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Paper

Working Papers

Type:

Date:

2015-05-03

Categor

Operating profitability, accruals, cash flows, anomalies, asset pricing

y:

Title:

Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns

Authors

Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa and Valeri V. Nikolaev

:

Source:

SSRN Papers

Summa

A cash-based operating profitability measure (i.e., excludes accruals)

ry:

outperforms other measures of profitability. A long-short strategy can yield a monthly three-factor alpha of 0.9%

Intuition

Profitable firms earn higher average returns However, increases in profitability solely due to accruals have no relation with the cross section of expected returns Therefore, purging accruals from operating profitability should generate a stronger predictor of future stock performance Variables definitions

Cash-based operating profitability = sales - cost of goods sold – SG&A - accruals Or, Cash-based operating profitability = Revenue (REVT) − Cost of goods sold (COGS) − Reported sales, general, and administrative expenses (XSGA−XRD) − Δ(Accounts receivable (RECT)) − Δ(Inventory (INVT)) − Δ(Pre-paid expenses (XPP)) + Δ(Deferred revenue (DRC+DRLT)) + Δ(Trade accounts payable (AP)) + Δ(Accrued expenses (XACC)) Portfolio formation

Each June, sort stocks into deciles based on their cash-based operating profitability Long stocks in the highest decile, short stocks in the lowest decile ● Rebalance annually Cash-based profitability measure outperforms operating profitability and accruals

Monthly three-factor alphas

Cash-based

Operating

Accruals

operating

Profitability

 

profitability

1 (Low)

-0.556%

-0.469%

0.219%

10 (High)

0.347%

0.284%

-0.208%

High - Low

0.903%

0.752%

-42.700%

Source: The Paper Cash-based profitability strategy generates higher Sharpe ratio:

Factors used to construct portfolio

Sharpe

ratio

Market premium, size, value, momentum

1.07

Market premium, size, value, momentum, accruals

1.13

Market premium, size, value, momentum, operating profitability

1.40

Market premium, size, value, momentum, cash-based operating profitability

1.70

Source: The Paper ● Adding accruals factor after cash-based profitability only increases Sharpe ratio to 1.72 (Table 7) Cash-based profitability generated significantly higher cumulative returns:

Source: The Paper ● Less effective after 2004: similar to trends in momentum, the returns on

Source: The Paper ● Less effective after 2004: similar to trends in momentum, the returns on the three profitability strategies have become less significant since 2004 (Figure 1) Cash-based profitability explains expected returns as far as ten years ahead (Figure 3) Cash-based profitability measure subsumes the effect of accounting accruals (Tables 2, 5) The results are robust to using a balance sheet or a cash flow statement for accruals calculation (Table 3)

Data

 

U.S. stock data from The Center for Research in Security Prices (CRSP)

U.S. firm fundamental data from Compustat

Data range: 1963 – 2013

Paper

Working Papers

Type:

Date:

2012-12-31

Catego

Quality measures, accruals, global evidence

ry:

Title:

Global Return Premiums on Earnings Quality, Value, and Size

Author

Max Kozlov and Antti Petajisto

s:

Source:

SSRN Working Paper

Summa

Quality factor produces a higher Sharpe ratio than the market, size, or value

ry:

factors, and works in the period since 2005 despite its popularity. A composite quality strategy yields even better performance and generates a monthly three-factor alpha of 65 (64) bps in the global (U.S.) market

Background Prior studies show that quality (e.g., accruals) works in US markets

This study serve as an out-of-sample test with almost a decade of new data across all developed markets Constructing quality portfolios

Define quality as the popular accruals measure

● ● Construct earnings quality portfolio (cash-minus-earnings, CME) by double sorting stocks on accruals and size
Construct earnings quality portfolio (cash-minus-earnings, CME) by
double sorting stocks on accruals and size
Quality factor has limited correlations with value and size factors (Table
III)

E.g., global CME has a negative correlation (-32%) with HML Quality portfolio earns the highest Sharpe ratio

Highest Sharpe ratio (Table IV)

 

Annual

Annualized

Sharpe

excess return

volatility

ratio

Market

4.0%

16%

0.25

Value

4.9%

9%

0.56

Quality

2.8%

4%

0.69

Size

-0.1%

8%

-0.06

Combining value and quality greatly helps (Table IV)

A combined equal-weighted (risk-weighted) portfolio has a Sharpe ratio of 0.91 (0.99), a significant improvement over the Sharpe ratio of either factor alone Decent performance in recent 5 years (Figure 1) Suggesting that globally, quality hasn’t been arbitraged away despite its popularity

● Industry-adjusted quality-, value-, and size-portfolios improve Sharpe ratios (Table VI) ○ Sharpe ratio improved to

Industry-adjusted quality-, value-, and size-portfolios improve Sharpe ratios (Table VI) Sharpe ratio improved to 0.8 (0.97, 0.1) for CME (HML, SMB) Mostly due to the reduced volatility, though it also slightly

reduces its average return U.S. findings similar to results from global data (Figure 2 and Table VII) U.S. market (value, quality, size) factor yields annual excess return of 5.5% (4.9%, 3.4%, 2.6%), with annual Sharpe ratio of 0.35 (0.44, 0.58, 0.22) Works in long-only and large cap stocks (Table IX and Figure 4) Cap-weighted large-cap stocks and long-only Combining value and quality earns the highest return, which outperforms index by 3.9% (5.8%) per year among large- (small-) cap stocks Composite quality factors even better than individual quality factors

Alternative quality factors are:

Return on equity (ROE) CF/A (cash flow to assets) D/A (debt to assets)

Composite quality metric by either (1) averaging raw score

(“averaging”), or (2) summing score ranking (“mix”) “Mix” quality factor works best (Table VIII and Figure 3)

“Mix” factor earns a three-factor alpha of 65 bps per month (t=9), higher than any of its components By contrast, the “average” factor has an alpha (29 bps) Similar results for U.S. stocks (Table VIII)

Data

“Mix” (“average”) portfolios generate significant alphas of 64 (34) bps with t = 9.1 (9.7) The “mix” portfolio has similar negative loadings on market, small size, and value

7/1988 - 6/2012 data for 23 developed markets (from four regions:

North America, Europe, Japan, and Asia Pacific) are from Worldscope/Barra 7/1963 - 6/2012 U.S. stock data are from CRSP and Compustat

Paper Type:

Working papers

Date:

2010-07-19

Category:

Novel strategies, accruals

Title:

The Accrual Volatility Anomaly

Authors:

Sati P. Bandyopadhyay, Alan G. Huang, Tony S. Wirjanto

Source:

FMA conference paper

Link:

Summary:

High accrual volatility predicts subsequent lower returns. In other words, for firms whose accruals/sales ratio is consistent historically, their future stock returns tend to be higher. A corresponding strategy generates 10% annual returns

Definitions and intuition ● Accrual volatility (AV) = the standard deviation of the (accruals / sales) over the past 16 quarters AV measures how consistent earnings deviate from cash flows. That is, AV indicates a long-term earnings-cash flow deviation Intuition: investors on average are suspicious of and will punish stocks that show varying deviation of earnings from cash flows Portfolio results

Sort stocks based on their AV and form two hedged portfolios:

D1-D10, i.e., low AV minus high AV, and

D1 to D5 minus D6 to D10

When value-weighting stocks, and adjust returns for

usual known factors: market, size, value, and momentum The risk-adjusted return spread of D1-D10 is 0.75% per month, (~10% annually) The risk-adjusted return spread of D1:5 - D6:10 is 0.36% a month (~5% annually) Findings highly stable during 1980 - 2008 period: for the

value-weighted D1-D10 portfolio, only 7 out of 29 years have negative return Findings similar at various horizons (6-month, 1, 2 and

5-year)

Findings robust to transaction costs: after transaction cost, for the value-weighted D1-D10 portfolio, the return D1-D10 alpha spread degrades to 0.68% a month

Data

1976 to 2008 quarterly data for NYSE/NASDAQ/AMEX stocks are from CRSP/Compustat

Paper Type:

Working papers

Date:

2010-03-31

Category:

Novel strategy, accruals

Title:

Percent Accruals

Authors:

Nader Hafzalla, Russell J. Lundholm, Edmund Matthew Van Winkle III

Source:

SSRN working papers

Link:

Summary:

This paper proposes a new accrual measure (“percent accruals”) which yields significantly higher returns than the conventional accruals measure. The new measure scale accruals by earnings (the absolute value of net income), instead of total assets. Such “percent accruals” are not dependent on the presence or absence of special items, and can differentiate loss firms as well as profitable firms, and the improvement comes mostly from the long position in low accrual stocks

Definition and intuition ● Traditional Operating Accruals = (Net Income – Cash from Operations)/(Average Total Assets) Percent Operating Accruals = (Net Income – Cash from Operations)/(absolute value of Net Income) A “percent accruals” makes more sense since it directly measures how distorted a reported earning is from actual cash-based earnings Specifically, stocks with extreme negative “percent accruals” tend to have large positive cash from operations, but then accrues cause net income to go down to close to zero

By scaling the accrual by the level of net income, “percent accruals” effectively pick out more extreme combinations of cash flows and accruals By contrast, the conventional accruals are scaled by assets, and the resulting measure is essentially the percentage change in operating assets This paper uses income statement to construct accruals, instead of balance sheet data Backtest results

Better returns

An annually rebalanced portfolio based on “percent accruals” yields an annual return of 11.7% (vs 6.9% based on conventional measure) Returns more balanced

“Percent accruals” gives similar returns from long and short leg: long (5.5%) and short (6.2%) For the conventional accruals measure, most profits are from the long leg (5.53%) than short (1.27%, and in-significant) Less size-bias

The bottom decile of stocks with lowest “percent accruals” is larger in size ($1.5 billion ) than those defined by asset-scaled accruals ($474 million) Not sensitive to accruals definition

