Ignore Earnings Misses; Check Accounting Quality

I note that over the last few years that news reports regarding quarterly earnings have taken on another dimension — revenues get tracked as well as earnings.  I look at that and I shrug.  Not every sale is a good sale.  In overly competitive environments we should want to see companies making fewer sales, and perhaps shrink aspects of the company that can easily be rebuilt.

Ignore Earnings Misses; Check Accounting Quality

So when the companies that I own miss revenue estimates, I don’t care much.  I care far more about their discipline to obtain quality business that produces reliable profits.

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This is a different story with growth companies, which I don’t generally invest in.  Growth companies should see reliable and large increases in sales.

Perhaps some analysts think that growing revenues supports growing earnings.  It would be far better to look at operating cash flow, or lack of growth in accrual items to validate earnings.  The less earnings coming from accounting accruals, the better the quality of earnings.

That’s all for now.  The quick summary: ignore revenue estimates, and check accounting quality.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.