WEBVTT

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Welcome to the Deep Dive.

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You,

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the learner,

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are looking to get smart,

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fast,

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and today we've got something truly fascinating for you.

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We're diving deep into the stock market,

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looking at how two powerful forces,

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price momentum,

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and,

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well,

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the real engine of a company's earnings,

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interact in some really surprising ways.

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Yeah,

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it's a great topic.

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Forget feeling overwhelmed.

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Our mission today is basically to give you those crucial insights,

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those aha moments,

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that can sharpen your understanding of the market.

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Exactly.

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We're laser focused today on some really groundbreaking research.

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It's from a paper called Accrual's Effect combined with Price Momentum.

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Okay.

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And it really digs into this question.

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Does the classic momentum strategy,

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you know,

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buying recent winners,

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selling recent losers,

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does its performance actually depend on how stable or persistent a company's earnings are?

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Right.

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Okay.

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Let's break that down a bit.

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Price Momentum,

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it's this idea pretty well known that winners tend to keep winning,

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losers keep losing.

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almost

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It feels intuitive sometimes.

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It does.

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And then you've got earnings,

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right?

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The profit a company reports.

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The bottom line.

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Exactly.

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But here's the twist we're exploring.

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And this is key.

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Not all earnings are,

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well,

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created equal.

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Some parts are more reliable,

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more persistent than others.

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Some are rock solid,

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maybe cash-based.

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Others more accounting-based.

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Less permanent,

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maybe.

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Precisely.

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Accruals versus cash flows.

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And the really cool part is seeing how these two ideas mesh.

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Does the quality of earnings,

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how much is cash?

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First,

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these accounting adjustments,

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the accruals actually change how well momentum works.

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OK,

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yeah,

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that's the core question.

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So momentum itself,

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it's not just like a Wall Street myth.

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I know.

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Jagadush and Tippmann really documented it back in 93,

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right?

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Showed pretty convincingly that stocks that did well recently tended to keep doing well and vice versa for the ones doing poorly.

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Yeah,

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absolutely.

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And it's been,

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well,

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remarkably persistent across different markets,

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different time periods,

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even different asset classes.

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It's been a real puzzle for standard finance theory.

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A puzzle?

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How so?

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Well,

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if markets are perfectly efficient,

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like the standard models often assume,

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then all information should be priced in immediately.

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These kinds of trends shouldn't really last.

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Ah,

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OK.

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So past performance shouldn't predict future performance in that world.

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Exactly.

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Even the big names in asset pricing,

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Fama and French,

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they acknowledge momentum was a significant challenge.

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An anomaly their models struggle to explain.

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But here's where it gets really interesting for today's deep dive.

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The paper we're looking at actually points out something important.

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They show,

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I think it's in their figure one,

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that the simple momentum strategy,

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just buy win or sell losers,

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it's actually become less profitable over recent decades.

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That's a crucial point.

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So that seemingly easy way to maybe beat the market,

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not quite so easy anymore.

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It's weakened.

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Which naturally leads to asking,

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why?

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And maybe...

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Can we make it better?

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Precisely.

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And that brings us neatly to the second big idea,

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earnings persistence.

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Okay.

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The basic idea here is that some components of that reported earnings number are much better predictors of future performance than others.

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Like some parts tell you more about the long-term health of the business?

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Yeah.

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Think of it like,

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well,

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a steady salary versus a one-off bonus.

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Yeah.

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One of the much better guides to your ongoing financial situation.

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Makes total sense.

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And the research here,

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it builds on earlier work.

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It does,

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particularly Sloan's famous 1996 paper.

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He found that accruals,

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these non-cash accounting items,

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are less persistent than operating cash flows.

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Okay,

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accruals.

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Right.

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Remind me again.

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Things like depreciation estimates,

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changes in inventory valuation,

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stuff like that.

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Exactly.

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Stuff that hits the income statement but isn't immediate cash in or out.

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It involves estimates,

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management judgment.

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It's not quite the same as cold,

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hard cash generated from operations.

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Got it.

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So cash flows may be more real and more sustainable.

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Often,

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yes.

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And what's fascinating is this related idea of earnings fixation.

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Earnings fixation.

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Sounds like investors getting tunnel vision.

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Kind of.

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The theory suggests investors might maybe naively focus too much on that bottom line income number.

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They might not fully appreciate the difference in persistence between the cash flow part and the accrual part.

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So they treat all earnings dollars as...

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equally good predictors of the future,

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even when maybe they shouldn't.

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That's the hypothesis.

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They might be overlooking the quality aspect.

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OK.

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And that's where Xu,

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Zhang,

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and Zhang,

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the authors of our paper,

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come in.

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They decided to test this directly,

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right?

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Yes.

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They wanted to see if this difference in persistence accruals versus cash flows could actually explain some of the patterns,

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maybe even the weakening we see in momentum.

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How did they do that?

