Brent Miller

By Brent Miller, CFA
President & Director of Research, Gradient Analytics (a Sabrient Systems company)

The value of quantitative, rules-based, process-driven equity models is clear. They can be tested based on various historical timeframes and market conditions, sectors, market caps, and regions, while removing emotion from investment decisions. And with the exception of brief market periods driven by speculative fervor, investors tend to favor high-quality companies with solid fundamentals.

Sabrient Systems specializes in building fundamentals-based equity models that seek to generate alpha versus a market benchmark, including alpha factors and strategic beta indexes. In 2011, Sabrient acquired Gradient Analytics, a fundamental equity research firm with a team of forensic accounting specialists who focus on assessing earnings quality and anomalous insider activity, in part to enhance Sabrient’s quantitative model-building capabilities. Together, we leverage a unique collaboration of engineers and forensic accountants and a scientific hypothesis-testing approach to create proprietary alpha factors, multifactor models, process-driven portfolio strategies, and rules-based indexes.

In 2013, the combined team created the original version of our Earnings Quality Rank (EQRv1), a pure accounting-based risk assessment factor based on the collective experience and expertise of Gradient’s analyst team in identifying company-level earnings quality issues, aggressive accounting tactics, and misleading “financial engineering.” More recently, we enhanced the model to create EQRv2.

Furthermore, the Sabrient/Gradient team has created a variety of other valuable alpha factors, including an enhanced version of Sabrient’s flagship Growth at a Reasonable Price (GARP) model and several other factors related to value, growth, quality, and momentum. All told, we now publish the following eight “Sabrient Scores”:

  1. Growth at a Reasonable Price (GARPv2)
  2. Earnings Quality Rank version 2.0 (EQRv2)
  3. Growth Quality Rank (GQRv2)
  4. Strategic Valuation Rank (SVR)
  5. Strategic Growth Rank (SGR)
  6. Aggregate Price Momentum Rank (AMR)
  7. Bull Score (BULL)
  8. Bear Score (BEAR)

For institutional quants and systematic traders, we offer five of these alpha factors (EQR, GQR, SVR, SGR, AMR) as a factor suite (“Equity Factor Rankings”) for licensing through Nasdaq Data Link. However, fundamental analysts, financial advisors, and individual investors also find them valuable for screening, idea generation, risk monitoring, and confirmation. On a temporary basis, you can access all 8 of these Sabrient Scores free of charge through our SmartSheets products (one that provides scores for over 4,200 stocks and one for over 1,200 equity ETFs). Ultimately, they will be behind a paywall as a companion product to our powerful and comprehensive SmartLightsTM web application.

In this article, I provide further details on the purpose and basis for our Earnings Quality Rank and other alpha factors, including a summary of back-tested performance.  Read on....

Ian Striplin  by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

The very nature of borrowing shares, securities lending, and short selling is opaque. During recent equity events, existing reporting procedures exacerbated the misperception of short interest levels and influenced the intentional short squeeze mechanics. Without rehashing what has been discussed at length, written about, and even chronicled in film, the SEC has been put in a difficult – but not unmanageable – position to “do something” about nefarious practices among some powerful short sellers. As a result, the SEC is proposing Rule 10c-1 under the Exchange Act, which would require any person who loans a security on behalf of itself or another person (Lender) to provide the specified material terms of their securities lending transactions to a registered national securities association (RNSA).

While the proposal impacts many asset classes, the securities lending market is dominated by US equities, and we focus on those impacts here at Gradient Analytics. Our clients look to us for differentiated short ideas built on a foundation of earnings quality concerns. Along with other liquidity measures, Gradient has always been mindful of short interest, not only to avoid crowded short trades but also to provide fresh ideas to our institutional clientele. If anything, we believe our research will stand to benefit from increased transparency, which demands greater effort to find actionable short ideas.

There are many items on SEC chairman Gary Gensler's agenda, and this may simply be the “topic of the day.” Indeed, we believe the short-seller bogeyman fits well with other recent demands – including a congressional stock trading ban, forced ESG investment, and T+0 (i.e., same-day) settlement of security transactions. In the interim, we looked at the proposal and came away with several thoughts, many of which one also might find in the comment section of the SEC website.  Read on…

Rachel Bradley  by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

A common misconception is that accounting figures are always black and white, i.e., well known and precise. But in practice, there are many ways that the estimates and subjective judgement of management can color financial statements. Recent amendments to accounting standards address specific examples when companies have applied prior accounting guidelines differently from their peers. When this occurs, analysts are unable to compare accounting figures across companies without additional analysis. Further, differing accounting methodologies coupled with opaque disclosures may prevent analysts from ascertaining an accurate apples-to-apples comparison.

