[06/04/19] Alternative Data to the Rescue of Financial Reports

In Brief

  • The usefulness of financial reports to investors is fast diminishing.
  • Alternative data are actively sought by investors and academics
  • Research has shown that satellite-imaging, web searches, job announcements, among others, can assist in predicting companies’ sales.

 

The Sad State of Financial Information

It’s no longer a secret that corporate financial reports lost in recent years most of their usefulness to investors. Already in 2006, the CEOs of the six largest accounting firms proclaimed in a white paper: “FASB rules produce financial statements that virtually no one understands.” Fast forward 13 years―the Wall Street Journal (February 5, 2019) writes: “Don’t obsess over the earnings season: In theory and in practice quarterly earnings just aren’t that important.”  In our recent book, The End of Accounting (Wiley, 2016), Feng Gu and I provide extensive empirical evidence on the continuous decline of financial information usefulness and the reasons for this adverse development. The far-reaching structural changes of corporate business models, elevating intangible assets to the prime value-creators of businesses―a phenomenon totally mismeasured by accountants―and the relentless fair-value drive of the FASB, which increases exponentially the number and impact of subjective and often unreliable managerial estimates and forecasts underlying financial information, are among the main causes of financial reports’ value relevance lost.

But nothing demonstrates better the loss of financial reports’ usefulness to investors than the following figure which portrays the gains from a perfect prediction of all the companies which will exactly meet or, better yet beat analysts’ consensus estimate of earnings. The dream of analysts come true. Specifically, I calculate for every quarter (1986-2018) the gains from investing two months prior to quarter-end in all the companies which will subsequently meet or beat the consensus, and winding the investment after earnings announcement (roughly three months holding period). As is made clear by the figure, while the gains from such a perfect foresight strategy were high in the 1980s (before the rise of intangibles and the FASB’s drive for “fair value”), they plummeted thereafter. Today, even a perfect foresight of earnings―impossible, of course, in the real world―will yield a trifle 1.0%. The reason: corporate (GAAP) earnings no longer reflect enterprise performance and value creation. A sad state of affairs, to be sure. So, what’s investors to do?

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 Alternative Data to the Rescue

A very promising development in investment circles and academic research is the active search for “alternative data” capable of supplementing, and in some cases substituting for financial report information. Some industry-specific examples of such data are widely known. Certain vendors collect data on daily or weekly pharmacy prescription sales, allowing for an accurate prediction of drug companies’ sales. Another example: satellite-based 24/7 images of parking lots enable estimates of retailers’ sales. The challenge, however, is to find more generalized alternative data. Following are two recent examples.

Chiu et al. (“Using Google Searches of Firm Products to Assess Revenue Quality and Detect Revenue Management,” 2018). The researchers examine Google Trends (https://trends.google.com) which aggregates consumer online searchers of reviews, ratings, and coupons of specific products. Google forms from these searches volume indexes (SVI) of the queried products. The researchers examine whether changes in the volume indexes in a given quarter provide information about companies’ sales, and find that indeed changes in Google search indexes are significantly correlated with same quarter sales changes: the higher the volume of search by customers, the higher the company’s sales growth. Interestingly, they report that companies with decreases in search intensity but increases in reported sales are suspect of revenue manipulation. Indeed many of these companies were later subject to SEC revenue misreporting actions.

Thus, Google’s consumer product search indexes―hourly updated and easily available to investors―provide important, non-accounting information about companies’ sales and the integrity of their sales reporting.

I hypothesize that new job posting by companies will enable prediction of their future performance. Stands to reason that firms increase job posting in anticipation of improved sales in the future. I am currently examining this issue, stay tuned.

The search for alternative data is, in my opinion, very promising. Join the hunt.

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