Earnings Quality Revisited
Posted: 21 May 2019
Date Written: May 30, 2013
Earnings quality as an investment signal has been popular among equity portfolio managers for the last decade. The basic idea behind this “accruals anomaly” is that stocks with high and increasing accruals tend to have low earnings quality while stocks with low and decreasing accruals tend to have high earnings quality. The earnings quality signal stopped working in the mid-2000s but since the end of 2008 has staged a remarkable rebound. Here we evaluate whether earnings quality is a true alpha signal, whether it is a risk factor, or both. We find that in the periods where the signal worked, the strategy was largely driven by stock selection, suggesting earnings quality is indeed an alpha signal. Second, we find that earnings quality is not a good risk factor, in that it does not have high statistical significance when regressed cross-sectionally on returns along with other well-known risk factors and is not very volatile over time. Overall our results indicate that earnings quality may have really been that rare example of a “pure alpha” factor.
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