Return predictiveness of “percent accruals” exists, independent of whether there are special items, and whether earnings are positive or negative More stable yearly returns, much better returns in recent years “percent accruals” outperforms conventional accruals in 15 of 19 years during 1989-2007

Source: the paper Not sensitive to firm negative/positive earnings

Earlier study show that conventional accruals have no

significant returns for any decile in firms with negative earnings Yet 34% of the observations in the population have

negative earnings By contrsast, the “percent accruals” can differentiate

stocks with negative earnings In fact, it worked better in the loss subsample than in the

Data

profitable subsample

1989 – 2008 stock prices and accounting data are from Compustat and CRSP US databases. Total firm year observations are 81,526 firm-years

Paper Type:

Working papers

Date:

2010-01-30

Category:

Accruals

Title:

Going, Going, Gone? The Demise of the Accruals Anomaly

Authors:

Jeremiah Green, John R.M. Hand, Mark T. Soliman

Source:

SSRN working paper

Link:

Summary:

The returns to the accruals anomaly have almost disappeared in U.S. markets. The reason maybe 1) investors are no longer mispricing accruals and 2) more quant managers are using this signal

The returns to accruals have almost disappeared ● Before 2004, all but only one year during the 1989-2003 15-year span see positive accrual returns Since 2004, only 1 of the 5 year see positive risk-adjusted annual returns The t-statistic on the raw hedge return drops from 2.6 (1989-1996) to 1.4 (1996-2003) to -1.0(2003-2008) Such findings are robust when adjusting for book-to-market, size, alternative definitions of accruals, alternative scalars (total assets, total shareholder equity, and annual net income), etc

Reason1: in recent years investors are more aware of the mispriced accruals ● The proposed reason for accruals anomaly: investors wrongly believe that earnings with large portions of accruals will have similar level of persistency as earnings with large portions cash flows So to test this reason, one can measure the relative persistence of cash flows and accruals in the extreme

accrual deciles Per Fig. 3, there is a decline in the difference between the persistence of accruals versus cash flows the persistence of accruals versus cash flows Reason2: more quant money are exploiting this signal

When more money are chasing any single strategy, its

profit will likely diminish and vanish The authors use the trading volume in extreme accrual

Data

firms to prove that quant hedge funds lead to the demise of accruals

1989 - 2008 stock data are from Compustat Point-in-Time database

Paper

Working papers

Type:

Date:

2009-12-30

Catego

Portfolio optimization, novel strategy, accruals, asset growth

ry:

Title:

The Importance of Accounting Information in Portfolio Optimization

Author

John R. M. Hand, Jeremiah Green

s:

Source:

UNC working paper

Link:

df

Summa

This paper proposes a new stock optimization framework that may help avoid

ry:

quant crowd-ness. Weighting stocks as a linear function of certain accounting measures (e.g., change in earnings, asset growth) can yield a higher information ratio compared with price-based measures (e.g., size,

book-to-market, and momentum) Such weighting scheme also perform better during (1) the Quant Meltdown of

August 2007 and (2) the bear market in 2008 (it earns 12% compared during 2008 as compared to the -38% for the stock market index)

Background of the weighting scheme, Parametric Portfolio Policies (PPP)

An earlier paper, “Parametric Portfolio Policies: Exploiting Characteristics in the Cross Section of Equity Returns”,

nov.pdf) proposes a simple parametric portfolio policy (PPP) technique, where stocks‘ weight is a linear function of firm characteristics For example, stock weight = weight in benchmark + coefficients * rank

of asset growth In PPP, the accounting measure may lead to higher stock weight in two ways: (1) through generating alpha (2) through reducing portfolio risk When weighting stocks using firm size/book-to-market/momentum, PPP is shown to outperform value-weighted market index by 5.4% per year Definitions

Price based portfolio (PBC): a portfolio that is optimized by weighting

stocks as a function of market capitalization (MV), book-to-market (BTM), and momentum (MOM) Accounting based portfolio (ABC): a portfolio that is optimized by weighting stocks as a function of accruals(ACC), change in earnings(UE), and asset growth(AGR)

Two steps to construct the optimal portfolio Step1: The portfolio weight of each stock is set to be a function of the firm’s accounting measures. E.g., weight = weight in benchmark + coefficient * rank of asset growth Step2: Estimate the coefficients in step1 by maximizing a utility function (equation 11 in the paper). The investor is assumed to have constant relative risk aversion (CRRA) preferences Key findings (Table 2)

In both in-sample and out-of sample, weighting stocks using 4 factors

are shown to generate significant excess returns (BTM, MOM, UE and AGR) Accruals is not significant, suggesting that hedge returns to accruals

have disappeared in recent years due to wider use of such strategy The PPP method yields reasonable mis-weights (maximum misweight 3.1% and minimum misweight -1%) ABC has twice as much short-selling than do price-based characteristics Out-of-sample PBC portfolio 106% turnover per month, while the ABC portfolio generates more than double this at 216% No significance when short-sale not allowed: The out-of-sample Sharpe ratio of the ABC falls from a significant 1.71 to in-significant 0.48 When limiting the universe to the largest 500 stocks (Table 3)

All three price-based characteristics (market capitalization,

book-to-market, and momentum) are insignificant Change in earnings (UE) and asset growth (AGR) are still significant

Accruals not significant

Considering transaction cost lowers returns and Sharpe Ratios(Table 5) The Sharpe ratio for the PBC+ABC out-of-sample portfolio was 1.89 (before transactions costs), but only 1.12 in the presence of variable transactions costs ABC portfolio more sensitive to transaction cost (due to higher turnover)

Performance during 200707-200709 quant melt-down and 2008 crisis Suggesting that PPP is a less used strategy and avoided quant crowding effect

Paper Type:

Journal papers

Date:

2009-10-14

Category:

accruals, macro factors, market timing

Title:

Market timing with aggregate accruals

Authors:

Qiang Kang, Qiao Liu and Rong Qi

Source:

The Journal of Asset Management, Vol 10

Link:

Summary:

We propose a market-timing strategy that aims to exploit aggregate accruals’ return forecasting power. Using several performance measures of the aggregate accruals-based market-timing strategy, such as excess portfolio return, Sharpe ratio, and Jensen’s alpha, we find robust evidence that, relative to the passive investment strategy of buying and holding the stock market, the market-timing strategy delivers superior performancethat is both statistically and economically significant. Specifically, on average, the market-timing strategy beats the S&P500 index by 6 to 22 percentage points (annualized) after controlling for transaction costs over the 1980–2004 period.

Paper Type:

Working papers

Date:

2009-10-14

Category:

Novel strategies, accruals anomaly, macro factors

Title:

Two Accrual Anomalies: A Dichotomy of Accrual-Return Relations

Authors:

Qiang Kang, Qiao Liu and Rong Qi

Source:

FMA Conference 2009

Link:

Summary:

The paper decomposes discretionary accruals into a firm specific and market­wide component:

Firm specific component predicts future stock returns negatively

Market­wide component predicts future stock returns positively A hedge strategy based on these two components yields a significantly higher return than that of a typical accrual strategy

There exist two accruals anomaly Negative predictability for single stocks: firms with high accruals on average earn lower future expected returns Positive predictability for aggregate market: value­weighted average of accruals in the market predicts future expected market returns positively (per Hirshleifer, Hou and Teoh (2008)) Intuition of the coexistence of these two accrual anomalies Firm­level (discretionary) accruals is a proxy for firm­level earnings

management However, on the market level, the higher accruals suggests that on average companies are expanding their business, which is a good sign for market returns Decomposing firm­level discretionary accruals Step 1: estimating firm­level discretionary and normal components of accruals

Run regression: Accruals(t)/total assets(t) = alpha + a * change in revenues/total assets(t) + b * gross property plant and equipment (t) / total assets (t) + residual (t)

Normal accruals = The fitted part of the regression Discretionary residuals = the regression residuals

Step 2: decomposing firm­level discretionary accruals

Aggregate accruals (AAC) is the value­weighted average

discretionary accruals Run regression with 10­year (t − 10 to t − 1) data:

Discretionary_AC(t)= alpha + b * AAC (t) + residual Market component of discretionary accruals = The fitted value from the above regression Firm level component = the regression residuals

Constructing portfolios to verify the existence of two independent accruals Portfolio1: When sorting the stocks by coefficient b from step2 above, the average monthly four­factor adjusted return is 0.105% Portfolio2: When sorting the stocks by on firm­level component from step2, the average monthly four­factor adjusted return is 0.159%

Portfolio3: Double sorting ­ first by the firm­level component of discretionary accruals, and then by the market wide component The positive return predictability of the market level component is highest for low firm­level discretionary accruals firms (intuitively these tend to be more stable, value, big companies)

Paper Type:

Working papers

Date:

2009-08-03

Category:

Novel strategies, accruals, accruals quality, January effect

Title:

The Pricing of Accruals Quality: January vs. The Rest of the Year

Authors:

Christina Mashruwala and Shamin Mashruwala

Source:

SSRN Working Paper

Link:

Summary:

The paper attributes the accruals quality (AQ) to a January effect. High AQ stocks are shown to outperform low AQ stocks only in January

AQ effect is a well-documented anomaly and is a measure of information risk

High AQ means that company financial reporting standard

(and in particular reported accruals) is less predictable Estimating AQ step1: run the yearly regression on total

current accruals (TCA) TCA=a + b1 *CFO (t-1)+b2* CFO (t) + b3*CFO (t+1) + b4 change in revenues + b5*fixed assets Where CFO=Net income before extraordinary items- TCA +Depreciation fixed assets = gross property, plant and equipment Intuitively, this means that TCA is mainly driven by the cash flow balance, change in revenues and fixed assets Size is not listed as an independent variable because fixed assets is used Estimating AQ step2: AQ is defined as the standard deviation of firm-specific residuals from year t-4 to year t

The firm specific residuals are defined as (the Actual TCA) - (the Expected TCA) from the regression above Return predictability of AQ only significant in January ● Similar findings for sorting stocks by AQ every month, and for double-sorting stocks first by size and then by AQ

