Welcome to the Deep Dive.
You,
the learner,
are looking to get smart,
fast,
and today we've got something truly fascinating for you.
We're diving deep into the stock market,
looking at how two powerful forces,
price momentum,
and,
well,
the real engine of a company's earnings,
interact in some really surprising ways.
Yeah,
it's a great topic.
Forget feeling overwhelmed.
Our mission today is basically to give you those crucial insights,
those aha moments,
that can sharpen your understanding of the market.
Exactly.
We're laser focused today on some really groundbreaking research.
It's from a paper called Accrual's Effect combined with Price Momentum.
Okay.
And it really digs into this question.
Does the classic momentum strategy,
you know,
buying recent winners,
selling recent losers,
does its performance actually depend on how stable or persistent a company's earnings are?
Right.
Okay.
Let's break that down a bit.
Price Momentum,
it's this idea pretty well known that winners tend to keep winning,
losers keep losing.
almost
It feels intuitive sometimes.
It does.
And then you've got earnings,
right?
The profit a company reports.
The bottom line.
Exactly.
But here's the twist we're exploring.
And this is key.
Not all earnings are,
well,
created equal.
Some parts are more reliable,
more persistent than others.
Some are rock solid,
maybe cash-based.
Others more accounting-based.
Less permanent,
maybe.
Precisely.
Accruals versus cash flows.
And the really cool part is seeing how these two ideas mesh.
Does the quality of earnings,
how much is cash?
First,
these accounting adjustments,
the accruals actually change how well momentum works.
OK,
yeah,
that's the core question.
So momentum itself,
it's not just like a Wall Street myth.
I know.
Jagadush and Tippmann really documented it back in 93,
right?
Showed pretty convincingly that stocks that did well recently tended to keep doing well and vice versa for the ones doing poorly.
Yeah,
absolutely.
And it's been,
well,
remarkably persistent across different markets,
different time periods,
even different asset classes.
It's been a real puzzle for standard finance theory.
A puzzle?
How so?
Well,
if markets are perfectly efficient,
like the standard models often assume,
then all information should be priced in immediately.
These kinds of trends shouldn't really last.
Ah,
OK.
So past performance shouldn't predict future performance in that world.
Exactly.
Even the big names in asset pricing,
Fama and French,
they acknowledge momentum was a significant challenge.
An anomaly their models struggle to explain.
But here's where it gets really interesting for today's deep dive.
The paper we're looking at actually points out something important.
They show,
I think it's in their figure one,
that the simple momentum strategy,
just buy win or sell losers,
it's actually become less profitable over recent decades.
That's a crucial point.
So that seemingly easy way to maybe beat the market,
not quite so easy anymore.
It's weakened.
Which naturally leads to asking,
why?
And maybe...
Can we make it better?
Precisely.
And that brings us neatly to the second big idea,
earnings persistence.
Okay.
The basic idea here is that some components of that reported earnings number are much better predictors of future performance than others.
Like some parts tell you more about the long-term health of the business?
Yeah.
Think of it like,
well,
a steady salary versus a one-off bonus.
Yeah.
One of the much better guides to your ongoing financial situation.
Makes total sense.
And the research here,
it builds on earlier work.
It does,
particularly Sloan's famous 1996 paper.
He found that accruals,
these non-cash accounting items,
are less persistent than operating cash flows.
Okay,
accruals.
Right.
Remind me again.
Things like depreciation estimates,
changes in inventory valuation,
stuff like that.
Exactly.
Stuff that hits the income statement but isn't immediate cash in or out.
It involves estimates,
management judgment.
It's not quite the same as cold,
hard cash generated from operations.
Got it.
So cash flows may be more real and more sustainable.
Often,
yes.
And what's fascinating is this related idea of earnings fixation.
Earnings fixation.
Sounds like investors getting tunnel vision.
Kind of.
The theory suggests investors might maybe naively focus too much on that bottom line income number.
They might not fully appreciate the difference in persistence between the cash flow part and the accrual part.
So they treat all earnings dollars as...
equally good predictors of the future,
even when maybe they shouldn't.
That's the hypothesis.
They might be overlooking the quality aspect.
OK.
And that's where Xu,
Zhang,
and Zhang,
the authors of our paper,
come in.
They decided to test this directly,
right?
Yes.
They wanted to see if this difference in persistence accruals versus cash flows could actually explain some of the patterns,
maybe even the weakening we see in momentum.
How did they do that?
They used a standard accounting identity to actually
break down reported earnings into these two main components,
operating cash flow and total accruals.
They're basically looking under the hood of that earnings number for every company.
Okay,
so they've got momentum portfolios and they've got this earnings breakdown.
