram Rajgopal and Mo-han Venkatachalam, “Th e Accrual Anomaly: International Evidence,” March 2003; and H. Otani, “Discretionary Accruals: Th e Impact of Earnings Management on Stock Price,” Nomura Global Quantitative Research, February 27, 2004 (English translation).

BSAs: CAN YOU EXPORT THE CONCEPT?



companies and disclosure of cash fl ows. Aft er

that, we switched to the broad defi nition we

used elsewhere.

For the UK, we excluded acquirers from the

universe because until 1998, purchase accounting

was handled quite diff erently in the UK than in

the US and elsewhere. In the US and elsewhere,

an acquirer’s balance sheet increases with an

acquisition. Under the old UK rules, however, the

acquirer immediately wrote off all goodwill related

to the transaction, so the balance-sheet increase was

much smaller—and sometimes even negative.

You can see this in the case of Vodafone (Display

C). Its balance sheet in March 1998 showed net

assets declining by more than 50% over the prior

year, even though it had made large acquisitions in

the French and Dutch telecom markets during that

period. Only if you read the footnotes and adjusted

for the full value of the acquisitions—including the

associated goodwill—would you have discovered

that its net assets actually grew by more than 20%. In

other words, Vodafone’s true BSAs were expanding

rapidly rather than shrinking.

Display CUnder Old UK Rules, Acquisitions Could Shrink a Firm

Vodafone 1998 As ReportedPro Forma for Rule Change

Beginning Net Assets £829 Mil. £829 Mil.

Change in Assets ex Goodwill 186 186

Goodwill Acquired in 1998 (635) —

Ending Total Net Assets 380 1,015

Change –54% +22%Source: Company reports and Bernstein estimates

Display DBSAs Worked Much Better in UK After Accounting Change

Return vs. UK Market

1991–1999 2000–2003

Lowest BSAs 1.2% 2.6%

Highest BSAs (0.1) (3.7)

Spread 1.3 6.3Bernstein investment universe for UK, excluding financials, divided

into BSA quintiles annually using Bernstein definition of net operating

accruals; quarterly performance annualized.

Source: MSCI, Worldscope and Bernstein

Because of this accounting treatment, the BSA tool

has been less eff ective in the UK historically. Since

the UK adopted purchase accounting rules more

similar to those in the US, however, it has become

dramatically more eff ective. Th e spread increased

from a little over 1% to in excess of 6% (Display D).

Of course, it’s not safe to generalize too much from

four years of data, but given what we know about

how the tool works elsewhere—and why—we are

confi dent that it should work well in the UK.

We are continuing to improve our research on the

effi cacy of using BSAs in other markets, and we hope

to introduce the tool into the investment process for

our non-US portfolios sometime in 2005. ■Please note: Past valuations are no indication of future results.



But the write-off subset of low accruals is tricky. It

includes some spectacular turnarounds, such as Chrysler

in the early 1990s, Applied Materials just before a big

run-up in the semiconductor sector in 1999 and, more

recently, the upturn at Xerox (Display 9, top). It also

includes some spectacular fl ameouts: companies that

never recovered, such as Woolworth and Fruit of the

Loom, and companies, such as Circuit City Stores and

LSI Logic, that got worse before they got better (Display

9, bottom). Indeed, seven of the 10 big bankruptcies of

recent years passed through the fi rst quintile of BSAs.

Th us, research judgment is crucial to making successful

investments in these situations. Earnings revisions data

may also help to separate the wheat from the chaff , as we

will later show.

Display 9Some Restructurings Succeed…

Company NameFlagged for Write-Off

Relative Return Next 12 Months

Applied Materials April 1999 190%

Chrysler January 1992 165

Phelps Dodge January 2003 102

Kroger April 1990 82

Xerox October 2002 76

…While Other Restructurings Fail

Company NameFlagged for Write-Off

Relative Return Next 12 Months

Fruit of the Loom July 1998 –89

Circuit City Stores April 2000 –87%

Kmart October 1999 –65

Woolworth October 1997 –60

LSI Logic January 2000 –59Past valuations are no indication of future results.

Total returns relative to the S&P 500 for select companies with large write-offs

in the most attractive quintile of BSAs. Large write-offs defined as net income at

least 20% lower than income before extraordinary items, with a difference of at

least $5 million.


