FUNDAMENTALS Conclusion When purchasing a used car, finding the cherry in the basket of lemons is a challenge. Seemingly identical cars may hide important differences in quality due to their past owners’ driving habits, maintenance practices, and accident history. Finding a cherry takes effort, but that effort is rewarded with many June 2015 miles of worry-free driving acquired at a reasonable price. Likewise, when purchasing high dividend-yielding equities, the challenge is to find high-quality companies at reasonable prices. Simply paying the lowest price for a given dividend is not an optimal strategy.

Some high-yield equities are cherries, cheaply priced equity of high-quality dividend-paying companies. Other high-yield equities are lemons, cheaply priced equity of lowquality companies with unsustainable dividends. Identical dividend yields may hide important differences in the quality of companies arising from financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud. Endnotes References 1. 2. Akerlof, George A.

1970. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics, vol. 84, no.

3 (August):488–500. 3. 4. In our analysis, delisting is due to default. Just as with DCR, ROA is not a magic indicator of profitability. ROE or gross profitability would give similar outcomes. In this simulation we use DCR to identify potentially distressed companies. The results are robust to many other metrics that could be useful to identify distress. Using the DCR filter, the absolute number of delisted companies is zero. It is actually quite rare for companies in the top 1,000 roster by market capitalization to be delisted; for every company that actually defaulted and delisted while in the top 1,000, tens of companies dropped out of the top 1,000 because the market perceived their imminent default, leading to their subsequent delisting.

This result shows that DCR is a great measure to predict default, but in live portfolios can provide no guarantee that the portfolio is immune to default risk. Hirshleifer, David, Kewei Hou, Siew Hong Teoh, and Yinglei Zhang. 2004. “Do Investors Overvalue Firms with Bloated Balance Sheets?” Journal of Accounting and Economics, vol.

38 (December): 297–331. Sloan, Richard G. 1996. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” The Accounting Review, vol.

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