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Saturday, November 24, 2007

More on The Accrual Anomaly

Here's another paper on "tradable" patterns in stock returns. The CXO Advisory Group recently put up a summary of the study titled "Repairing the Accruals Anomaly" by Hafzalla, Lundholm and Van Winkle. The paper examines the pattern that stock market performance of firms with low accruals (i.e. the difference between the firm's earnings and cash flows) is significantly greater than the performance of their higher accrual counterparts. It does a pretty good job of examining Sloan's "Accrual Anomaly" with a few tweaks:
  • It corrects for the extent to which the firm is financially healthy, using Piotrowski's "financial health" indicator.
  • It measures accruals in relation to earnings rather than to assets
Their findings are that the accrual anomaly does a better job of sorting out investment performance for financially healthy firms. Their results are pretty strong (note- the following is CXO's summary):
  • A hedge strategy that is long (short) firms of high (low) financial health (ignoring accruals) generates an average size-adjusted annual return of 9.36% across the entire sample.
  • After excluding firms with the lowest financial health scores, a hedge strategy that is long (short) the 10% of firms with the lowest (highest) traditional accruals generates an average size-adjusted annual return of 13.64%, with 7.98% coming from the long side
  • Using the total sample, a hedge strategy that is long (short) low-accrual, high financial health (high-accrual, low financial health) firms produces an average size-adjusted annual return of 22.93%, with a 14.92% from the long side. (See the first chart below.)
Here's a pretty good grapic of size adjusted abnormal returns on the various portfolios. Note that financially healthy firms with low accruals earn a size-adjusted abnormal return of about 15% annually, while those in the "financially unhealthy/high accruals" group have negative size adjusted returns of about almost 10% a year.

Read the paper here.

It looks like my students in Unknown University's Student Managed Fund will have another indicator to look at next semester.

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