Buy or Short These Chemical Companies?

Understanding what lies beneath a company's reported revenue is a key to finding winning or losing stock ideas. Many investors screen on metrics like Net Income or related measurements such as EBIT, EBITDA, or operating cash flow. Revenue, profitability, and cash flow growth equals opportunity, right? Not necessarily. Companies know that Wall Street is closely monitoring these factors, and do their level best to provide a "good story" for investors.

Investors can get a much better picture of a company's revenue or cash flow story by also looking into the quality of earnings. Ideally, you can play the role of forensic accountant, reading all of a company's SEC filings and financial statements in search of accounting tricks that might tend to mask deteriorating company performance. Or one powerful shortcut that you can use is to measure operating cash flow-net income.

I'm going to test how well this shortcut works in a series of articles that look at whether quality of earnings can help us find the buys and shorts within an industry, looking only at companies with 5-year annualized growth rates >10%. I'll then rank companies by my quality of earnings metric, normalized to account for companies of different sizes: (Operating Cash Flow – Net Income ) / Market Cap).

Finding the longs and shorts in chemicals
Here are the top two and bottom two companies in my quality of earnings screen:

Top Quality of Earnings

Source: Capital IQ, a division of Standard & Poor's, and author calculations.

Bottom Quality of Earnings

And let's look at how companies have performed over the last decade when ranked by my simple quality of earnings metric:

The graphs tell the story
Higher quality of earnings companies significantly outperform lower quality of earnings companies. Quantile 1 stocks (with the highest earnings quality) generated nearly 20% annualized returns while Quantile 5 stocks (lowest earnings quality) returned about 5%.

Clearly the revenue growth story for the Chemicals companies above is an inadequate measure to evaluate these companies.  Our earnings quality screen suggests that Senomyx and LSB Industries are our buy candidates and Monsanto and Airgas might potentially even be shorting opportunities. Of course, before pulling the trigger, investors should do their homework to get an even better and more comprehensive picture of quality of earnings and earnings growth.

Finding companies to short using a quality of earnings screen 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.