The return of the zero­investment portfolio is shown to be highest during the first 5 days of each January (Table 5)47.79% of all the returns during the month of January occurs in the first 5 days Data ● The paper uses CRSP and COMPUSTAT for the time period 1971­2003 Discussions

The AQ return predictability is much higher for equal­weighted returns (9.50% for equal­weight, 3.79% for cap­weight, per table 2, 3), which suggests that the implementability may suffer from size bias and higher trading costs We would like to see more discussions on the reasons of the finding: Why January? This is particularly interesting since most companies do not file their annual financial reports in January ● Relationship with the discretionary accruals: some quant managers use the unexpected component of accruals (the residual after regressing accruals on factors such as size,growth, cash positions, etc) to forecast stock returns. AQ is an indication of the volatility of discretionary accruals, and seems to us to be a less direct measure

Paper Type:

Working papers

Date:

2009-08-03

Category:

Novel strategies, accruals, accruals quality, January effect

Title:

The Pricing of Accruals Quality: January vs. The Rest of the Year

Authors:

Christina Mashruwala and Shamin Mashruwala

Source:

SSRN Working Paper

Link:

Summary:

The paper attributes the accruals quality (AQ) to a January

effect. High AQ stocks are shown to outperform low AQ stocks only in January

AQ effect is a well-documented anomaly and is a measure of information risk

High AQ means that company financial reporting standard (and in particular reported accruals) is less predictable Estimating AQ step1: run the yearly regression on total current accruals (TCA) TCA=a + b1 *CFO (t-1)+b2* CFO (t) + b3*CFO (t+1) + b4 change in revenues + b5*fixed assets Where CFO=Net income before extraordinary items- TCA +Depreciation fixed assets = gross property, plant and equipment Intuitively, this means that TCA is mainly driven by the cash flow balance, change in revenues and fixed assets Size is not listed as an independent variable because fixed assets is used Estimating AQ step2: AQ is defined as the standard deviation of firm-specific residuals from year t-4 to year t The firm specific residuals are defined as (the Actual TCA) - (the Expected TCA) from the regression above Return predictability of AQ only significant in January ● Similar findings for sorting stocks by AQ every month, and for double-sorting stocks first by size and then by AQ

The return of the zero­investment portfolio is shown to be highest during the first 5 days of each January (Table 5)47.79% of all the returns during the month of January occurs in the first 5 days Data ● The paper uses CRSP and COMPUSTAT for the time period 1971­2003 Discussions

The AQ return predictability is much higher for equal­weighted returns (9.50% for

equal­weight, 3.79% for cap­weight, per table 2, 3), which suggests that the implementability may suffer from size bias and higher trading costs We would like to see more discussions on the reasons of the finding: Why January? This

is particularly interesting since most companies do not file their annual financial reports in January Relationship with the discretionary accruals: some quant managers use the unexpected

component of accruals (the residual after regressing accruals on factors such as size,growth, cash positions, etc) to forecast stock returns. AQ is an indication of the volatility of discretionary accruals, and seems to us to be a less direct measure

Paper

Working Papers

Type:

Date:

2008-08-13

Category:

funds, asset allocation, earnings, accruals, Alpha Bubble, Quantitative

Title:

Strategies Alpha, Alpha, Who’s got the Alpha?

Authors:

Langdon B. Wheeler

Source:

CFA Institute conference

Link:

Summary

.pdf This paper hypothesizes that today’s market is in an alpha (excess return)

:

bubble, gives reason for the bubble and suggests what managers should do now.

Alpha bubble starts with initial (late 1990-early 2000’s) investors’

profit from investing into quant equity strategy, and the subsequent investors’ excitement about the strategy’s potential This profit attracts new investors, especially naïve investors, who

drive the price up Eventually this excessive investment leads to alpha bubble burst, as

evidenced in the August 2007 quant meltdown The paradigms shifts in the market demand new innovations

Managers should focus on innovation

Either be big or be good: there should be a limit on assets under

management Alpha may not return until alpha bubble deflates

Some basic quant techniques remain valid irrespective of bubble:

 

Buy more earnings or book per $ of share price Buy clean earnings (avoid accruals) Buy companies with improving earnings Risk controlled portfolio

Paper Type:

Working Papers

Date:

2008-08-13

Category:

novel strategy, Intangible Returns, Accruals, Return Reversal

Title:

Intangible Returns, Accruals, and Return Reversal: A Multi-Period Examination of the Accrual Anomaly

Authors:

Robert J. Resutek

Source:

SSRN working paper series, 2008

Link:

Summary:

This paper finds that the well-documented accrual effect can be subsumed by "intangible returns" from the period prior to accrual formation.

Definition of intangible returns Defined as the returns not explained by accounting measures Intuitively, it reflects investors‘ anticipation of

 

future growth not yet captured by accounting measures Study accruals in 3 periods, not 2 periods. PPIR is

 

short for prior period (ie, year t-5 to year t-1) intangible return, CPIR is short for current period (ie, year t-1 to year t) intangible return period 1 (prior 4 years return):

 

ret (t-5, t-1) = book/market (t-5) + log (change of book value) + issuance + PPIR period 2 (formation year return) :

ret (t-1, t) = book/market (t-1) + total accruals (TACC) + non-accrual growth (N_TACC) + issuance + CPIR period 3 (future 1 year return): ret(t, t+1) PPIR is driving previous accrual results

 

Based on a regression of ret(t, t+1) =

 

Book/market components + PPIR The return predicting power of current period accruals are due to the relations between prior period intangible return. Once PPIR are controlled, the negative association between future returns and current period accruals disappears. Accrual anomaly is a derivative of value/growth anomaly

Both anomalies are driven by the intangible returns. Likely reason: return maybe driven by factors orthogonal to accruals Mechanically interpreting relationship between future returns and current period accruals ignores the fact that price can move for reasons that are orthogonal to that captured by accounting metrics.

Comments:

1. Discussions This paper is related to the “Market Reactions to Tangible and Intangible Information”,

(http://faculty.fuqua.duke.edu/areas/finance/papers/daniel.pdf, reviewed in 2006/04/07 issue), where it is shown that changes in BM due to changes in book equity (so-called “tangible information”) do not predict returns, but changes in price unrelated to changes in book equity (“intangible information”) have marginal forecast power.

A logical question people may ask is: will PPIR predict formation year return, Ret(t-1, t), as well? It would be see why not if the proposed reason is that stock return maybe driven by factors orthogonal to accruals.

2. Data Listed US firms from CRSP/Compustat merged dataset for the period of 1968 to 2005. Firms needs to appear on the CRSP/Compustat merged database and have positive book value of equity at fiscal year end for years t-5, t-1.

Paper Type:

Working Papers

Date:

2008-03-16

Category:

Accruals, UK market, Global markets

Title:

The Accruals Anomaly - Can Implementable Portfolio Strategies be Developed that are Profitable Net of Transactions Costs in the UK?

Authors:

Nuno Soares, Andrew W. Stark

Source:

SSRN working paper

Link:

Summary:

• In short, No. The paper profit disappeared after “conservative estimates of transaction costs are taken into account”. • Moreover, accruals strategy profits significantly depend on long/short relatively small capitalization stocks, where trading cost and short cost can drastically lower profits

Paper Type:

Working Papers

Date:

2007-12-03

Category:

Accruals

Title:

Repairing the Accruals Anomaly

Authors:

Nader Hafzalla, Russell Lundholm, Matt Van Winkle

Source:

Penn State University working paper

Link:

7

Summary:

This paper finds that the accruals factor can be enhanced by 1) combining with firm financial health measure, or 2) measuring accruals by scaling earnings (instead of total assets). Piotroski‘s financial health measure was used. This measure simply gives one point for each one of eight attributes, such as:

1) earnings is positive, 2) cash from operations is positive, 3) return on asset increases from the prior year, etc. Key findings:

The traditional methods of calculating accrual strategy

Eg, a decile strategy based on Piotroski financial

profits are biased, since they inevitably select only those stocks whose next year’s stock returns are available (so a back-test can be done) The size-adjusted return of highest earning quality (lowest accrual decile) stocks is a significant 12.3% with the bias, but only an insignificant 2.7% without it. Both accruals and financial health factors work on

stand-alone basis:

health measure generates an average size-adjusted annual return of 8.3% from

1988-2004

Removing stocks with worst financial health scores helps

accrual strategy: when such stocks are removed, strategy that is long (short) the stocks with lowest (highest) 10% accruals generates an average size-adjusted annual return of 13.6% (compared with 2.7% when all stocks are included) Two-way sort works even better: a strategy that is

long stocks with low-accrual, high financial health short stocks with high-accrual, low financial health yields a size-adjusted annual return of 24% Earning is a better denominator than total assets

It yields a 2-3 percentage points higher returns Using earning (instead of total assets) to scale accruals generates a similar portfolio fo high accruals stocks, but very different firms for the low accruals stocks.

Comments:

1. Discussion The so-called look-ahead bias theory is valid only for smaller stocks. For large-cap managers, this should be a non-issue since the likelihood of a large cap stock going bankruptcy is very limited.

The authors show that removing look-ahead significantly changes accrual strategy profit, we think this merely illustrates that this paper, like many others, may have a strong size bias where some small/illiquid/distressed stocks largely drive paper profit.

This said, one possibility for managers covering small caps may be to use high (low) accruals in an opposite way for stocks with worst financial health measure.

Why earning is a better denominator? To us, we think it is a better measure since it directly measures theimpact of accruals as a percentage of net earnings, which is what concerns and mis-leads most investors. An interesting quote by the authors is that “when accruals are scaled by assets, the resulting measure isessentially the percentage change in operating assets.”

Another insightful finding in the paper is that using earning essentially removes the impact of special items in balance sheet (which usually include restructuring charges, asset impairments and other one-time gain/losses), while using total assets will generate a list of stocks with large special items.

