Quality is a very popular word within the fund-management world. There are more than 120 equity-focused funds listed on Bloomberg with the word “quality” in their names including “conservative quality” funds, “quality growth” funds and many other apple-pie sounding combinations using the word.
But what exactly does “quality” mean? Many of the typical descriptions of a quality company, such as a good management team or clean balance sheet, are hard to assess and even harder to factor into a stock price. Instead, to measure quality in a more concrete manner, investors often zero in on a company’s net earnings, or bottom line.
A better method may be to look at a company’s “quality of earnings.” The idea is to not only look at a company’s level of earnings but to also look at metrics that help assess how persistent or stable those earnings are likely to be in the future. One of the most well understood of these metrics is the accruals measure, which tracks the non-cash portion of a company’s earnings.
How does this measure relate to the potential stability of future earnings? We can start with the example of a company that relies on receivables as part of its business. It sells a product and records a sale on its books, but it does not receive the full cash amount until sometime in the future. Now, imagine that this company increases its sales partly via expanding the use of more lax receivable terms for its customers. Earnings will grow as sales grow, but now a larger share of those earnings is non-cash and, in many cases, less reliable. Why? Sales that rely on an increased use of receivables may be more sensitive to changes in economic or industry conditions (such as interest rates or credit availability), and a larger share of those sales may be at risk of not be collected. Indeed, it turns out that companies whose receivables expand over time, tend to have less stable earnings than companies with similar profiles but smaller changes in their receivables.
A similar dynamic is at work with other non-cash components of earnings, from changes in inventories to depreciation. In aggregate, there is significant evidence that companies with larger accruals not only have less stable earnings but also tend to have lower returns compared with similar companies that have lower accruals. Our own work suggests that this effect has been persistent across time and across different markets and of economically significant scale.
What explains this dynamic? Part of the answer is that some segment of the investment public appears to be too focused on the “bottom line” results of the companies they are invested in. As is the case with a range of investor biases these investors do not fully incorporate the fact that the composition of those earnings make a difference in how stable future earnings will be. In short, some investors may buy companies whose earnings growth is being driven by large accruals only to be surprised in future earnings announcements to learn that the non-cash component of those earnings was not as stable as they expected. An investment strategy that overweights low-accrual companies and underweights high-accrual companies can seek to take advantage of this effect.
The concept of a “quality” company can be fuzzy and difficult to pin down. But the upshot for investors is that a more focused definition of quality based on an analysis of a company’s composition of earnings can be a useful tool for selecting securities or evaluating fund manager’s strategies.
Daniel Morillo, PhD, is the iShares Head of Investment Research.
 Data is from Bloomberg. Only equity-focused funds and only the primary listing is counted, so funds with multiple share classes or listing exchanges are counted only once.
 See, for example, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings” by Richard Sloan, 1996. The Accounting Review Vol 71.
 See, for example, “Earnings Quality and Stock Returns” by Chan et. Al, 2006. Journal of Business.