In today’s increasingly unpredictable markets, most investors are looking for an edge. We decided to test a simple idea: instead of trying to pick the winners, what if you just avoided the worst?
Using Transparently’s AI-powered accounting risk scores, we built a monthly strategy that shorts the 25 highest-risk companies with market caps over $2 billion listed in the US, and goes long the S&P 500 Index.
In other words, the model is long the US market and short the 25 companies with the worst accounting quality. We tracked the performance over the time period that Transparently has been producing these results, to avoid any issue with backtests.
The results were striking, and we’ll come to those in a moment. First, let’s explain why we use accounting quality, which in turn explains the core value of what our product offers.
Accounting quality as a screening tool
Accounting quality — a company’s financial truthfulness, consistency, and clarity — is a powerful lens for filtering out trouble. Companies with aggressive or opaque financials often carry hidden risks that don’t show up in traditional analysis until it’s too late.
By systematically avoiding the worst offenders, you not only sidestep major blowups, but also improve your portfolio’s overall signal-to-noise ratio. In other words, better accounting inputs lead to better investment outcomes.
That’s exactly where Transparently comes in. Our AI-powered Risk Engine assesses the accounting quality of over 85,000 listed companies worldwide by analyzing decades of financial statements through the lens of forensic accounting.
It distills this complexity into two intuitive metrics: a 0–100% risk score indicating the probability of manipulation and collapse, and a letter-grade rating that benchmarks companies against their peers. Behind the scenes, more than 200 financial models — trained on forensic practices used by short sellers, auditors, and analysts — power this assessment, flagging subtle red flags that often go unnoticed until it’s too late.
The strategy's performance
This risk-avoidance strategy has delivered impressive results since its inception in late July 2021:
- An annualized return of 46.1%, compared with 10% for the S&P 500
- A total return of 255.4%, eclipsing the US index’s 35%
Put another way: This strategy would have transformed a $100,000 investment into $355,400, while the S&P 500 would have turned the same amount into $135,000 over the same period. That’s an outperformance of 2.5 times.
(Please note: This test did not include transaction costs. But remember, there are only 26 positions being held at any one point in time. Even the most egregious view of transaction costs, cost of stock borrow, etc. would struggle to see anything other than a substantial amount of outperformance left over.)
The strategy also delivered a Sharpe ratio of 1.7 — nearly three times higher than the S&P 500’s 0.6. The Sharpe ratio measures how much excess return you earn for each unit of risk taken, making it one of the most useful ways to compare risk-adjusted performance. In simple terms: this strategy didn’t just return more, it did so more efficiently.
Just as important, the strategy delivered gains in 70.5% of months, above the S&P 500’s 59%. For institutional investors, that kind of consistency isn’t just comforting, it’s strategic. It supports smoother portfolio-level returns, reduces behavioral risk, and makes the strategy easier to integrate alongside other mandates without introducing excess volatility.
Smarter risk, not just bigger returns
This strategy isn’t just about making more — it’s also about losing less when things get rough. The worst drop it experienced, known as a drawdown, was -18.6%. That’s the biggest peak-to-trough decline, and it’s actually smaller than the S&P 500’s worst slide of -23.9% over the same period.
It’s true that the strategy showed higher volatility — in other words, its returns bounced around more than the market’s. But the payoff was more than worth it.
One of the most interesting features is its negative beta of -0.4. In plain terms, that means the strategy tends to move in the opposite direction of the market. When stocks broadly fall, this strategy often does well — which makes it a valuable potential hedge, especially in portfolios that are otherwise long-heavy.
We also ran a stress test called a Value at Risk (VaR) analysis — essentially, it estimates how much you could lose in a worst-case scenario. Using a 99% confidence level and a method called the Modified Cornish-Fisher (which accounts for unusual market behavior and non-normal returns), the model showed a potential one-month loss of -17.0% (i.e. what could occur in 1 month in 8-9 years). That’s a manageable downside, especially given the strong long-term returns.
The power of avoiding high-risk companies
What makes this strategy particularly compelling is how it harnesses a simple insight: systematically avoiding (and actively shorting) the highest-risk companies can dramatically boost performance. In fact, the companies flagged as high risk by our Engine haven’t just underperformed, they’ve destroyed value.
Since July 2021, the average return of these names was -25.4% per year. Their cumulative loss hit -72.8%, with some collapsing by more than 70% from peak.
The takeaway is clear: bad accounting often leads to bad outcomes. By systematically avoiding companies with the weakest financial quality, our modelled strategy captures alpha by cutting out the most likely losers.
What this means for investors
The implications of this analysis are profound for portfolio managers and investors (and not just those that can short stocks):
- Risk avoidance can be more powerful than return chasing: Systematically eliminating high-risk companies from a portfolio can deliver superior results compared to seeking high-potential winners. For long-only investors, avoiding these names can significantly enhance performance.
- Diversification beyond traditional approaches: With its negative correlation to high-risk assets and low correlation to the broader market, this strategy offers genuine diversification benefits.
- Consistency matters: The strategy's high percentage of positive months (70.5%) implies a more consistent investment journey.
In an investment landscape where generating consistent alpha becomes increasingly difficult, strategies that systematically avoid the highest-risk companies may offer a compelling path forward. While past performance is never a guarantee of future results, the risk-adjusted returns demonstrated by this approach deserve serious consideration by investors seeking to enhance their portfolio outcomes.
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