2. Data 1988-2004 stock data are from the 2004 merged Compustat/CRSP database, with financial firms excluded. A stock does not need to have next year’s return data to be included in the portfolio, the only requirements are that it has sufficient financial data to compute either operating accruals or total accruals, and that it has return data available at the portfolio formation date.

Paper Type:

Working Papers

Date:

2007-10-29

Category:

Accruals, earning surprises

Title:

Reconciling the Market’s Overreaction to (Abnormal) Accruals and Under reaction to Earnings

Authors:

Henock Louis, Amy X. Sun

Source:

London Business School working paper

Link:

Summary:

This paper finds that the negative (positive) earning surprise drift effect is stronger for stocks with high income-increasing (decreasing) accruals.

The authors first make a general observation

  • - investors seem to overreact to (abnormal)

accruals

 
  • - but they under-react to earnings surprises

  • - and under-react to earnings-to-price ratios (E/P)

This may be due to investors’ failure to detect earning

management: to mitigate shocks to investors, companies with large negative unexpected earnings surprises (standardized unexpected earnings, SUE) may have used income increasing accruals, while companies with large

positive (SUE) may have used large income decreasing accruals

Hence the negative (positive) earning surprise effect

should be stronger for stocks with high income- increasing (decreasing) accruals. A strategy that is

  • - long stocks with positive surprise (ie, high SUE) / low

abnormal accrual / value (ie high E/P) firms-

  • - short stocks with negative surprise (ie, low SUE) / high abnormal accrual / moderate E/P firms

earns an abnormal return of 46% annually (23% over the two quarters after earning announcement). In fact, there is virtually no earning surprise drift when such stocks are removed. ● Moderate E/P firms are used instead of low E/P firms to select stocks for short, because investors are less likely to be mistaken by the upward earnings management activities of the negative SUE, low(or negative) E/P firms, which tend to risky stocks.

This strategy is consistent across time, generating positive abnormal returns in every quarter in the sample period.

Comments:

1. Discussions This paper gives a great example of factor interaction:

conditioning stock ranking of one factor on otherfactor(s) may

give improved results. 1 + 1 > 2. The profit of the strategy sounds real big and rather consistent (profitable very quarter during 1988- 2004). The problem is

whether this is strategy is “outdated” given the bad performance of earning-based strategies since 2003

whether this strategy works in different universes. The authors, like many others, throw all the stocks in all exchanges in this study. The out-sized profit may be due some small and illiquid stocks.

2. Data 1987 - 2004 stock data are from Compustat quarterly files.

Paper Type:

Working Papers

Date:

2006-12-17

Category:

Leverage, accruals

Title:

Leverage, Accruals, and Cross Sectional Stock Returns

Authors:

Ayla Kayhan, Adam Y.C. Lei, Ji Chai Lin

Source:

FMA 2006 conference paper

Link:

Summary:

This paper defines two quarterly leverage measures:

Market leverage = total debt divided by the sum of total debt and market equity Book leverage = total debt divided by the sum of total debt and the book value of shareholders' equity

It shows that:

Financial leverage predicts lower stock returns. This result

is robust after controlling for many known factors The return predictingpower of accruals becomes insignificant when leverage is controlled

Leverage largely accounts for the finding that firms with higher financial constraints earn lower returns.

Comments:

1. Why important This paper is interesting because it shows a surprisingly strong impact of leverage on stock risk adjusted returns and on other known return predicting factors, including accruals.

  • 2. Data

2004 stock price data are from CRSP database, accounting data

are from the Compustat database, and the institutional holdings data from the CDA/Spectrum database.

  • 3. Discussions

If the paper is right and leverage subsumes accrual effect, what might be the reason? The author says that higher financial leverage firms "tend to be financially constrained and rely more o n outside equity capital, which raises incentives for managers to manage earnings through accruals". This makes sense, and it would-be interesting to directly test the correlation between accruals and leverage, i.e. do high leverage firms have high accrual Does accruals strategy give us a similar portfolio as when we use leverage?

The result about the predicting power of leverage is different from those discussed in other papers, notably Fama and French (1992). We would like to see the authors explain more about why there is such difference. Knowing that they are studying a different set of data for different period, at least a study of same sub period plus a portfolio return can help comparing notes.

Paper Type:

Working Papers

Date:

2006-10-20

Category:

Accruals, profitability

Title:

The Pricing of Accruals for Profit and Loss Firms

Authors:

Nicholas Dopuch, Chandrakanth Seethamraju, Weihong Xu

Source:

Olin School working paper

Link:

Summary:

This paper finds that the accrual strategy is related to the companies profitability:

The accruals for profit firms are overpriced, with a hedged

return ~15% The accruals for loss firms are slightly underpriced, with an

insignificant hedged return ~6% Further,

Accruals for transitory loss firms (loss firms that are more likely to turn profitable ) are not mispriced Accruals for persistent loss firms (loss firms that are less likely to turn profitable are under priced

Comments:

1. Why important The conclusion of this paper makes intuitive sense since investors use accounting information very differently between profit and loss firms. For loss firm, stock valuation is based on a probability to reverse loss, and current accounting numbers are of less relevance.

  • 2. Data

1988 2001 financial statement data are from COMPUSTAT/CRSP

database. Financial firms were excluded in the study.

  • 3. Discussions

This paper provides an interesting perspective by differentiating profit and loss firms, as well as "persistent loss" and "transitory loss" firms. It is interesting if one can expand this study to other strategies that use accounting data, e.g., p/e

Paper Type:

Working Papers

Date:

2006-09-08

Category:

Strategy, accruals

Title:

Cash Flows, Accruals, and Future Returns

Authors:

Joshua Livnat, Massimo Santicchia

Source:

Financial Analysts Journal, Vol. 62, No. 4, pp. 48-61, July/August

2006

Link:

Summary:

This study finds that the accrual anomaly exists for quarterly accruals in addition to annual accruals. Also current net operating cash flows have higher forecasting power than accruals.

Comments:

Paper Type:

Working Papers

Date:

2006-09-08

Category:

Strategy, accruals

Title:

Cash Flows, Accruals, and Future Returns

Authors:

Joshua Livnat, Massimo Santicchia

Source:

Financial Analysts Journal, Vol. 62, No. 4, pp. 48-61, July/August

2006

Link:

Summary:

This study finds that the accrual anomaly exists for quarterly accruals in addition to annual accruals. Also current net operating cash flows have higher forecasting power than accruals.

Paper Type:

Working Papers

Date:

2006-08-10

Category:

Strategy, Asset Growth Effect, size, value, momentum, accruals

Title:

What Best Explains the Cross-Section Of Stock Returns? Exploring the

Authors:

Asset Growth Effect Michael J. Cooper , Huseyin Gulen And Michael J. Schill

Source:

Purdue working paper

Summary:

This paper finds that a portfolio of long (short) stocks with lowest (highest) last year‘s asset growth rate generates 18% risk-adjusted annual return. It also shows that such asset growth rate has a stronger effect on subsequent returns than other known factors (b/p, market cap, momentum, accruals, etc.)

Comments:

1. Why important This paper is unique in that it shows that asset growth, a factor that‘s so common to everyone, can predict returns better than other more "sophisticated" factors. It also suggests that the asset growth effect may dominate many other well-studied balance sheet structure effects, e.g., new equity issuance effect (IPO) and external financing.

  • 2. Data

1962-2003 All NYSE, AMEX, and NASDAQ non-financial stocks data are

from CRSP/COMPUSTAT

  • 3. Discussions

At the first glance, one can say that asset growth rate is correlated with

everything: value/growth, market cap and also momentum. So people probably would care less about what‘s zero-cost return, but more about how this new factor dominates other known factors (b/p, market cap, momentum, accruals, etc). Statistic robustness test is key here. The authors prove their point by (1) showing a much higher Sharpe ratio of zero-cost portfolio based on asset growth (1.19) compared with other factors. (2) repeating the study for largest 80 percent of stocks only. (3) using 2-way sort to show the dominance of asset growth rate. (4) using risk-adjusted returns. The rather consistent hedged return time series on Figure 3 is very encouraging.

Our concerns are that (1) this strategy may behave like value strategy, it works more often than not, but you don‘t know when. Many a times the profit is a function of business cycle and market sentiment. (2) 80% largest companies still include some small cap stocks. The performance in large cap will be very telling.

Paper Type:

Working Papers

Date:

2006-07-27

Category:

Strategy, accruals, loan

Title:

Do Sophisticated Investors Understand Accounting Quality?

Authors:

Evidence from Bank Loans Sreedhar T. Bharath, Jayanthi Sunder, Shyam V. Sunder

Source:

BIS Conference on Accounting, Transparency and Bank Stability

Link:

Summary:

Companies have to disclose more information to banks (when applying for loans) than to investor communities. This paper documents the relationship between bank loan terms and accruals: loans are more costly and stricter for companies with high abnormal operating accruals.

Given the information advantages of banks, we think it would be interesting to test whether higher loan rate and stricter terms can lead to lower stock returns.

Comments:

1. Why important This is one of those few papers we reviewed that do not directly discuss trading strategies. It is thought- provoking for a simple reason: loan rate/terms reflect more information than an investor could get, can this information predict stock returns? In other words, this paper shows that loan rate/terms are connected with stock accruals, and we know accruals can predict stock returns. Is there a link between loan rates/terms and stock returns? Hopefully the new information can predict returns better than accruals.

We are always advocates of using new databases for new strategies. Currently most quant strategies in US are based on data from Compustat, in Europe from DataStream. These two have been thoroughly studied by thousands of researchers worldwide. We do believe that new data sources are more likely to yield new strategy.

  • 2. Data

The loan information is from the Loan Pricing Company (LPC).

They do offer trial subscription to interested companies.

  • 3. Discussions

The authors find a "U-shaped" relationship between signed abnormal accruals and loan terms, with firms having high positive or negative abnormal accruals facing the most stringent loan terms. This may be because banks seem to dislike companies with both growth uncertainties, whether it's high

positive growth or negative growth. Given what we know about accruals, quant researchers may want to compare stock returns between stocks with high accruals and stricter loan rates/terms, and stocks with average loan rates/terms.