Here at Gradient Analytics, we specialize in forensic accounting research and consulting, and our analysts stay current on changes in the regulatory landscape, including crucial updates to disclosure requirements. Normally, we focus research on areas in which companies might be tempted to “manage” or overstate earnings, either by pulling forward future revenues or pushing out current expenses. Layer on more complexity from changing reporting requirements and it becomes clearer how a vital piece to the puzzle might slip through the cracks.

In this article, I provide details on updates to four accounting standards – and how they may shape financial statements with the potential to mislead investors. First, several Interbank Offered Rates (IBORs) ceased to exist at the end of 2021, and countries are transitioning to alternative reference rates. Second, the International Accounting Standards Board (IASB) revised guidance such that companies no longer may deduct certain items from the cost of property, plant, and equipment (PPE). Third, the IASB now requires that a proportion of production overhead must be included when reporting so-called “onerous contracts.” And fourth, the Financial Accounting Standards Board (FASB) issued a proposal to eliminate accounting for loans in modification through troubled debt restructurings.  Read on....

Rachel Bradley  by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In any given quarter for almost every publicly traded company, there is often a swirling vortex of signals as to the firm’s long-term health and future opportunities. Within this conflux of signals, there are two that often cause investor stress and confusion when they contradict each other: GAAP versus non-GAAP earnings.

The simple rubric that often comes to mind is that GAAP earnings are the more conservative figure for the firm [as these accounting standards are closely monitored and controlled by a governing board, the Financial Accounting Standards Board (FASB)], while its non-GAAP earnings are the more optimistic view (after being heavily tweaked and adjusted by management). However, this assumption does not always hold true. Often, a firm’s non-GAAP results more accurately represent its historical earnings power.

But it’s not clear-cut. As the global economy struggles to emerge from the severe and diverse impacts of the pandemic, corporate financial reports have been littered with a variety of non-GAAP adjustments that need to be deciphered and analyzed, particularly as investors transition from a speculative “recovery rally” mindset (that has bid up valuations) to a greater focus on fundamental earnings quality.

Gradient Analytics specializes in forensic accounting research and consulting to discern weak versus strong earnings quality, which has proven valuable for both short idea generation and vetting of long candidates, as we have discussed in a previous article. So, with the current flood of adjusted earnings, we felt it would be a good time for some examples to illustrate that not all earnings adjustments are created equal, and although investors must be judicious in deciding when and how they use non-GAAP results, they often may be better served by focusing on non-GAAP.  Read on....

gradient / Tag: forensic accounting, earnings quality, FDA, IPR&D, write-down, GAAP, non-GAAP, BDX, BMY, CPRI / 0 Comments

Ian Striplin  by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Special Purpose Acquisition Companies (SPACs) are publicly traded companies formed with the sole purpose of raising capital to acquire one or more unspecified businesses – which is why they are often called “blank-check” companies. They will often (but not always) have an espoused target market or desired exposure for which they are pursuing target companies, but little else in the way of visibility to indicate what an investor ultimately will own. The management team that forms the SPAC (the “sponsor”) funds the offering expenses in exchange for founders shares in the entity.

SPAC preference has been increasing in recent years as a way to get a private firm into public markets more expeditiously. We believe the change in preference likely tracks well to abundant liquidity, ultra-low interest rates, and lofty valuations in many equity markets. Therefore, we view the rash of SPAC deals announced this year as a cautionary signal that markets may have become overly speculative. The SPAC process can be instrumental in unlocking private “unicorn-style” valuations, and its rise in popularity is contemporaneous to growth in private equity demand. Furthermore, many of the headline-generating deals are principally based on a long growth runway into questionable TAM (total addressable market) estimations. However, the growing reliance on non-GAAP earnings and consistently unprofitable public companies illustrates that investors’ willingness to wait for a return appears greater than ever.