Mean Reversion of Sales and EarningsOur examination of high-accrual stocks produced

another surprising fi nding: From a sales and a return-

on-equity perspective, on average these stocks had been

very successful in the recent past. From 1978 to 2003, the

companies with the highest accrual growth on average had

17.5% sales growth in the previous year—far better than

the 2.7% average for low-accrual companies (Display 10).

Th e high-accrual stocks were also more profi table, with

an average ROE 1.2 percentage points above the market

average, while the low-accrual companies’ average ROE

was 2.2 percentage points below the market average.

Taken at face value, this would imply that the BSA tool

is somehow unfairly penalizing companies that have

recently been successful and that have been growing

quickly. Th is implication, however, confl icts with our

fi nding that the tool is actually quite eff ective when

applied to a universe of growth stocks.

Our research suggests that some of the diff erence in

stock performance between high- and low-accrual

stocks relates to the diffi culty of sustaining above-market

sales growth and profi tability. When companies are

successful in these ways, their managements, anchored

in recent experience, typically become optimistic:

Th ey order more inventory, plant and equipment, or

distribution outlets—or perhaps pay a high price for

an acquisition—because they expect their success

to continue.

Display 10Success Can Lead to High BSAs


Average trailing one-year sales growth for BSA quintiles reformed quarterly


(Continued from page 9)



But success is notoriously diffi cult to sustain for long

periods. Successful companies attract competition,

and fads fade. As a result, growth oft en decelerates

and profi tability declines. Th us, optimistic manage-

ments frequently fi nd themselves with excess inventory

they need to discount or write off , plants they need to

shutter, employees they must lay off and goodwill from

high-priced acquisitions they must write off . Such stocks

oft en sell at loft y valuations because the market oft en

shares management’s optimism. Th us, they oft en under-

perform massively when investors recognize that the

company’s growth prospects are decelerating and that

management has overbuilt capacity in the expectation of

continued growth.

Th e market tendency to extrapolate—oft en incor-

rectly—from recent success or failure can be seen clearly

by looking at consensus forecasts and returns for high-

and low-accrual stocks. On average, the highest-accrual

companies had trailing return on equity 1.2% above the

market average, and as a group, sell-side analysts—as

measured by I/B/E/S—have expected them not only

to sustain their above-average ROE, but to improve it

(Display 11, top). Instead, their ROE declined: Although

the high-accrual companies maintained an above-

average ROE, they failed to match both expectations and

their own prior performance.

Th e pattern played out again the following year: Analysts

lowered their ROE expectations yet still expected the

high-accrual companies to be above average, but the

group failed to match the lowered expectations. Aft er

just two years, the high-accrual companies on average

had slightly below-average ROE.

Th e low-accrual stocks, by contrast, started out less

profi table than the market (Display 11, bottom). Analysts

predicted improvement, forecasting an ROE defi cit that

narrows to about 1% less than the market. Manage-

ments, however, adapted to the challenges they faced,

and on average they succeeded, delivering a better-than-

expected ROE.

Th e next year, analysts raised their ROE estimates for this

group to about equal to the market average, but again,

they underestimated the magnitude of the change. Th e

group now surpassed the market ROE. ■

Display 11Analysts (Wrongly) Expect High Profitability to Persist…

…and Underestimate Recovery for Low-Profit Companies


ROE relative to US large-cap universe and I/B/E/S one-year forecast for highest and

lowest quintiles of BSAs, using Bernstein definition

Source: Compustat, I/B/E/S and Bernstein



Is the BSA Tool Biased Against High-Growth Companies?When we fi rst began sharing our research on BSAs with

our fi rm’s own analysts, we encountered an immediate

suspicion that the tool was biased against companies with

rapid growth. Th e mean reversion of ROEs shown in the

previous section and the concentration of slow trailing

sales growth in the attractive BSA quintile reinforced

this view.

Isn’t it right and natural for companies with growing

sales to increase their balance sheets? Aft er all, analysts

generally study changes in inventory and receivables

relative to sales. Our fi nding that the tool worked within

the growth domain as well as the market as a whole gave

us some confi dence that the tool wasn’t biased against

growth stocks, but we decided to study the apparent bias

against prior sales growth.