Paper Type:

Working Papers

Date:

2006-06-29

Category:

Strategy, accruals, momentum, anomalies overview

Title:

Dissecting Anomalies

Authors:

Eugene F. Fama and Kenneth R. French

Source:

SSRN working paper

Link:

Summary:

In this paper, the two renowned professors review some stock price anomalies, namely, net stock issues, accruals, momentum, profitability, and asset growth. They conclude that some anomalies (net stock issues, accruals, and momentum) are pervasive, as evidenced by the back testing portfolio results and cross-section regressions. Others (asset growth anomaly, profitability) are less consistent.

Comments:

1. Why important This paper is worth reading for two reasons: first, it gives an overview of some well-studied anomalies from July 1963 up to December 2005. Second, it offers insights in terms of how to improve the robustness test in financial empirical research.

  • 2. Data

The data are from CRSP and Compustat.

  • 3. Discussions

The authors pinpoint two common problems with many empirical research studies:

1.) The big impact of the extreme (return) values of "tiny" stocks (defined as those with market cap below the 20th NYSE percentile). Many existing papers compare the performances of top and bottom segments, both of which tend to be filled with these tiny stocks whose extreme (return) values can be misleading.

2.) Different anomalies can be correlated. To address this issue, the authors examine “sorts of regression residuals” on each explanatory variable. In our view, a sound robustness test should answer the following questions:

● Is the anomaly real? Is it driven by certain size, style, sector, period (eg. internet bubble time)? Is the anomaly new? What‘s the correlation with other existing factors? What would be extra alpha if this new factor is added to the existing quant model?

Paper Type:

Working Papers

Date:

2006-04-21

Category:

Strategy, Repurchase, Accruals, Earnings

Title:

Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance

Authors:

Konan Chan, David L. Ikenberry, Inmoo Lee, Yanzhi Wang

Source:

AFA 2006 Boston conference

Link:

Summary:

This paper documents that companies with lower equity quality may be using share repurchase announcements to boost stock prices in the short term.

Comments:

1. Why important for practitioners With record high cash reserve, more companies are expected to make share repurchase announcements. A strategy based on stock repurchase has been shown to yield significant return historically, but recent performance is mixed. This paper can potentially improve this factor by combining with the earning quality.

2. Data source The repurchase data is from SDC, and earning quality data are based on CRSP.

3. Next steps For practitioners, a key question is: will a strategy based on both repurchase announcements and earning quality provide better alpha than any of the single factor? What would be the performance after controlling for usual factors such as value, momentum, etc.?

Paper Type:

Working Papers

Date:

2009-02-01

Category:

130/30, alternative index

Title:

Benchmarking 130/30 strategies

Authors:

Srikant Dash and Philip Murphy

Source:

SSRN Working Paper

Link:

Summary:

The paper claims that traditional market indices are the most appropriate benchmarks for 130/30 managers.

With the growth of the 130/30 strategy the need for an

appropriate benchmark has arisen S&P 500 130/30 and Credit Suisse 130/30 have been launched to constitute passive exposure The general problem with both indices is that there is no broad consensus on underlying quantitative investment strategies (e.g. accounting factors, technical analysis, market factor or macroeconomic factors) The median or average returns of the peer group of funds

is also not very useful for 130/30 strategy The survivorship bias is a serious concern for the use average peer return as a benchmark in general Most of the 130/30 funds are fairly young and there is no long enough time series history The paper claims that traditional indices are better benchmarks for 130/30 strategies The short portion of the portfolio shouldn’t change the risk characteristics The goal of 130/30 managers is to deliver a portfolio beta of close to 1, which is the market beta 130/30 managers themselves report that they take the index as the benchmark (S&P survey results)

Paper Type:

Working Papers

Date:

2008-08-13

Category:

alternative index, fundamental indexing

Title:

The Value of Fundamental Indexation

Authors:

David Blitz and Laurens Swinkels

Source:

SSRN working paper series

Link:

Summary:

This paper suggests that fundamental indexation (FI) is inferior to other more sophisticated multi-factor quantitative strategies.

Definition of FI

An index in which stocks are weighted by economic fundamentals, such as book value, sales and/or earnings, instead of market capitalization Rationale: capitalization weighted indices are inferior because they necessarily invests more in overvalued stocks and less in undervalued stocks FI outperforms market index

FI (using RAFI 1000 index) generates the alpha amounts to 0.19% per month in case of the Fama-French market factor (beta) (1962-2005), and 0.26% per month in case of the Russell 1000 index (1979-2005). FI has high exposure to value factor In the 3-factor Fama and French model, FI shows a large and highly significant (tstatistic over 30) exposure of 0.36 towards the value factor.

It shows a beta of 0.38 with regard to the Russell 1000 Value/Growth return difference, associated with a highly significant t-statistic of over 30

Little exposure to size

The loading on the size factor is small and

negative, just -0.07 FI vs. Capitalization-weighted indices The market capitalization is unique in the sense that it is the only portfolio which every investor can hold with minimum turnover FI cannot be held in equilibrium by every investor, and contrary to a market capitalization-weighted index, a fundamental index does not represent passive, buyand-hold strategy Several subjective choices needed to define a FI. Most notably, which particular fundamental factor to use (e.g. book value, sales, earnings, cash-flow,

dividends, etc.) and how exactly should it be defined Fundamental indices more resemble active strategies FI may be inferior to multifactor quantitative Strategies FI benefit only from the value premium where as Multifactor Quantitative Investment Strategies benefit from numerous anomalies

Comments:

1. Discussions FI has been successfully marketed to investors. In our humble view, it is more like wrapping an old idea (ie, value) with new packaging. This paper provides a detailed analysis why the FI strategies might not be bearing superior results as suggested by proponents of fundamental indices. At a time when many smart people have intensively studied equity quant strategies, we tend to think it’s more likely for new alpha to come from new data source.

Though this paper provides theoretical argument against the fundamental indices, extensive empirical analysis is need for supporting the conclusions.

2. Data RAFI 1000 index (the Research Affiliates Fundamental Index for the top 1000 US equities) and Russell 1000 index are used for the period of 1962- 2005.

Paper Type:

Working Papers

Date:

2008-05-20

Category:

130/30, alternative index

Title:

130/30 Investing: Just Another Hype or Here to Stay?

Authors:

David Blitz

Source:

Link:

Summary:

In terms of alpha potential and beta exposure, 130/30 funds behave more like traditional mutual funds than hedge funds, mainly because of their market exposure.

Some 130/30 indices, e.g., “130/30: The New Long-Only”

 

74622) are questionable since they are not “unambiguous and transparent” in selecting factors, weight and optimizations.

 

Expenses for 130/30 funds are likely higher than

 

long-only funds due to cost related to shorting stocks and managing a more complex portfolio

 

A piece-wise implemented 130/30 funds (eg, a 100% long portfolio on top of a 30% market neutral portfolio) is sub-optimal since its portfolio construction is not integrated

Paper Type:

Working Papers

Date:

2008-05-01

Category:

130/30 index, alternative index

Title:

Benchmarking 130/30 Strategies

Authors:

Srikant Dash, Philip Murphy

Source:

S&P white paper

Link:

Summary:

This white paper proposes that a better benchmark for 130/30 funds is actually an appropriate long-only index. Any dedicated 130/30 index may be in-appropriate. Their reasons:

No set of factors in 130/30 indices can capture a broad consensus in identifying stock mis-pricing. 130/30 managers can use both quantitative and qualitatively methodology The 130/30 proposed by Lo and Patel (which emphasizes the impact of leverage) is problematic since:

● the effects of leverage are no different than effects of big factor bets such as style, industry or size. the goal of 130/30 managers is to deliver a portfolio beta of close to 1

generally managers try to outperform in a risk controlled fashion

Interestingly, this paper does not agree with a 130/30 index by S&P

which we covered before

rategy_Index_Methodology_Web.pdf), where a short extension is added to S&P’s proprietary stock-selection model.

Paper Type:

Working Papers

Date:

2008-04-09

Category:

Optimal indexing scheme, MSCI World Index, alternative index

Title:

Alternative Indexing with the MSCI World Index

Authors:

Thomas Neukirch

Source:

SSRN working paper

Link:

Summary:

This paper finds that “equal-risk weighting” performs better than the cap-weight scheme used by the MSCI World Developed Index during 2001/01 through 2008/01.

Weighting

Description

Performance

scheme

Original index

• Uses float-adjusted

• Yields -2.86%

weighting

market capitalization

during 2001/01 -

as weights

2008/01

Equal weighting

• All constituents get same weight

• Equal-weighted both components and countries generates 8.19%.

Equal risk

• Each constituents

• Equal-risk

weighting

get a weight of

weighting index

 

1/(constituents’

components:

volatility) i.e., each

6.27%,

constituents contributes the same amount of risk (volatility) to the resulting portfolio

• Equal risk weighting with equal country weighting generates 8.27%, with low volatility

Other findings:

● All alternative weighting schemes perform better than the original index, though such out-performance is more obvious when market is rising The costs of implementing an equal weighting strategy:

Before expenses, the equal weighting strategy returns 1.45% annually, the original index returns

-3.17%

After expenses, the equal-weighted index returns 0.70%, and the authors did not give the number for the original index

Comments:

1. Discussions Our major concern is that the finding here has a look-ahead bias. What happened during 2001/01-2008/01 may not repeat in the future. The author has the benefit of perfect hindsight: he first found that during the past 7 years, higher cap weighted countries yield lower returns (figure 2), and then proposes the “equal-risk weighting” and “equal-weighting”. He argues that “? riskiness is quite stable over time and hence a risk weighting component may lead to more stable results”, this may not always be true. Using an example in US, energy sector was a low-beta, low volatility sector before 2006, but it is no longer the case.

