Today, we present an article by John Del Vecchio that will change the way you think about the market average, which is the wrong yardstick for stock performance and index investing. John is the creator of the Del Vecchio Earnings Quality Index, and index provider to the Forensic Accounting ETF (NYSE: FLAG), as well as a former forensic accountant and active short seller for 14 years. He is co-author with Tom Jacobs of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio (McGraw-Hill, 2012). The book provides more detail on the Del Vecchio Earnings Quality index components.

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The Trillion Dollar Mistake:
Why the allocation in portfolios to the S&P 500 is sub-optimal and what to do about it

By John Del Vecchio

Among my conversations with asset allocators, the anecdotal evidence suggests that the largest allocation in equity portfolios is the S&P 500, which has become a proxy for "the market."

However, traditional indexes such as the S&P 500 have major flaws in their construction. First, the indexes are market capitalization weighted. By the time companies become large constituents of the index, they're often past their innovative and high-growth phases, and more often than not, act as a significant drag on performance.

Consider the chart below. According to Ned Davis Research, "popularity kills." Since 1972, the S&P 500 increased nearly 5,000%. Yet, owning the top stock in the S&P 500 by market capitalization increased in value approximately 400%.

Copyright 2013 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

The stocks that have been among those carrying the highest weight in the index include AT&T, Altria (formerly Philip Morris), Apple, Cisco Systems, Exxon Mobil, General Electric, IBM, Microsoft, and Wal-Mart. Most people would consider these to be "good," if not "great," companies. But, great companies do not necessarily make for great stocks.

Another study (source: Daniel Solin) measured the performance of the S&P 500 from 1957-1997. During that time period, the index was up over 8,500%, with dividends reinvested. However, of the 74 stocks in the index during the entire time period, only 12 stocks outperformed the index itself.

In our own research, we extended a portfolio of holdings to include the top 10 companies in the S&P 500 by market capitalization. Typically, these stocks comprise approximately 20% of the index by weight. These, too, are household names, and include Exxon, Apple, IBM, Chevron, Microsoft, GE, Proctor & Gamble, AT&T, Johnson & Johnson, and Pfizer. In our tests from 1983-2012, the S&P 500 increased over 2,600%, while the top 10 stocks in the index rose in value just 800%.

The Market Cap Weighting Problem

Removing the market capitalization bias is one step toward enhancing returns for the S&P 500. Since 1989, the equal-weighted S&P 500 has outperformed its more popular market cap weighted version by 1.89% annually (source: Bloomberg). This one stock, one vote, approach dramatically underweights the largest, most popular companies, and reallocates the index toward middle-capitalization companies that may become the future leaders of the market.

According to S&P's own survey results, by 2010, approximately $1.3 trillion was indexed to the S&P 500. Given the poor performance of market capitalization weighting across multiple time periods, we view this as a serious trillion-dollar misallocation. Finally, market capitalization is not often the way one invests. Ask yourself if you size the securities in your portfolio by market capitalization.

Most Stocks Underperform

The second problem with traditional indexing, in our view, is that most stocks are underperformers over time. In a capitalistic system, this makes sense. For every Wal-Mart, there are dozens of regional retailers that no longer exist due to lack of scale, distribution, and technology. In the 1970s, Eastman Kodak and Polaroid reigned supreme, only to be bankrupt later on. The "horsemen" of the Internet bubble, such as Microsoft, Cisco, Dell, and Intel, have lagged sharply. Today, Apple and Google are all the rage. But, where will they be in 10 years?

The chart below illustrates a study by Blackstar Funds. From 1983-2007, the Russell 3000 Index was up nearly 900%. Yet, 64% of the stocks underperformed. Nearly 40% were down in absolute terms, while 19% declined in value by 75% or more. Most strikingly, just 25% of the stocks accounted for all of the markets gains.

Thus, our second area of contention with traditional indexes is that, while they include all of the best stocks, they also include all of the worst. Yet, here we see just one of several presentations of empirical data suggesting that most stocks fail to keep pace with the indexes.

A Different Way to Invest

We've developed our own index, the Del Vecchio Earnings Quality Index, which is designed to overcome what we believe to be the two main flaws of traditional index construction. First, the index is weighted by earnings quality as opposed to market capitalization.

This starts with a five-step process highlighted below.

• Define: Universe consists of the 500 largest capitalized U.S. stocks
• Analyze: Perform forensic accounting analysis on each stock
• Grade: Each stock receives an overall grade of "A-F"
• Avoid: Avoid stocks graded "F" due to financial red flags
• Invest: Remaining stocks comprise index with a tilt toward A-graded stocks

The earnings quality (EQ) scores are derived from the quality and sustainability of cash flows, the propensity for management to have overstated revenue or understated expenses, as well as a host of "shenanigans" that management may utilize to overstate reported profits on a sustainable basis. These concerns are categorized by where they reside on the income statement and the degree to which they are likely to impact reported results.