Following a trail blazed by Professor Hong Xie,6 we

tried refi ning the accrual metric to diff erentiate between

“normal” accruals and “excess” accruals. We defi ned

accrual growth equal to sales growth as normal, accrual

growth in excess of sales growth as excessive and accrual

growth slower than sales growth as low. We then tested

whether adding information about trailing sales would

make the tool more indicative of the performance of

growth companies.

First, we deducted sales growth from the unadjusted

growth in accruals. If accruals grew 10% but sales grew

25%, adjusted accrual growth would be negative 15%

(Display 12). In this case, the company would get credit

for restraining accrual growth relative to sales, rather

than a penalty for expanding its balance sheet. We also

tried several other formulations that adjusted accrual

growth for trailing sales growth.

We measured the correlation of each of these formula-

tions to the change in future stock price. Like Professor

Xie, we found that the unadjusted version was a better

signal of future stock performance. Th e more credit we

gave for sales growth as an explanation for the growth in

accruals, the worse the tool performed.

We also measured the performance of the adjusted and

unadjusted tool over time. For the adjusted version

that gives half credit for sales growth (the best of the

modifi ed formulas we tried), low-accrual stocks beat

high-accrual stocks by about 7.2% a year on average—a

nice amount, but about 200 basis points less than our

original unadjusted version (Display 13).

Display 12BSA Tool Can Be Adjusted for Sales Growth…

BSAs Adjusted for Sales GrowthUnadjusted BSAs Total Sales 1/2 Sales

Accrual Growth +10.0% +10.0% +10.0%

– Sales Growth N/A 25.0 12.5

= Adjusted Score +10 (15) (2.5)Trailing one-year sales growth for Bernstein US large-cap growth universe

Display 13…but That Makes It Less Effective…

Indexed to 100 on December 31, 1977; return vs. US large-cap universe. Large-cap

universe divided into balance-sheet accrual quintiles using Bernstein definition

of net operating accruals, based on quarterly data. Trailing one-year sales growth;

quintiles formed monthly. Adjusted version gives half credit for sales growth.


Display 14…Because Sales Growth Tends to Revert to the Mean


Trailing one-year sales growth for Bernstein US large-cap universe


BSAs AND GROWTH INVESTING

(15)

(10)

(5)

0

5

10

15

20

Year 5Year 4Year 3Year 2Year 1Year 0

1972-2003

Company vs. Market Sales Growth

6 Hong Xie, “Th e Mispricing of Abnormal Accruals,” Th e Accounting Review, July 2001, vol. 76., no. 3



Why BSAs Work Within the Growth ArenaTh e reason that adding trailing sales growth to the

accrual equation diluted, rather than enhanced, the

tool’s effi cacy may be quite simple: Trailing sales growth

is not a good predictor of future sales growth. When we

divided our universe of large-cap US stocks into quintiles

on the basis of trailing sales growth and looked at their

subsequent sales growth, we found that the sales growth

of the fastest and slowest quintiles regressed to the mean

at an astonishing speed (Display 14).

Mean reversion—the value investor’s friend—is the

growth investor’s enemy. As my colleagues in Alliance

Capital’s Growth Equity business say, the challenge for

growth investors is to identify companies that will beat

the odds and sustain their superior growth. Th us, in many

instances, justifying rapid accrual growth by pointing to

trailing sales growth turns out to be a mistake.

If trailing sales growth doesn’t justify fast accrual growth,

does future sales growth? To study this, we fi rst divided

our universe of large-cap US stocks in half on the basis of

actual sales growth over the next 12 months. We found

that the half with above-average sales growth outper-

formed the market by 3.7% a year on average, while the

half with below-average sales growth underperformed by

3.1%. Th us, a hypothetical growth investor with perfect

foresight about future sales growth would do quite well

by focusing his or her portfolio on those stocks with

the highest future sales growth. As Display 15 shows,

companies with above-average growth outperformed all

other companies by about 6.8%.

Display 15BSA Tool Helps Whether or Not Future Sales Growth Is Strong

Annual Returns vs. Market 1978–2003

Next Year Sales Growth1 All Stocks Low BSA2 High BSA2

Above Market Average +3.7% +5.5% +1.7%

Market Average or Below –3.1 –0.6 –8.6

Spread 6.8 6.1 10.3Past valuations are no indication of future results.