Paper Type:

Working Papers

Date:

2007-12-26

Category:

130/30 index, alternative index

Title:

130/30: The New Long-Only

Authors:

Andrew Lo, Pankaj Patel

Source:

SSRN working paper

Link:

 

Summary:

This paper proposes two indices for the increasingly popular

130% long/30% short (130/30) funds.The two indices are:

An investable index: which uses only prior information

and is dynamically rebalanced based on a mechanic trading rule A"look-ahead" index: which uses look-ahead information

 

(such as realized excess return) and can be used as a performance upper bound.

 

The proposed indices are based on a stock ranking strategy and a standard portfolio construction method.Specifically, stocks are ranked based on 10 commonly used factors:

  • 1. Traditional Value. (price ratios such as p/e, p/b, etc)

  • 2. Relative Value

  • 3. Historical Growth

  • 4. Expected Growth

 
  • 5. Profit Trends

 
  • 6. Accelerating Sales

  • 7. Earnings Momentum.

  • 8. Price Momentum.

  • 9. Price Reversal.

 

10. Small Size.

Key insights:

 

● An optimal benchmark index should be: transparent (systematic rules, clear), investable (liquid components), passive (mechanical implementation, no human discretion)

Compared with the S&P 50 index, the new 130/30 index

has similar volatility (about 15% annualvolatility for both) Compared with the S&P 500 index, the new 130/30 index has slightly higher Sharpe ratio (0.4 for the 130/30 index,

vs 0.37 for the S&P 500 index).The authors claim that this comparison is fair since although 130/30 has 1.6 times leverage, the volatility and beta of the 130/30 index is at similar level to S&P 500) It has high correlation with com on equity indices eg, Russell 2000

Comments:

1. Discussions In our view, the proposed indices sound more like a quant index and less a 130/30 index.130/30 funds aredifferent from

(arguably, better than) the traditional long-only for two reasons:

it can exploit the short side of stocks, which many believe there still exist in-efficiencies since managers do not have a way to express their negative view of some stocks. An ideal index should reflect opportunity set in this new territory. it has a 1.6 leverage (130% + 30%). In reality few 130/30 managers would keep their volatility and beta at the same level of S&P 500. A more desirable index (in our humble view) is an index with higher volatility. This said, the proposed 130/30 index has better performance than S&P500 due to its quant stock selection (likely value tilt).

2. Data 1996/01 - 2007/09 US stock data are used. The authors uses the MSCI Barra Aegis Portfolio Manager with the Barra U.S. Equity Long-Term Risk Model to construct the 130/30 portfolios

Paper Type:

Working Papers

Date:

2007-12-26

Category:

130/30 funds, alternative index

Title:

An Empirical Analysis of 130/30 Strategies

Authors:

Gordon Johnson, Shannon Ericson, Vikram Srimurthy

Source:

Lee Munder research paper

Link:

Summary:

This is a nice summary of the key features of the 130/30 strategies. Key points:

less than 10% of stocks can be underweight 25bps or

more relative to large cap benchmark stocks with highest weights do not necessarily have the

lowest alphas so a 130/30 funds can potentially increase alpha

In back-testing 130/30 outperform long-only by about 1.5

times, with a tracking error that is about 1.15 times higher. The authors also proposed a simple performance contribution analysis.

Paper Type:

Working Papers

Date:

2009-02-01

Category:

130/30, alternative index

Title:

Benchmarking 130/30 strategies

Authors:

Srikant Dash and Philip Murphy

Source:

SSRN Working Paper

Link:

Summary:

The paper claims that traditional market indices are the most appropriate benchmarks for 130/30 managers.

With the growth of the 130/30 strategy the need for an

appropriate benchmark has arisen S&P 500 130/30 and Credit Suisse 130/30 have been launched to constitute passive exposure The general problem with both indices is that there is no broad consensus on underlying quantitative investment strategies (e.g. accounting factors, technical analysis, market factor or macroeconomic factors) The median or average returns of the peer group of funds

is also not very useful for 130/30 strategy The survivorship bias is a serious concern for the use average peer return as a benchmark in general Most of the 130/30 funds are fairly young and there is no long enough time series history The paper claims that traditional indices are better benchmarks for 130/30 strategies The short portion of the portfolio shouldn’t change the risk characteristics The goal of 130/30 managers is to deliver a portfolio beta of close to 1, which is the market beta 130/30 managers themselves report that they take the index as the benchmark (S&P survey results)

Paper Type:

Working Papers

Date:

2008-08-13

Category:

alternative index, fundamental indexing

Title:

The Value of Fundamental Indexation

Authors:

David Blitz and Laurens Swinkels

Source:

SSRN working paper series

Link:

Summary:

This paper suggests that fundamental indexation (FI) is inferior to other more sophisticated multi-factor quantitative strategies.

Definition of FI

An index in which stocks are weighted by economic fundamentals, such as book value, sales and/or earnings, instead of market capitalization Rationale: capitalization weighted indices are inferior because they necessarily invests more in overvalued stocks and less in undervalued stocks FI outperforms market index

FI (using RAFI 1000 index) generates the alpha amounts to 0.19% per month in case of the Fama-French market factor (beta) (1962-2005), and 0.26% per month in case of the Russell 1000 index (1979-2005). FI has high exposure to value factor In the 3-factor Fama and French model, FI shows a large and highly significant (tstatistic over 30) exposure of 0.36 towards the value factor.

It shows a beta of 0.38 with regard to the Russell 1000 Value/Growth return difference, associated with a highly significant t-statistic of over 30

Little exposure to size

The loading on the size factor is small and

negative, just -0.07 FI vs. Capitalization-weighted indices The market capitalization is unique in the sense that it is the only portfolio which every investor can hold with minimum turnover FI cannot be held in equilibrium by every investor, and contrary to a market capitalization-weighted index, a fundamental index does not represent passive, buyand-hold strategy Several subjective choices needed to define a FI. Most notably, which particular fundamental factor to use (e.g. book value, sales, earnings, cash-flow,

dividends, etc.) and how exactly should it be defined Fundamental indices more resemble active strategies FI may be inferior to multifactor quantitative Strategies FI benefit only from the value premium where as Multifactor Quantitative Investment Strategies benefit from numerous anomalies

Comments:

1. Discussions FI has been successfully marketed to investors. In our humble view, it is more like wrapping an old idea (ie, value) with new packaging. This paper provides a detailed analysis why the FI strategies might not be bearing superior results as suggested by proponents of fundamental indices. At a time when many smart people have intensively studied equity quant strategies, we tend to think it’s more likely for new alpha to come from new data source.

Though this paper provides theoretical argument against the fundamental indices, extensive empirical analysis is need for supporting the conclusions.

2. Data RAFI 1000 index (the Research Affiliates Fundamental Index for the top 1000 US equities) and Russell 1000 index are used for the period of 1962- 2005.

Paper Type:

Working Papers

Date:

2008-05-20

Category:

130/30, alternative index

Title:

130/30 Investing: Just Another Hype or Here to Stay?

Authors:

David Blitz

Source:

Link:

Summary:

In terms of alpha potential and beta exposure, 130/30 funds behave more like traditional mutual funds than hedge funds, mainly because of their market exposure.

Some 130/30 indices, e.g., “130/30: The New Long-Only”

 

74622) are questionable since they are not “unambiguous and transparent” in selecting factors, weight and optimizations.

 

Expenses for 130/30 funds are likely higher than

 

long-only funds due to cost related to shorting stocks and managing a more complex portfolio

 

A piece-wise implemented 130/30 funds (eg, a 100% long portfolio on top of a 30% market neutral portfolio) is sub-optimal since its portfolio construction is not integrated

Paper Type:

Working Papers

Date:

2008-05-01

Category:

130/30 index, alternative index

Title:

Benchmarking 130/30 Strategies

Authors:

Srikant Dash, Philip Murphy

Source:

S&P white paper

Link:

Summary:

This white paper proposes that a better benchmark for 130/30 funds is actually an appropriate long-only index. Any dedicated 130/30 index may be in-appropriate. Their reasons:

No set of factors in 130/30 indices can capture a broad consensus in identifying stock mis-pricing. 130/30 managers can use both quantitative and qualitatively methodology The 130/30 proposed by Lo and Patel (which emphasizes the impact of leverage) is problematic since:

● the effects of leverage are no different than effects of big factor bets such as style, industry or size. the goal of 130/30 managers is to deliver a portfolio beta of close to 1

generally managers try to outperform in a risk controlled fashion

Interestingly, this paper does not agree with a 130/30 index by S&P

which we covered before

rategy_Index_Methodology_Web.pdf), where a short extension is added to S&P’s proprietary stock-selection model.

Paper Type:

Working Papers

Date:

2008-04-09

Category:

Optimal indexing scheme, MSCI World Index, alternative index

Title:

Alternative Indexing with the MSCI World Index

Authors:

Thomas Neukirch

Source:

SSRN working paper

Link:

Summary:

This paper finds that “equal-risk weighting” performs better than the cap-weight scheme used by the MSCI World Developed Index during 2001/01 through 2008/01.

Weighting

Description

Performance

scheme

Original index

• Uses float-adjusted

• Yields -2.86%

weighting

market capitalization

during 2001/01 -

as weights

2008/01

Equal weighting

• All constituents get same weight

• Equal-weighted both components and countries generates 8.19%.

Equal risk

• Each constituents

• Equal-risk

weighting

get a weight of

weighting index

 

1/(constituents’

components:

volatility) i.e., each

6.27%,

constituents contributes the same amount of risk (volatility) to the resulting portfolio

• Equal risk weighting with equal country weighting generates 8.27%, with low volatility

Other findings:

● All alternative weighting schemes perform better than the original index, though such out-performance is more obvious when market is rising The costs of implementing an equal weighting strategy:

Before expenses, the equal weighting strategy returns 1.45% annually, the original index returns

-3.17%

After expenses, the equal-weighted index returns 0.70%, and the authors did not give the number for the original index

Comments:

1. Discussions Our major concern is that the finding here has a look-ahead bias. What happened during 2001/01-2008/01 may not repeat in the future. The author has the benefit of perfect hindsight: he first found that during the past 7 years, higher cap weighted countries yield lower returns (figure 2), and then proposes the “equal-risk weighting” and “equal-weighting”. He argues that “? riskiness is quite stable over time and hence a risk weighting component may lead to more stable results”, this may not always be true. Using an example in US, energy sector was a low-beta, low volatility sector before 2006, but it is no longer the case.