What happens when they put them together?
Well,
this is where it gets really counterintuitive and interesting.
Their main finding is that momentum profits are actually higher in portfolios of stocks that have high accruals.
Wait,
higher profits for the high accrual stocks?
The ones with potentially less persistent earnings?
Yes.
Or,
put another way,
stocks with low operating cash flow relative to their earnings.
Their table 1 shows this quite clearly.
The momentum payoff that's the return difference between the winner portfolio and the loser portfolio was about 0.41%
per month higher for high accrual stocks.
compared to low accrual stocks.
Wow.
Okay.
My intuition would have gone the other way.
I'd think high cash flow winners would be the best bet.
Mine too.
Initially,
it's a real twist.
The seemingly less reliable part of earnings actually seems to,
well,
supercharge the momentum effect.
So why?
What's the thinking there?
If high accruals are less persistent,
maybe signal lower quality,
why would they boost momentum returns?
Shouldn't a rational market price that in faster?
That's the puzzle.
The researchers suggest this actually supports that
Earnings fixation idea we talked about.
How so?
Well,
if investors don't fully appreciate that high accruals today might mean lower earnings tomorrow,
especially for companies that have already been performing poorly,
the past losers.
They might be too slow to adjust their expectations downwards.
Exactly.
Their valuations might remain too high for too long.
And for past winners with high accruals,
maybe the optimism gets overdone.
This slower reaction,
this mispricing,
could then lead to bigger price corrections later.
As reality bikes.
Which creates larger swings and therefore bigger potential profits for a momentum strategy that catches those swings.
That's the proposed mechanism.
The market's failure,
if you like,
to fully discount the lower persistence of high accrual earnings actually fuels a stronger momentum effect.
It's a bit perverse,
isn't it?
It really is.
So the market's potential mistake becomes the momentum trader's opportunity.
Precisely.
And this insight led them to think,
OK,
can we use this?
can we build an even smarter and enhanced momentum strategy?
Ah,
so not just blindly buying all winners and shorting all losers.
Right.
Instead,
let's look at the earnings quality within those winner and loser groups.
Okay,
tell me more.
What's the secret sauce here for this enhanced version?
The researchers found the most potent combination was this.
Go long by the past winners,
but specifically the ones with low accruals.
The winners whose success seems backed by solid cash flow.
Simultaneously.
Go short sell the past losers,
but focus on the ones with high accruals.
The losers whose reported earnings might be propped up by those less persistent,
maybe questionable accruals?
Exactly.
You're essentially betting that the market will eventually wake up to the higher quality earnings of those low accrual winners and the lower quality earnings of those high accrual losers.
And does it work?
Do the results back this up?
Oh,
yeah.
The results are quite striking.
Their table four shows this enhanced strategy generated average monthly returns.
of up to 1.46%,
maybe even 1.57%,
depending on the exact formulation.
Wow.
And how does that compare to the simple momentum strategy?
Significantly better.
Simple momentum over their period was yielding about 0.77%
per month.
So you're looking at potentially doubling the return.
That's a huge difference.
And it wasn't just about higher raw returns,
was it?
I think the paper mentioned risk too.
Absolutely critical point.
It wasn't just about boosting returns.
It was about better returns for the risk taken.
They found these enhanced strategies had lower downside risk.
Fewer big losses.
Right.
Fewer really painful months.
And importantly,
they showed a much improved Sharpe ratio,
nearly double in some cases.
And the Sharpe ratio,
that's basically return per unit of risk,
right?
Exactly.
So you're getting potentially much more bang for your risk buck,
so to speak.
Better risk adjusted performance.
OK,
that's compelling.
Now,
did they just look at total accruals versus total cash flow?
Or did they slice it even finer?
They went deeper.
They broke down total accruals into normal accruals,
the more predictable,
routine kind,
and abnormal or discretionary accruals.
Discretionary,
meaning where management has more wiggle room in the accounting.
Pretty much.
More potential for,
let's say,
earnings management.
They also decomposed cash flows into things like changes in the cash balance itself,
money paid out to shareholders,
dividends,
buybacks,
and money paid to debt holders.
And did this finer analysis give more clues?
Which
specific parts were driving the effect?
It did.
They found the enhanced momentum effect was mainly driven by those abnormal accruals.
The discretionary ones.
Yes.
And also by net distributions to equity holders.
So dividends and buybacks.
Interesting.
So the market seems particularly susceptible to mispricing around companies with maybe more aggressive accounting or companies.
actively returning cash to shareholders.
That's what the evidence suggests.
It's like these specific components are where the investor fixation or misinterpretation is strongest.
Fascinating stuff.
Now,
good research always considers alternative explanations,
right?