One-year forward returns versus equal-weighted US large-cap universe

1Assuming perfect foresight of sales growth over the next year

2Low BSAs defined as Q1–Q3 and represent roughly 50% of stocks in the

above-market sales category. High BSAs defined as Q4–Q5.


Our next step was to see whether the BSA tool would

be of any use to the analyst with perfect foresight about

future sales growth. To do so, we divided the stocks with

above-average future sales growth into two groups: the

three quintiles with the lowest (most attractive) BSAs

and the two quintiles with the highest (least attractive)

BSAs. Historically, about half of all fast-growth stocks

fall into the three most attractive BSA quintiles, creating

plenty of fertile ground for the growth investor.

We found that the portfolio of rapid-growth stocks that

also had more attractive BSA scores did better than the

rapid-growth stocks as a whole—it outperformed the

market by 5.5% a year, on average, as Display 15 also

shows. Th e other half of the rapid growth stocks—those

in the highest two quintiles of BSAs—did worse but still

outperformed the overall market. Th us, the rapid accrual

growth was justifi ed by rapid sales growth.

Perhaps the more interesting results came from

looking at the stocks that turned out to have average or

below-market future sales growth. Th e companies

in this group with attractive BSA scores lagged the

market slightly. Th ose with unattractive BSA scores were

severely penalized.

A closer look at the worst-performing segment—stocks

with high BSAs and below-average sales growth—

showed that the vast majority had above-average sales

growth in the prior year. Th is reinforces the view that

their managements may have been growing the balance

sheet because a period of fast growth had made them

optimistic. Disaster struck when the continued growth

they expected failed to materialize.

Using BSAs in the Growth ArenaAnother potential concern about using the BSA tool in

the growth arena is that there may be entire industries

with rapid balance-sheet growth, refl ecting a period of

rapid expansion or innovation. In many cases, it may

be impractical for the growth investor to avoid such

an industry entirely. Furthermore, the analyst may

conclude that the growth in accruals is warranted,

given the analyst’s outlook for the business. Th us, we

examined the eff ectiveness of the BSA tool in forecasting

performance within an industry.



Th e results of this work were quite encouraging. In

decomposing the overall benefi t of the BSA tool, we

found that the quintile of stocks with the lowest balance-

sheet accruals relative to the industry outperformed

their industry by 3.8%, while the quintile with the

highest accruals underperformed their industry by 4.7%

(Display 16). Th e spread between the two quintiles was

8.5%. Th us, it could be argued that most of the premium

the tool has delivered comes from helping the investor to

select stocks relative to their own industry. Th is suggests

that paying attention to earnings quality as measured

by accrual growth should not disrupt the investment

process within growth industries. When considering

an investment within an industry with rapid accrual

growth, the investor should simply have a bias, all other

things being equal, toward the company or companies

with slower accrual growth.

Display 16BSA Tool Works Well Within Industries

Indexed to 100 on December 31, 1977; return vs. US large-cap universe. Large-cap

universe divided into balance-sheet accrual quintiles monthly using Bernstein defi-

nition of net operating accruals, based on quarterly data.


Our conclusion is that the BSA tool should be comple-

mentary to a growth investment process. Although

the most attractive BSA quintile has historically had

slow trailing sales growth, the population of stocks

with fast future sales growth and above-average BSA

scores is actually quite large. Historically, growth

investors would have improved their performance by

focusing on the intersection of the two variables. When

expectations of future rapid sales growth have been

met, the slower-accrual growth subset has outper-

formed. More importantly, when stocks fail to meet

expectations of future rapid sales growth—and especially

when they have failed to match the market average—the

high-accrual growth subset has underperformed by a

wide margin. Avoiding this downside has been quite

rewarding. In this sense, the BSA tool can be seen

as valuable protection against forecast risk for the

growth investor. ■



Our understanding of the fundamentals behind the BSA

tool gave us the confi dence to begin using it as part of

the fundamental research process in our US large-cap

value portfolios. Although our analysts already paid

close attention to cash fl ows and balance-sheet issues, we

have found that the BSA tool provides a helpful disci-

pline: It focuses our analysts’ attention on subtle signals

of incipient changes in earnings quality. In addition, by

quantifying companies’ accruals relative to the market,

the BSA tool gives our analysts a way to compare all the

companies they cover, regardless of size, growth rate or

other characteristics.