Paper Type:

Working Papers

Date:

2007-12-26

Category:

130/30 index, alternative index

Title:

130/30: The New Long-Only

Authors:

Andrew Lo, Pankaj Patel

Source:

SSRN working paper

Link:

 

Summary:

This paper proposes two indices for the increasingly popular

130% long/30% short (130/30) funds.The two indices are:

An investable index: which uses only prior information

and is dynamically rebalanced based on a mechanic trading rule A"look-ahead" index: which uses look-ahead information

 

(such as realized excess return) and can be used as a performance upper bound.

 

The proposed indices are based on a stock ranking strategy and a standard portfolio construction method.Specifically, stocks are ranked based on 10 commonly used factors:

  • 1. Traditional Value. (price ratios such as p/e, p/b, etc)

  • 2. Relative Value

  • 3. Historical Growth

  • 4. Expected Growth

 
  • 5. Profit Trends

 
  • 6. Accelerating Sales

  • 7. Earnings Momentum.

  • 8. Price Momentum.

  • 9. Price Reversal.

 

10. Small Size.

Key insights:

 

● An optimal benchmark index should be: transparent (systematic rules, clear), investable (liquid components), passive (mechanical implementation, no human discretion)

Compared with the S&P 50 index, the new 130/30 index

has similar volatility (about 15% annualvolatility for both) Compared with the S&P 500 index, the new 130/30 index has slightly higher Sharpe ratio (0.4 for the 130/30 index,

vs 0.37 for the S&P 500 index).The authors claim that this comparison is fair since although 130/30 has 1.6 times leverage, the volatility and beta of the 130/30 index is at similar level to S&P 500) It has high correlation with com on equity indices eg, Russell 2000

Comments:

1. Discussions In our view, the proposed indices sound more like a quant index and less a 130/30 index.130/30 funds aredifferent from

(arguably, better than) the traditional long-only for two reasons:

it can exploit the short side of stocks, which many believe there still exist in-efficiencies since managers do not have a way to express their negative view of some stocks. An ideal index should reflect opportunity set in this new territory. it has a 1.6 leverage (130% + 30%). In reality few 130/30 managers would keep their volatility and beta at the same level of S&P 500. A more desirable index (in our humble view) is an index with higher volatility. This said, the proposed 130/30 index has better performance than S&P500 due to its quant stock selection (likely value tilt).

2. Data 1996/01 - 2007/09 US stock data are used. The authors uses the MSCI Barra Aegis Portfolio Manager with the Barra U.S. Equity Long-Term Risk Model to construct the 130/30 portfolios

Paper Type:

Working Papers

Date:

2007-12-26

Category:

130/30 funds, alternative index

Title:

An Empirical Analysis of 130/30 Strategies

Authors:

Gordon Johnson, Shannon Ericson, Vikram Srimurthy

Source:

Lee Munder research paper

Link:

Summary:

This is a nice summary of the key features of the 130/30 strategies. Key points:

less than 10% of stocks can be underweight 25bps or

more relative to large cap benchmark stocks with highest weights do not necessarily have the

lowest alphas so a 130/30 funds can potentially increase alpha

In back-testing 130/30 outperform long-only by about 1.5

times, with a tracking error that is about 1.15 times higher. The authors also proposed a simple performance contribution analysis.

Paper Type:

Working Papers

Date:

2014-04-10

Category:

Pre-announcements, Management forecasts, Analyst forecasts

Title:

Stock Market Overreaction to Management Earnings Forecasts

Authors:

Jean-Sébastien Michel

Source:

CIRPÉE

Link:

Summary:

Stock prices overreacts to management earnings forecasts, and revert

around the earnings announcement. Negative forecast surprises lead to a -5.9% abnormal return around the forecast and a 1.9% correction in the 2-month after earnings announcements. Positive surprises lead to a 1.9% abnormal return and a -1.7% correction

Variables definitions ● Reaction to management earnings forecasts: the returns over the first 3days following the forecast Reaction to earnings announcement: the returns over the first 61 days following the announcement Overreaction to management earnings forecasts, particularly negative forecasts ● The 3-day CAR is -5.86% for negative surprises, 1.93%/0.65% for positive (no) surprises (Table 1) Results are robust to controlling for firm characteristics and analyst forecasts (Table 2) Following the RegFD, the 3-day stock returns after

management forecasts is lower yet still significant (~2% after RegFD vs ~6% before RegFD) (Table 3) Correction after earnings announcements

Significant CAR reversal following earnings announcement:

negative surprises predicts 1.88% CAR over next two months, positive(no) surprise predicts -1.72(-1.61%) (Table 1) Robust to firm characteristics and analyst forecasts (Table 2)

Source: The Paper ● In regressions, more reliable results after RegFD when controlling for firm characteristics

Source: The Paper ● In regressions, more reliable results after RegFD when controlling for firm characteristics and analyst forecasts (Table

4)

A management forecast cumulative abnormal return increase

of 1% is associated with a subsequent correction of -0.41% (Table 4) Robust to size, value/growth, and analyst coverage: a

management earnings forecast CAR increase of 1% is associated with a subsequent correction of -0.38% to -0.44% (Tables 6, 7, 8) Overreaction is present mainly when analyst forecasts

Data

corroborate management forecasts (Table 9)

U.S. firms accounting data from the Compustat database

U.S. stock data from CRSP database

Data on companies’ EPS guidance from First Call

Data on analyst EPS forecasts from the I/B/E/S database

Data range: 1994 - 2011

Paper

Working Papers

Type:

Date:

2013-07-03

Category:

Novel strategy, company guidance range, analyst estimate

Title:

Investor Overreaction to Analyst Reference Points

Authors:

Jean-Sebastien Michel

Source:

SSRN working paper

Summary

Analysts tend to keep their estimates within the company guidance range.

:

Those estimates that are exactly equal to endpoints of guidance range may suggest analysts’ conservatism. Investors overreact to such forecasts, but not other types of forecasts

Intuitions and definitions ● Most companies tend to give a range of their expected earnings Analysts tend to keep their estimates within the company issued guidance (CIG) range. Any estimates outside of the range signals analysts unusual confidence, and may risk their reputation Investors seem to be overconfident that endpoints estimates are conservative, and overreact to such estimates Define Low RP (reference point): equals 1 when at least one analyst forecast equals the low point of CIG, and 0 otherwise Define High RP: equals 1 when at least one analyst forecast equals the high point of CIG, and 0 otherwise Define “No RP (low)”: equals 1 when all analyst forecasts are less than the low point of CIG , and 0 otherwise Define “No RP (High)”: equals 1 when all analyst forecasts are greater than the high point of CIG, and 0 otherwise Define forecast error: the percentage difference between the analyst quarterly EPS forecast and realized quarterly EPS 1/3 of estimates are on the endpoints, with comparable forecast error ● The percentage of forecasts exactly equal to the CIG Low (High) are around 15% (20%) (Table 1) The percentage of forecasts between the CIG Low and High hovers around 50%. (Table 1) When Analyst Forecast < CIG Low, the error is much higher at 19%,

compared with other cases where the error is -2% to 4% (Table 1, 2) Strong reversal on announcement days for low RP stocks

For the Low RP stocks, days before the earnings announcements see

large negative abnormal return T-stat is significant (Table 4) Suggesting that investors react more strongly to analyst forecasts in this case Similar pattern for No RP (Low) and No RP (High) stocks (Table 4,

Figure2)

Source: the paper The over-reaction theory is further supported by higher turnover ● Low (high) RPhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2209171 Summary: Stocks with analysts revision confirming prior insider trading yields significant return spreads, with a return spread of 8.6% in the three-day period surrounding the revision. Such interaction works best for insider sales in US, and for insider purchases in international markets " id="pdf-obj-52-2" src="pdf-obj-52-2.jpg">

Source: the paper

The over-reaction theory is further supported by higher turnover ● Low (high) RP stocks have share turnover of 2.67% (2.64%) 30% higher than the turnover of No RP stocks whose turnover is 2.09%. (Table 8 panel A) Not driven by the magnitude of the forecast When comparing the forecasts equal to CIG endpoints to those that exceed CIG endpoints, the overreaction is even more pronounced

Data

January 2000 to June 2011 EPS guidance are from First Call

Only retain range estimates Data on analyst EPS forecasts are from the I/B/E/S

Stock returns, prices and shares outstanding are from CRSP/Compustat

Paper Type:

Working Papers

Date:

2013-02-28

Category:

Novel strategy, insider trading, analyst revi

Title:

Insider Trading and Analyst Forecast Revisions: Global Evidence

Authors:

Wen Jin, Joshua Livnat, and Yuan Zhang

Source:

SSRN Working Paper

Link:

Summary:

Stocks with analysts revision confirming prior insider trading yields significant return spreads, with a return spread of 8.6% in the three-day period surrounding the revision. Such interaction works best for insider sales in US, and for insider purchases in international markets

Definitions INSIDER: set to 1 if there is any insider trading activity in the designated window, and 0 otherwise Insider PURCHASE (SALE): set to 1 if the aggregate time-weighted trading is a net purchase (sale), and 0 otherwise In US, there are 833 purchases and 1439 sells on average each month In international market, there are 1478 net purchase position and 904 net sale position each month(Table 5) Suggesting a weaker emphasis on stock-based compensation outside of the US Insider trading predicts stock returns

From January 1996 to October 2011, long(short) insider buy(sell) earns 0.22% in the 30-day window after the

calendar month end (Table 1) Most of the hedge return coming from long portfolio:

suggesting that insider purchases are more informative In international market, the returns spread is 0.77%, with more return comes from short portfolio Market reacts immediately to analyst revisions

Sort the analyst forecast revisions into 10 deciles

In US, the three-day hedged return is 7.6% (Table 2, Panel A) In international markets, the hedged return is much lower at 2.5% (Table 6 Panel A ) Insiders trading and analyst revisions are supplement to each other

In the US market, when analysts confirm the insider

trading signal, the hedged return around the three-day period surrounding the revision is 8.6%, with the lowest (highest) decile of revisions earns -5.2% (3.4%) When analysts conflict with prior insider trading, the

hedged return is 7.1% (20% lower than confirming scenario) Similar findings in international markets

Data

When analysts agree with insiders, the market responds more strongly (coefficient 25% higher) to their forecast revisions (Panel B, Table 7)

1996-2012 US data are from the Thomson Reuters insider

trading database Analyst forecast data are from IBES

2006-2012 international insider trading data are from 2iQ Research, which covers European and Asia-Pacific countries

Paper Type:

Working Papers

Date:

2012-07-29

Category:

Novel strategy, analyst revisions, analyst optimism

Title:

Are Analysts Really Too Optimistic?

