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Greenberg: It's the Stocks You Don't Own That Matter

Thursday, 31 Jan 2013 | 8:17 AM ET

When you spend as much time as I do raising red flags over stocks, the inevitable push back is that it's all about shorting stocks.

Wrong!

It's about managing risk, and as the smartest investors will tell you: Investing is as much about not losing money as it is about making money.

Sometimes the wisest way to do that: Deciding which stocks not to buy.

Which is why the new Forensic Accounting ETF (ticker: FLAG), which launches today, is so interesting. This is not an endorsement of the fund, which focuses on earnings quality, but a spotlight on a concept that is often woefully overlooked.

Here's how it works: Using an algorithm created by fund manager John DelVecchio, and an index aptly called the DelVecchio Quality of Earnings Index, the fund rates stocks in the S&P 500 on a scale of "A" to "F," based on earnings quality.

The twist: The F-rated stocks, which are 20 percent of the S&P, are excluded.

DelVecchio — who co-manages the Ranger Equity Bear ETF and wrote the book, "What's Behind the Numbers" — figures S&P 500 index investors can improve their returns by eliminating the worst stocks. "You create performance by getting rid of the losers," he said.

While the earnings-quality algorithm crunches various items, all of them spawn off of two core metrics: cash flow and the way revenue is recognized.

Then they're sorted based on their grades, with A-rated stocks amounting to 40 percent of the portfolio, and B, C and D each getting 20 percent. (The 20 percent that would have gone to F goes to A.) "FLAG is mostly equal weighted, but the edge is in deleting the companies with the red flags and adding that back to the A-quality companies," DelVecchio said.

Since it's an algorithm, DelVecchio's index isn't foolproof. For example, it can catch a false-positive by a company whose numbers might be inflated by a flawed business model. But DelVecchio said it has been back-tested, rising 19.1 percent last year, 4.15 percent in 2011 and 28.9 percent in 2010.

With that as a backdrop, five of the stocks he would avoid based on earnings quality: Chipotle, Fossil, Perrigo, First Solar and Rockwell Collins.

By contrast, among the highest quality: Dell, Big Lots, Tenent Healthcare, Bristol-Myers Squibb and (no surprise) Berkshire Hathaway.

My take: Great idea.

—By CNBC's Herb Greenberg; Follow him on Twitter: @herbgreenberg and Google

Subscribe to Herb at http://www.facebook.com/herb.greenberg

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Disclaimer

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    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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