Did they look into other possibilities?
Maybe this isn't really about accruals per se.
They absolutely did.
Rigorous work.
One big one they tackled was the growth anomaly.
Growth.
How does that relate?
Well,
there's this idea that the accrual effect itself
might just be picking up on characteristics of high-growth companies.
High growth often involves more investment,
more estimates,
maybe naturally higher accruals.
OK,
so maybe accruals are just a proxy for growth.
That was the question.
They tested a momentum strategy based purely on growth in net operating assets and found it did produce comparable profits.
And interestingly,
the enhanced accrual based momentum strategy we've been discussing,
it was actually more pronounced in high growth stocks.
So growth is definitely part of the story tangled up with accruals.
It seems intertwined.
Yes.
It doesn't fully explain away the accrual finding,
but growth is clearly relevant.
What else?
Did they consider maybe it's just harder to trade these stocks?
Yes.
The limits to arbitrage idea.
Right.
Meaning even if there's a clear mispricing,
maybe it's too costly or risky for big investors to actually trade on it and make it disappear.
Exactly.
So they looked at things like transaction costs,
bid ask spreads,
how liquid the stocks were,
trading volume,
institutional ownership and also arbitrage risk.
Measured by things like idiosyncratic volatility,
how much the stock price bounces around for reasons unrelated to the overall market.
And what was the verdict there?
Did these trading frictions explain the enhanced momentum profits?
Actually it was kind of the opposite.
They found the enhanced momentum strategy performed better generated higher profits among stocks with high transaction costs or high arbitrage risk.
So the very things that make it hard to arbitrage might be allowing these accrual related mispricings to persist longer?
That's the interpretation.
The difficulty in trading these stocks might be protecting the anomaly in a sense.
OK,
interesting.
But what about the big one risk?
Maybe this enhanced strategy is just way riskier in ways standard models don't capture and the higher returns are just fair compensation.
The million dollar question always they hit this hard.
They ran the results through a whole battery of risk adjustments and standard asset pricing models.
Like the CAPM
Fama French models.
Yep.
CAPM,
the Palma-French
3-factor, the
5-factor, Carhartt's 4-factor model,
which includes momentum itself,
even the Q-factor model.
Basically,
the standard toolkit for checking if returns are just explained by known risk factors.
Did the extra returns disappear once they accounted for all that risk?
Nope.
The alphas,
that's the measure of excess return after accounting for risk,
remained positive and statistically significant across these different models.
strongly suggests
that while risk is always part of the equation,
this enhanced momentum effect isn't just a reward for taking on more standard forms of market risk.
There seems to be something else going on.
OK,
so let's try and pull this all together.
What's the big takeaway here for you,
the learner listening to this?
I think the core insight is really powerful.
It's that combining different approaches,
fundamental analysis,
like digging into the quality and persistence of earnings.
Looking beyond the headline number,
checking accruals versus cash flow.
Exactly.
Combining that with technical strategies like price momentum can potentially lead to really significant improvements,
not just higher returns,
but better risk-adjusted returns,
too.
So it's not enough just to chase stocks going up.
You need to look under the hood.
It really seems that way.
Understanding what's driving the earnings and how sustainable that driver is appears crucial for refining a momentum approach.
It suggests focusing only on price charts or only on that bottom-line earnings number might be leaving potential gains or maybe better risk control.
on the table.
This has been,
well,
a genuinely fascinating deep dive.
It really shows how digging into academic research,
even stuff that sounds complex like accruals can yield practical insight.
Absolutely.
It shows the market isn't always perfectly efficient,
right?
There could be opportunities when investors perhaps systematically overlook or misinterpret certain fundamental signals like earnings quality,
especially when combined with strong price trends.
So for you,
the learner listening right now,
Maybe the practical first step is just awareness.
Like next time you look at a company's results,
consciously check the difference between net income and cash from operations.
That's a great starting point.
Just noticing that difference can spark new questions.
So here's the final thought to chew on as you digest all this.
How might you,
the learner,
start incorporating this concept,
this idea of earnings persistence,
of earnings quality into how you think about companies and market trends?
Are you currently relying only on past price moves or just that single EPS number?
Maybe asking where did those earnings come from and how likely are they to stick around could provide a much richer and potentially more profitable view.
It certainly opens up avenues,
doesn't it?
Thinking more about financial statement analysis,
behavioral finance,
why investors might fixate on certain numbers.
It connects a lot of dots.
It really does.
It's a reminder that there are always deeper layers to explore.
Always more to learn.
Well,
thanks so much for joining us for this deep dive.
We really hope it's given you some valuable food for thought.
Hope so too.
Until our next exploration,
keep digging deeper.