Authors:

Jean-Sébastien Michel and J. Ari Pandes

Source:

AAA Conference Paper

Link:

Summary:

A new measure of analyst ability, firm-level relative analyst earnings forecasts (ARAF), can predict future stock returns. A strategy based

on ARAF earns risk-adjusted return of 11% per year. This effect is more pronounced among smaller, more illiquid and more uncertain stocks

Background ● Stocks with high analysts revisions (adjusted for average estimate error) may signal analysts’ ability and confidence in the stock Note that such confidence is not analysts’ (unfounded) optimism, and it should be based on analysts’ private information and effective analysis Constructing average relative analyst forecast (ARAF) ● Step1: for each analyst, each stock, and each month, define relative analyst forecast (RAF) as

Paper Type: Working Papers Date: 2012-07-29 Category: Novel strategy, analyst revisions, analyst optimism Title: Are Analystshttp://aaahq.org/AM2012/display.cfm?Filename=SubID_557%2Epdf& MIMEType=application%2Fpdf Summary: A new measure of analyst ability, firm-level relative analyst earnings forecasts (ARAF), can predict future stock returns. A strategy based on ARAF earns risk-adjusted return of 11% per year. This effect is more pronounced among smaller, more illiquid and more uncertain stocks Background ● Stocks with high analysts revisions (adjusted for average estimate error) may signal analysts’ ability and confidence in the stock Note that such confidence is not analysts’ (unfounded) optimism, and it should be based on analysts’ private information and effective analysis Constructing average relative analyst forecast (ARAF) ● Step1: for each analyst, each stock, and each month, define relative analyst forecast (RAF) as ● Where Fi,j,t is analyst j’s forecast for firm i and for the forecast date t; μ() is the average forecast of all analysts for the period t to t-k for the same firm, and σ() is the standard deviation of these forecasts In other words, RAF is the (“analysts forecast” – “prior 3-months average forecast of all analysts”) / (“standard deviation of these forecasts” ) Step2: for each stock, get the aggregate RAF (ARAF) by averaging RAF across all analysts ○ So ARAF controls for any company or time-specific factors that affect forecasts and therefore eliminates the general biases attributed to consensus forecasts or recommendations ● Average ARAF varies substantially by quintile (Table 3) Constructing the ARAF portfolio ● ● " id="pdf-obj-54-59" src="pdf-obj-54-59.jpg">

Where Fi,j,t is analyst j’s forecast for firm i and for the forecast date t; μ() is the average forecast of all analysts for the period t to t-k for the same firm, and σ() is the standard deviation of these forecasts In other words, RAF is the (“analysts forecast” – “prior 3-months average forecast of all analysts”) / (“standard deviation of these forecasts” ) Step2: for each stock, get the aggregate RAF (ARAF) by averaging RAF across all analysts So ARAF controls for any company or time-specific factors that affect forecasts and therefore eliminates the general biases attributed to consensus forecasts or recommendations ● Average ARAF varies substantially by quintile (Table 3) Constructing the ARAF portfolio

Each month, sort stocks into quintiles by ARAF Rebalance monthly and calculate equal-weighted return for each portfolio The (unreported) value-weighted returns is qualitatively similar, though with lower economic significance Higher ARAF, higher returns

High-ARAF firms significantly outperform low-ARAF firms by

0.92% (1.45% vs. 0.53%) per month (annualized spread 11.04%) (Table 5) The risk-adjusted hedged portfolio monthly return is 0.97%

and highly statistically significant at the 1% level (annualized spread 11.64%) (Table 5) ● Returns monotonically increase with ARAF measure Robust to risk factors and Reg-FD

Double sort stocks by ARAF and size (P/B, momentum,

liquidity) into 5x5 portfolios ARAF works better in smaller, riskier (measured by

book-to-market) and less liquid segments But still demonstrate strong abilities among firms that are larger, less risky and more liquid (Table 6, 7)

Sort by size

Sort by illiquidity

Sort by volatility

In small cap quintile, 22.68% annually

In illiquid quintile, 18.36% annually

In high volatility quintile, 24.00% annually

In large cap quintile, 2.76% annually

In most liquid quintile, 3.00% annually

In low volatility quintile, 4.44%) annually

Regression confirms the findings (Table 8)

Control variables include size, book-to-market, momentum, analyst EPS forecast dispersion, prior-month return to capture the reversal, S&P long-term debt rating, and forecast error Weaker but still effective post-Reg FD (Table 9) Divide the sample into pre-Reg FD (1984-2000) and post-Reg FD (2001-2010) On a factor-adjusted basis, the annualized hedged

return is 14.40% pre-Reg FD and 7.56% post-Reg FD Higher ARAF, better accounting performance and higher forecast accuracy

Better operating performance in terms of ROA, CROA (cash flow on assets), and ROE

Strong and positive relationship: high ARAF portfolios significantly outperform low ARAF portfolios operationally by $0.95 to $1.32 per $100 of assets and $3.53 per $100 of equity in mean (Table 4) Forecast error (FCE) decreases with ARAF (Table 4) More pronounced for high uncertainty firms: they see a five-times larger mean difference in FCE between high and low ARAF firms (0.88 versus 0.17), comparing to low uncertainty firms (Table 4)

Data

January 1984 to December 2011 stock data is from CRSP

Analyst EPS forecasts data (for the one-year fiscal period) is

from Thomson Reuters’ I/B/E/S unadjusted detail history file Actual EPS is from the I/B/E/S unadjusted detail actuals file, while other accounting data from Compustat

Paper Type:

Working papers

Date:

2010-12-20

Category:

Novel strategy, analyst estimates, warranted forecasts

Title:

A New Approach to Predicting Analyst Forecast Errors:

Implications for Investment Decisions

Authors:

Eric C. So

Source:

SSRN Working paper

Link:

Summary:

A new earnings forecasting metric, Warranted Optimism (WO), yields long-short average portfolio returns of 16% per year. Such WO is better than analyst forecast since it forecasts future earnings directly from lagged firm characteristics, and is not related to analysts’ private information or incentive

Definitions and intuition ● Warranted Forecast (WF) are forecasts of future earnings estimated directly from lagged firm characteristics The regressors are the lagged values of the following firm characteristics: enterprise value (Vj), total assets (Aj), dividend levels (Dj), a binary variable indicating zero dividends (DDj), net income before extraordinary items (Ej), and a

binary variable indicating negative earnings (NEGE) (Equation 9, Page 11) Warranted optimism (WO) = (Warranted Forecast (WF) - Analyst Forecast (AF)) / (Total Assets)

The WF approach is less biased since it is directly based on firm characteristics It is well-known that Analyst Forecasts (AF) are systematically biased WF directly estimates future earnings based on firm characteristics, instead of regressing realized forecast errors on firm characteristics So WF results in unbiased estimates of future earnings, and WF forecast errors are unbiased estimates of the realized analyst forecast error Traditional approach to projecting analyst forecast errors are biased

In this approach, analyst forecasts (Fj,t) are a linear

function of observable firm characteristics and analysts’ private information and incentives Traditional approach regresses FEj,t (Realized analyst

forecast errors, defined as FEj,t = Ej,t −Fj,t ) on a set of firm characteristics The regression parameters obtained from this step are then used with current firm characteristics to estimate the analysts’ forecast error for the next year But the analysts’ private information or incentives are correlated with firm characteristics, so this traditional approach is biased (Equations 1, 2, and 3 on Page 5) Constructing portfolios based on WO

Sort stocks into quintiles by WO

Returns adjusted for Fama-French factors show

Portfolios are formed at the end of June each year, and

hold for 1-3 years Stock raw and risk-adjusted returns increase with WO

(Table 4) Over the next year, the long-short portfolio raw return spread is 16.4% (statistically significant) The long-short portfolio returns are statistically significantly positive for up to 3 years Risk adjusted return returns increase with WO:

significant alphas increasing in WO (Table 5) Robust to earnings drift and accruals (Table 6)

Robust to size, book-to-market, momentum, accruals, turnover, and long-term growth forecasts (Table 7), as WO effects still exist in a two-way sorting

Robust to extreme outliers: beginning in the third month following portfolio formation, average returns monotonically increase with WO, so the finding is not driven by a extreme performers (Figure 4) Good (maybe too good?) year-by-year performance (Table 9) ● The performance number look extraordinarily consistent:

only 1 year during 1976-2008 see negative return spread of WO Quintiles WO long-short portfolio returns have been positive almost every year during the 1976 - 2008 period. Over the 2003-2008 period, the size-adjusted long-short portfolio return is between 5.19% and 19.71%

Data

1976-2008 60,010 firm-years stock data are from CRSP, Compustat and IBES

Paper Type:

Working papers

Date: