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.