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Buy quality, short the rest

Accounting for accounting tricks.

(Photo: Getty Images)

(Photo: Getty Images)

A research note from Cantor Fitzgerald has an intriguing investing idea for making money regardless of the direction of the stock market: buy the Forensic Accounting ETF while short selling an ETF tracking the S&P 500.

The Forensic Accounting ETF  (ticker: FLAG) tracks the share prices of the top 500 large-cap U.S. companies minus companies with poor ratings for earnings and accounting quality. It’s based on the forensic-accounting work of John Del Vecchio, a chartered financial analyst, fund manager, and author of What’s Behind The Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses In Your Portfolio.

The thesis behind the recommendation to go long FLAG relative to the S&P 500 is that companies reporting solid earnings without the help of too many accounting tricks are more likely to outperform companies that get creative with accounting rules. The quality of corporate earnings and accounting systems can, in effect, be used as a proxy for financial strength and commercial prospects.

So, whether the stock market goes up or down, money can still be made in the proposed long/short ETF trade. All that’s needed is for the higher quality companies to outperform the lower quality companies.

A caveat for me would be the fact that there have been periods in the past when low-quality companies did outperform. This often occurs just after a substantial market sell-off: the stock prices of companies with questionable earnings become so oversold that when the market recovers, they spring back the most. Thus, I suspect the long/short ETF trade will make most of its gains during the later stages of bull markets and throughout bear markets.