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.
71, no. 3
(July):289–315.
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