In this article, I highlight several considerations for evaluating SPAC investments both in the pre-target phase and following the release of audited financials. I discuss several recent adaptations of the SPAC model, branding and potential outcomes from the blank-check boom, and use South Mountain Merger Corp (SMMC) and its reverse merger with Billtrust as an example of how investors might recognize “creative accounting” tactics with limited financial disclosures. As Elon Musk recently tweeted, “Caution strongly advised with SPACs.”  Read on...

Rachel Bradley  by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

 “Only time can heal what reason cannot.” – Lucius Annaeus Seneca

In response to the pandemic-driven economic downturn, both Congress and the Federal Reserve have intervened with fiscal and monetary support in the form of direct subsidies, loans, bailouts, tax rebates, supplemental unemployment benefits, ultra-low interest rates, support of capital markets, reduced regulatory constraints, and quantitative easing (QE). The Fed expanded its purchase program beyond Treasury bonds to also include municipal bonds, corporate bonds of both investment and speculative grade, as well as ETFs for the first time. While these policies can raise aggregate demand, employment, and investment in the short run, excess liquidity also supports inefficient firms that otherwise might not survive. The increased prevalence of these firms, as well as the valuation metrics at which their stocks trade can muddy the waters for analysts and thus contribute to a misallocation of capital. These firms also weigh on productivity growth going forward.

Because the downturn was spurred by the pandemic rather than the typical overheated economy and inflation, it has yielded several surprises for investors. For instance, despite unemployment reaching record levels, consumers spent more than expected on home repairs and remodeling which boosted sales at stores like Home Depot (HD) and Lowe’s Companies (LOW). Likewise, residential home sales have surged despite escalating unemployment. An intuitive expectation of an inverse relationship between the two would be incorrect, at least thus far. Outperformance of online retailers, like (AMZN), over some traditional recessionary picks, like Procter & Gamble (PG), has also been unexpected. Moreover, this was the first recession that drove people to spend more time outdoors, giving a boost to firms like sports vehicle maker Polaris (PII). However, the question to ask is:  Is this burst of COVID-driven growth anomalous and short-lived, or is it sustainable?

Another aspect to highlight is the conjectural nature of forward estimates and current valuations. The wild swings in near-term consensus estimates between earnings cycles seem to be highly speculative and largely based on the latest news headlines rather than analysis of underlying firms’ fundamental metrics. Similarly, it appears that some previously struggling firms are getting an unsustainable boost by pivoting to create products that help customers deal with COVID-19 impacts. In this article, I explore examples of two firms for which analysts anticipate rising near-term growth rates specifically driven by COVID-19 related tailwinds that we do not believe are sustainable longer-term. Read on....

Ryan DesJardin  by Ryan DesJardin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Here at Gradient Analytics, our focus extends far beyond domestic equity research. We are known to cover an extensive group of publicly traded companies whose shares trade on a wide variety of stock exchanges around the globe. Our team of analysts must be vigilant in keeping up to date on new accounting standards issued by both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). More importantly, our team must be able to understand and reconcile the key differences between United States Generally Accepted Accounting Principles (US GAAP) and International Financial Accounting Standards (IFRS) in order to accurately assess a firm's financial health.

The ability to distinguish between these accounting standards has become a crucial skill for investors as IFRS has become increasingly prevalent in recent years. Today, more than 140 countries worldwide (including the United States in some cases) either permit or require the use of IFRS for publicly listed companies. In fact, there are only three major capital markets that don't currently mandate the use of IFRS for publicly traded firms: Japan, China, and the United States. Since 2010, when Japan added IFRS to its list of approved standards for domestic issuers, more than a third of companies traded on the Tokyo Stock Exchange have either adopted or instituted a plan to adopt IFRS in the near future. China continues to amend its accounting standards to broadly align with IFRS. Furthermore, domestic investors must also be mindful of the variations between accounting standards as the SEC allows foreign issuers to report under IFRS despite trading on US exchanges.

In 2002, the FASB and IASB entered into the "Norwalk Agreement," which aimed to eliminate the many variations between US GAAP and IFRS. Since then, the boards have worked together to issue several accounting standard updates in an attempt to enhance the consistency and comparability of global accounting standards. Despite these ongoing efforts, many key dissimilarities remain between the two standards that present a number of obstacles to investors. This article uses earnings quality and fundamental perspectives to discuss key challenges while providing tips on evaluating a firm’s true earnings power.  Read on....