The stocks are scored A, B, C, D, and F -- much like you'd receive on a report card in high school -- and, of course, we all got A's, right? The "F"-ranked stocks, those deemed to have the worst earnings quality relative to the other 500 stocks in the index, are then removed, and then the stocks are weighted to the "A" stocks -- those perceived to have a higher degree of earnings quality. The index weights are as follows:

A: 40%
B: 20%
C: 20%
D: 20%
F: 0%

Eighty percent of the Del Vecchio Earnings Quality Index is equal weighted, which, as we highlighted from Bloomberg, has outperformed the S&P 500 by 1.89% annually since 1989. The key difference is using earnings quality and the EQ scores to attempt to remove stocks most likely to underperform. The table below illustrates the performance of stocks by EQ score since 2000 with a monthly rebalance:

There is a stair-step pattern among the various grades, with the "F" ranked stocks as net losers, even though the S&P 500 increased in value over the time frame. Furthermore, the "A" rated stocks have added excess return. Finally, the annual returns of the index are below (back-tested through 2009, then live 2010-12):

2000: 23.3%
2001: 0.4%
2002: (17.2%)
2003: 51.1%
2004: 13.8%
2005: 15.8%
2006: 16.8%
2007: (6.7%)
2008: (43.4%)
2009: 65.8%
2010: 28.9%
2011: 4.5%
2012: 19.1%

Conclusion

Traditional index suffers two major drawbacks. Market cap weighting is an inefficient process for sizing portfolios. And, over time, most stocks fail to keep pace with the market. The Del Vecchio Earnings Quality Index seeks to overcome these deficiencies by removing the market capitalization bias, testing and sizing companies based on quality of earnings issues with an emphasis on overweighting the highest-quality companies, and deleting the lowest-quality ranked companies from the index.

In this final video installment, Tom Jacobs talks about a company where all red flags were waving. "Yoo hoo," said the stock, "Short me time and time again if you'd like to make a lot of money." To find out the name of the company and why it was a delectable short, click here.

If you want to learn more about this topic, pick up a copy of Tom and John Del Vecchio's new book, What's Behind the Numbers? You can purchase a copy here.

Have you always wanted to short a stock, but have been held back by the fear of margin accounts and potentially unlimited losses? Shorting can be scary, especially because the time frame is unlimited. But, according to Tom Jacobs in this video, an alternative -- and less scary -- way to short a stock is by using put options. You'll profit if the stock goes down, but you'll always know the maximum amount you can lose during a limited time frame.

If you want to learn more about this topic, pick up a copy of Tom and John Del Vecchio's new book, What's Behind the Numbers? You can purchase a copy here.

Today, we're introducing you to Red Flag No. 4 -- too many days sales outstanding, or DSOs, which is defined as the number of days it takes for a company to collect revenue. In this video, Tom Jacobs talks about the problems with DSOs -- when they increase, it's a sign that troubles are ahead.

If you want to learn more about this topic, pick up a copy of Tom and John Del Vecchio's new book, What's Behind the Numbers? You can purchase a copy here.

Investors need to be on the lookout for a company that's a serial acquirer. Why? Because you can't tell if the acquisition adds value until you get a year-over-year comparison. Revenues may rise, sure, but what about inventories, accounts receivable, and cash flows? The acquisition obscures whether these numbers are good, or if they're red flags.

But wait ... a company that's a serial acquirer may go out, yet again, and do what it does best -- buy another company. Then you'll have to wait another year to make a realistic comparison.

In this video, Tom Jacobs discuses why highly acquisitive companies may be covering up a lack of organic growth --
and tells you two companies to steer clear of.

If you want to learn more about this topic, pick up a copy of Tom and John Del Vecchio's new book, What's Behind the Numbers? You can purchase a copy here.

Stock options are a great perk -- for the person who's receiving them. Investors, however, must look at those very same options from another perspective: Does adding them back make operating cash flow look better than it is, or is management extracting value that belongs to you? According to Tom Jacobs in the following video, stock options that are a large percentage of operating cash flow are Red Flag #2 in the world of financial chicanery. He shows you one of the worst offenders to avoid, sell, or short.

If you want to learn more about this topic, pick up a copy of Tom and John Del Vecchio's new book, What's Behind the Numbers? You can purchase a copy here.

Curious about how you can find the signs that indicate a company is going down? Then watch this short video by Tom Jacobs, the first in a series in which he raises the flags on financial chicanery.

The video also includes an overview of the top five books on earnings quality and short-selling, and a description of how his new book, What's Behind the Numbers?, which he co-authored with John Del Vecchio, builds on the work of the masters, but fills in the informational gap where the other books fall short.

You can purchase a copy of the book here.