At the same time, we turned our quantitative research

eff ort to seeing whether the information the tool captured

was additive to the information captured by other tools

used in our value investment process. We found that it

was: Th e tools work better in combination than alone.

Are BSAs Additive to Value?We fi rst looked at how the BSA tool interacted with our

dividend discount model (DDM), our primary measure

of value. As we have described, the accrual tool simply

measures changes in accruals relative to the balance

sheet; it does not take into consideration how much we

are paying for high- or low-accrual growth. While our

quantitative research had shown that the tool has been

very eff ective within the value domain, defi ned by naive

measures such as price to book or price to sales, it was

possible that our research-driven DDM already captured

the information in the BSA tool. Aft er all, our DDM

links the share price to our analysts’ forecasts of long-

term earnings power, and our analysts have historically

paid close attention to balance sheets and cash fl ows

when generating their forecasts.

Th e results from combining the BSA tool with our

DDM were quite encouraging. On its own, the cheapest

quintile of our DDM has outperformed the market by 4.4

percentage points on average from 1980 to 2003 (Display

17). But within that group, the stocks with low balance-

sheet accruals did much better: they outperformed the

market by more than 10%.

Display 17BSAs Enhance the DDM


Average forward-quarter return relative to equal-weighted US large-cap universe

for intersection of cheapest quintile of Bernstein dividend discount model with

each Bernstein BSA quintile.

Source: Bernstein

Cheapness, however, was not adequate protection

against high-accrual growth. Th e stocks in the cheapest

quintile of our DDM with high accruals underperformed

the market slightly. Th is implies that our view of what is

attractively valued should be tempered when accruals

have grown rapidly. Because a company’s reported

fi nancial history is oft en a factor in setting our forecast,

a high BSA score may imply that this starting point is

too high.

Are BSAs Additive to Earnings Revisions?Next, we looked at how BSAs work in conjunction with

earnings revisions, which have historically been eff ective

at gauging stock returns in the short term. Stocks with

upward earnings revisions relative to the market tend

to outperform in the near term, while stocks with

negative revisions underperform. We think the effi cacy

of earnings revisions is a result of anchoring: People tend

to be mired in their current reality, and when confronted

with new but confl icting information, they tend to

change their outlooks incrementally. Analysts’ earnings

revisions thus tend to go up and down incrementally,

and stock prices tend to move with them.

Our research shows this holds true within BSA quintiles

as well. When we isolated stocks with very positive

earnings revisions versus the market and measured their

forward monthly returns (the revision tool is a short-term

indicator), we found that low BSA stocks with positive

revisions did very well, outperforming by 1.8% a month,

much better than the 0.5% average outperformance of

the total low-accrual group (Display 18, next page).

BSAs AND VALUE INVESTING



Display 18BSAs Complement Earnings Revision Tool When BSAs Are Low…

Large positive revisions are stocks with I/B/E/S 1-month revision index at least

0.4% above market. Monthly performance versus equal-weighted US large-cap

universe; Bernstein BSA quintiles reformed quarterly.


Th is makes sense when we remember that the low-BSA

category has a relatively large share of companies that

were growing slowly or restructuring: Th e biggest risk

of investing in this category is that the restructuring

will persist further into the future, making the invest-

ments premature. Looking at positive revisions adds an

interesting new dimension. Sell-side analysts, who our

BSA research suggests are not suffi ciently focused on

balance sheets, see independent evidence that things are

getting better.

Low-BSA stocks with negative revisions, on the other

hand, underperform the low-accrual group as a whole.

In this case, negative revisions may signal that more bad

news is ahead. Th at is, the BSA tool helps investors to

diff erentiate between the spectacular turnarounds and

fl ameouts in the low-accrual category.

On the other extreme, stocks with high balance-sheet

accruals and negative revisions underperformed the

market by 0.9% per month, worse than the high-accrual

group overall (Display 19). Th is, too, makes sense. Th e

high accruals tell us the company has just expanded

rapidly. Th e negative earnings revisions tell us that

analysts are seeing separate information implying that

growth is not meeting expectations. Th is has been a

pretty good signal to avoid the stock: Investors paying

a high premium for superior growth typically react very

badly to disappointment.

