By Byron Macleod, CFA
Associate Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Given that Gradient Analytics’ research is primarily focused on forensic accounting, this common client question falls into our sweet spot. However, the link between earnings quality concerns and share price underperformance can be difficult to assess for two reasons:

   1.  Investors and sell-side analysts tend to focus their attention on the income statement, but there is not always a predictable correlation between the highlighted balance sheet trends and the income statement impact.
   2.  Because management has a huge amount of discretion over how accounting entries are handled (including when to recognize built-up expenses, impairments, non-cash gains, etc.), earnings quality concerns often have ambiguous timing.

Thus, investors often are left wondering just how and when eroding earnings quality in their portfolio holdings – whether long or short – will ultimately impact their fund’s performance.

Nevertheless, to illustrate how such red flags may indeed lead to notable share price decline, I will describe three real-life examples. For compliance reasons, I won’t disclose their names, but will simply refer to them as Company A, B, and C. Read on....