Rachel Bradley  by Rachel Bradley
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

At times, there are conflicts of interest between a company’s management and its investors, specifically shareholders, which creates a structural agency problem. So, it is common for companies to try to align the monetary interests of management with shareholders by awarding a large part of executive compensation in equity. As a result, management performance metrics often create an incentive to present the current period financials in the best light possible, even if it is unsustainable in the longer-term. This dynamic creates opportunities for a forensic accounting firm like Gradient Analytics, which specializes in assessing the quality of reported earnings of publicly traded companies to both vet long candidates and to identify short candidates.

An astute investor might ask the perfectly reasonable question, “If publicly traded companies are regulated and audited, then aren’t all reported earnings of passable quality?” However, consider that it is possible for a company to engage in “earnings management” by publishing financial statements that may mislead investors as to the firm’s true financial health without violating accounting standards. Moreover, we would argue that even though two given companies both followed GAAP accounting standards and received clean opinions from their auditor, earnings growth at Company A may be dramatically more sustainable than at Company B. Of course, it can be quite valuable for an investor to know when a firm is showing signs of unsustainability in its reported earnings growth.

In this article, I use three real-life examples to provide a high-level overview of our analysis process, which includes assessing earnings quality, anomalous insider trading activity, audit control risk, and corporate governance. Although Gradient does not employ a team of investigative journalists to knock on doors, interview company employees, or rummage through the trash for evidence, our comprehensive analysis of the published financial statements (and, importantly, the footnotes) can help stack the odds a little bit more in investors’ favor.  Read on....

Ian Striplin  by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Here at Gradient Analytics, where we specialize in forensic accounting research and consulting, it may seem to the outsider that we are just a bunch of pessimistic short researchers, sniffing out aggressive accounting practices that might soon cause a given company to miss earnings expectations and reduce forward guidance, for the benefit of our clientele of long/short hedge funds. To be honest, we are jaded in our belief that most companies will, from time to time, take liberties with their accrual accounting in order to achieve short-term reporting objectives. But most only do it sparingly and temporarily, and only those that become overly extended in employing aggressive practices – while facing fundamental headwinds that make it likely certain metrics will persist or worsen – make good short candidates. But that doesn’t automatically make all the others good long candidates.

Thus, our expertise is also useful for identifying solid earnings quality for the vetting of long candidates. Earnings quality analysis can reveal accounting benefits to future earnings potential and help ensure that a quant model or fundamental analysis that created a positive equity profile for a given company is indeed based on the underlying economics of the business rather than an aberration of accrual accounting. In other words, it can serve to add conviction or a confirmation signal to a long thesis.

In this article, we will describe several positive earnings quality factors that can act as a tailwind to sustainable future earnings growth, with four real-life examples. In forming a stock universe for this article, we screened the output file of our proprietary Earnings Quality Rank (EQR), which assigns a quintile score of 1-5 (with 5 being the “best” earnings quality relative to peers), and limited the population to companies in the top quintile and a market capitalization greater than $500 million, to avoid liquidity constraints. (Note: On the other hand, when seeking short candidates, we look to the bottom quintile of the EQR model.)  Read on….

gradient / Tag: forensic accounting, earnings quality, CFOA, GAAP, non-GAAP, accruals, AFDA, COGS, TTEK, ASML, PRO, FELE / 0 Comments

Dominic Finney  by Dominic Finney
  Senior Analyst & Chief Technical Editor, Gradient Analytics LLC (a Sabrient Systems company)

Perhaps the most reliable shortcut to identifying a company at elevated risk of a downturn in its share price is looking at how executives and directors use their equity instruments. This might sound too simple to be predictive – something that would be quickly understood by the market and integrated into investors’ thinking on a scale that would cause the “edge” to disappear. But there are complications that have prevented that from happening, on which I will elaborate shortly. But first, let’s look at some recent examples.

Over the past two years, Gradient Analytics has published five brief “snapshot” reports based on our Equity Incentive Analytics examining signs of unusual and concerning equity use by executives and directors. The subject companies were Amarin (AMRN), United States Cellular (USM), WW International (WW, or WTW when we wrote on it), Supernus Pharma (SUPN), and Magellan Health (MGLN). All five of the reports preceded significant declines in company share price, with four of the five stocks showing double-digit declines over the ensuing three months and all of them hitting double-digit declines over six months. Read on....