If, however, the expansion is met with continued

earnings estimate increases, the odds are that the

balance-sheet expansion was warranted. However, these

stocks still don’t do signifi cantly better than the market,

implying that the good news may have been largely

discounted in the stock price.

Display 19…and When BSAs Are High

Large negative revisions are stocks with I/B/E/S 1-month revision index at least

0.4% below market. Monthly performance versus equal-weighted US large-cap

universe; Bernstein BSA quintiles reformed quarterly.


In conclusion, our research implies that adding the BSA

tool to value measures should increase expected returns

for value portfolios. Since value investors are more likely

to look at companies that are growing slowly, restruc-

turing operations or writing off assets, adding earnings

revisions is also important to better judge the timing of

purchases and sales.

Putting the BSA Tool to WorkOur investment process marries our fundamental

insights with quantitative risk control and timing tools.

In Bernstein’s US large-cap value portfolios, we start

by using our dividend discount model to determine

the relative attractiveness of each stock by relating its

stock price to our long-term forecast of its earnings and

free cash fl ow. We quantify this so we can compute the

expected return of each stock relative to the market. Our

timing tools—relative stock performance and earnings

revisions—provide perspective on whether this is the

best time to purchase or sell an individual stock; they

may add or detract from the expected return. Finally, our

factor risk model quantifi es the degree to which a stock

would diversify the portfolio or add to its concentration

in terms of sector or traits such as capitalization, value or

earnings variability. Th e combination of all these factors

gives us a risk-adjusted expected return.

Aft er studying the linkage between the BSA score and

subsequent stock performance, we now also quantify

how much the stock’s BSA score would add or subtract

from its risk-adjusted expected return. In some cases,

BSAs might lower our risk-adjusted expected return for

a stock so much that we would decide not to buy the

stock. In other cases, such as Medco HealthSolutions,



the BSA tool has prompted us to accelerate our purchase

of the stock.

Medco HealthSolutions is a pharmaceutical benefi ts

management fi rm that appeared to be attractively valued

last summer. It provides a useful example of both the

mechanics of the tool and how it can guide research. In

this case, however, we had to fi rst adjust for some trans-

actions related to its spin-off from Merck.

To analyze Medco’s BSA growth, we divided its adjusted

net BSA growth over the 12 months ending March 2004

by its average balance sheet in that period and compared

it to the market average. Medco’s BSA score of negative

1.5% was much better than the market average of positive

5.9% (Display 20).

For our analyst, this was just a starting point. Th e

shrinkage in Medco’s accruals, he found, had two drivers

(Display 21). First, net property, plant and equipment

were down sharply because Medco was closing some

less-effi cient call centers and mail-order pharmacies and

thus had accelerated its depreciation of those facilities.

Second, Medco had accelerated the amortization of an

intangible asset created when Merck acquired Medco in

1993. Merck had attributed part of the price it paid to the

present value of customer relationships and amortized

them over 35 years. Since customer retention has fallen

in the past few years, those assets have shorter lives than

Merck initially assumed; Medco now amortizes them

over 23 years.

Display 20Applying BSAs: The Medco Example

BSA Score = Net Change/Total Assets

Net Change in Accruals $(150) Mil.

Average Total Assets $10,336 Mil.

Medco BSA Score (1.5)%

Market Average BSA Score 5.9%Past valuations are no indication of future results.

Net change March 2004 vs. March 2003 adjusted for transactions related to its

spin-off from Merck; BSA scores as of early July 2004.

Source: Company reports, FactSet and Bernstein

Display 21Medco’s BSAs Fell with PP&E and Intangibles

$ Millions

Mar 03 Mar 04 Change

Net Working Capital $515 $583 $68

Property, Plant and Equipment 816 718 (98)

Intangibles and Other Assets 5,834 5,708 (126)

Operating Liabilities (1,221) (1,215) 6

Net Change $(150)Past valuations are no indication of future results.

