Buy or Short These Trading Companies?

If you want to find winning -- or losing -- stock ideas, you'll need to understand what lies beneath a company's reported revenue. Many investors screen on metrics like net income or related measurements such as EBIT, EBITDA, or operating cash flow. But companies know that Wall Street is closely monitoring these factors, and they can sometimes attempt to massage their numbers in hopes of providing a "good story" for investors.

Investors can get a much better picture of a company's true revenue or cash flow story by looking into the quality of earnings instead. Diligent Fools will play the role of forensic accountant, reading all of a company's SEC filings and financial statements in search of accounting tricks that might be masking deteriorating company performance. To help your investigation, I've uncovered a powerful shortcut: subtracting net income from operating cash flow.

Let's test how well this shortcut works by rounding up a clutch of trading companies in the industrial sector with five-year annualized growth rates greater than 10%. Then we'll rank these contenders with my quality-of-earnings metric, divided by each company's market cap to normalize the candidates' different sizes.

Here are the top two and bottom two companies in my quality-of-earnings screen:

The highest:

Source: Capital IQ, a division of Standard and Poor's, and author calculations. Figures are the average of five one-year growth rates since 2005.

The lowest:

Let's examine how companies in the industrials sector have performed over the last decade when ranked by my simple quality-of-earnings metric. In the following charts, quantile 1 represents stocks with the highest earnings quality, while quantile 5 represents the lowest:

The graphs don't lie
Companies with higher quality of earnings significantly outperform those with lower quality. Stocks in quantile 1 generated more than 22% annualized returns, while the bottom-feeders of quantile 5 returned roughly 4% over the same time period.

Clearly, the revenue growth story for the trading companies above isn't enough to fully evaluate these companies.  Our earnings quality screen (and a decade of corroborating evidence!) suggests that DXP Enterprises and H&E Equipment Services are our buy candidates, while MSC Industrial Direct and Beacon Roofing Supply might be shorting opportunities. Of course, before pulling the trigger, investors should do their own homework, to get an even better and more comprehensive picture of quality of earnings and earnings growth.

Finding companies to short will take more than my simple quality-of-earnings shortcut. That's why John Del Vecchio, CFA, a leading forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.