Source: Company reports and Bernstein

Together, the accelerated depreciation and amortization

made Medco’s reported earnings look worse than the

company’s true earnings potential. Although the amorti-

zation of intangibles is purely an accounting matter,

capital spending had fallen below depreciation—and

our research indicates that capex could remain low for

many years. Th e BSA tool, we concluded, was telling

us that the company was doing somewhat better than

its recent reported earnings implied (Display 22). Our

fundamental research, meanwhile, showed a growing

trend toward use of mail-order prescriptions and a

greater emphasis on generic drugs, both of which are

positive for Medco’s earnings. When we combined the

fundamental information the BSA tool was capturing

with the positive implications of these industry trends,

we concluded that Medco was priced attractively relative

to its earnings potential, and we established a position in

the stock. ■

Display 22Medco Earnings Power Is Better Than It Appears


Source: Company reports and Bernstein

Please Note: References to Medco HealthSolutions are presented to illustrate the applications of our investment philosophy only and are not to be considered recommendations by AllianceBernstein. Th e specifi c securities identifi ed and described above (and in this report) do not represent the securities purchased, sold or recommended for any AllianceBernstein portfolio, and it should not be assumed that investments in any security identifi ed here will continue to be profi table. We will, upon request, furnish a listing of all investments made during the prior one-year period.



The following selection of papers informed our research into balance-sheet accruals.

Ahmed, Anwer S., S.M. Khalid Nainar, and X. Frank Zhang. Further Evidence on Analyst and Investor Mis-Weighting of Prior Period Cash Flows and Accruals. May 2003.

Beaver, William H., Maureen F. McNichols, and Karen K. Nelson. An Alternative Interpretation of the Discontinuity in Earnings Distributions. February 2003.

Burgstahler, David. Incentives to Manage Earnings to Avoid Earnings Decreases and Losses: Evidence from Quarterly Earnings. August 1997.

Collins, Daniel W., and Paul Hribar. Errors in Estimating Accruals: Implications for Empirical Research. September 2000.

Degeorge, François, Jayendu Patel and Richard Zeckhauser, “Earnings Management to Exceed Thresholds.” Journal of Business, 1999, vol. 72, no. 1.

Desai, Hemang, Shivaram Rajgopal, and Mohan Venkatachalam. The Relation between Value-Glamour and Accruals Mispricing. July 2003.

Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi Yohn. Accrued Earnings and Growth: Implications for Earnings Persistence and Market Mispricing. November 2001.

Fairfield, Patricia M., Scott Whisenant, and Teri Lombardi Yohn. The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Return on Assets. June 2002.

Frank, Mary Margaret, and Sonja Olhoft Rego. Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets? July 2003.

Louis, Henock. Earnings Management and the Market Performance of Acquiring Firms. October 2002.

Lui, Daphne W. When Accruals Meet Growth: Do Analysts’ Forecasts Fully Reflect the Future Earnings Implications of Accruals and Growth? October 2003.

Nelson, Mark W., John A. Elliott, and Robin L. Tarpley. “How are Earnings Managed? Examples from Auditors.” Accounting Horizons, 2003.

Otani, H. “Discretionary Accruals: The Impact of Earnings Management on Stock Price.” Nomura Global Quantitative Research. February 27, 2004 (Japanese original, December 8, 2003).

Penman, Stephen H., and Xiao-Jun Zhang. Accounting Conservatism, the Quality of Earnings, and Stock Returns. December 1999.

Pincus, Morton, Shivaram Rajgopal, and Mohan Venkatachalam. The Accrual Anomaly: International Evidence. March 2003.

Sloan, Richard G. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” The Accounting Review, July 1996, vol. 71, no. 3.

Richardson, Scott. “Earnings Quality and Short Sellers.” Accounting Horizons, 2003.

Richardson, Scott A., Richard G. Sloan, Mark T. Soliman, and Irem Tuna. Accrual Reliability, Earnings Persistence and Stock Prices. July 2003.

Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Management and the Long-Run Market Performance of Initial Public Offerings.” Journal of Finance, vol. LIII, no. 6, December 1998.

Teoh, Siew Hong, Ivo Welch, and T.J. Wong. “Earnings Management and the Underperformance of Seasoned Equity Offerings.” Journal of Financial Economics, June 1997.

Thomas, Jacob K., and Huai Zhang. Inventory Changes and Future Returns. December 2001.

Xie, Hong. “The Mispricing of Abnormal Accruals.” The Accounting Review, July 2001, vol. 76, no. 3.

Zach, Tzachi. Inside the “Accrual Anomaly.” June 2003.

Zlotnikov, Vadim. “Equity Portfolio Strategy: Do All Acquisitions Destroy Shareholder Value?” Bernstein Research Call, January 24, 2005.

Bibliography


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