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They used a standard accounting identity to actually

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break down reported earnings into these two main components,

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operating cash flow and total accruals.

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They're basically looking under the hood of that earnings number for every company.

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Okay,

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so they've got momentum portfolios and they've got this earnings breakdown.

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What happens when they put them together?

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Well,

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this is where it gets really counterintuitive and interesting.

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Their main finding is that momentum profits are actually higher in portfolios of stocks that have high accruals.

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Wait,

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higher profits for the high accrual stocks?

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The ones with potentially less persistent earnings?

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Yes.

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Or,

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put another way,

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stocks with low operating cash flow relative to their earnings.

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Their table 1 shows this quite clearly.

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The momentum payoff that's the return difference between the winner portfolio and the loser portfolio was about 0.41%

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per month higher for high accrual stocks.

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compared to low accrual stocks.

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Wow.

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Okay.

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My intuition would have gone the other way.

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I'd think high cash flow winners would be the best bet.

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Mine too.

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Initially,

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it's a real twist.

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The seemingly less reliable part of earnings actually seems to,

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well,

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supercharge the momentum effect.

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So why?

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What's the thinking there?

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If high accruals are less persistent,

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maybe signal lower quality,

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why would they boost momentum returns?

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Shouldn't a rational market price that in faster?

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That's the puzzle.

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The researchers suggest this actually supports that

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Earnings fixation idea we talked about.

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How so?

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Well,

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if investors don't fully appreciate that high accruals today might mean lower earnings tomorrow,

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especially for companies that have already been performing poorly,

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the past losers.

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They might be too slow to adjust their expectations downwards.

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Exactly.

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Their valuations might remain too high for too long.

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And for past winners with high accruals,

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maybe the optimism gets overdone.

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This slower reaction,

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this mispricing,

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could then lead to bigger price corrections later.

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As reality bikes.

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Which creates larger swings and therefore bigger potential profits for a momentum strategy that catches those swings.

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That's the proposed mechanism.

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The market's failure,

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if you like,

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to fully discount the lower persistence of high accrual earnings actually fuels a stronger momentum effect.

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It's a bit perverse,

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isn't it?

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It really is.

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So the market's potential mistake becomes the momentum trader's opportunity.

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Precisely.

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And this insight led them to think,

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OK,

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can we use this?

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can we build an even smarter and enhanced momentum strategy?

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Ah,

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so not just blindly buying all winners and shorting all losers.

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Right.

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Instead,

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let's look at the earnings quality within those winner and loser groups.

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Okay,

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tell me more.

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What's the secret sauce here for this enhanced version?

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The researchers found the most potent combination was this.

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Go long by the past winners,

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but specifically the ones with low accruals.

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The winners whose success seems backed by solid cash flow.

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Simultaneously.

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Go short sell the past losers,

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but focus on the ones with high accruals.

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The losers whose reported earnings might be propped up by those less persistent,

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maybe questionable accruals?

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Exactly.

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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.

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And does it work?

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Do the results back this up?

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Oh,

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yeah.

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The results are quite striking.

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Their table four shows this enhanced strategy generated average monthly returns.

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of up to 1.46%,

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maybe even 1.57%,

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depending on the exact formulation.

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Wow.

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And how does that compare to the simple momentum strategy?

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Significantly better.

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Simple momentum over their period was yielding about 0.77%

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per month.

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So you're looking at potentially doubling the return.

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That's a huge difference.

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And it wasn't just about higher raw returns,

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was it?

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I think the paper mentioned risk too.

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Absolutely critical point.

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It wasn't just about boosting returns.

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It was about better returns for the risk taken.

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They found these enhanced strategies had lower downside risk.

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Fewer big losses.

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Right.

283
00:08:29.465 --> 00:08:31.226
Fewer really painful months.

284
00:08:31.648 --> 00:08:32.465
And importantly,

285
00:08:32.949 --> 00:08:34.988
they showed a much improved Sharpe ratio,

286
00:08:35.090 --> 00:08:36.613
nearly double in some cases.

287
00:08:36.910 --> 00:08:37.816
And the Sharpe ratio,

288
00:08:37.855 --> 00:08:39.871
that's basically return per unit of risk,

289
00:08:39.980 --> 00:08:40.137
right?

290
00:08:40.168 --> 00:08:40.574
Exactly.

291
00:08:40.621 --> 00:08:44.246
So you're getting potentially much more bang for your risk buck,

292
00:08:44.355 --> 00:08:44.855
so to speak.

293
00:08:45.605 --> 00:08:47.277
Better risk adjusted performance.

294
00:08:47.418 --> 00:08:47.543
OK,

295
00:08:47.699 --> 00:08:48.465
that's compelling.

296
00:08:48.621 --> 00:08:48.746
Now,

297
00:08:48.840 --> 00:08:52.074
did they just look at total accruals versus total cash flow?

298
00:08:52.711 --> 00:08:54.613
Or did they slice it even finer?

299
00:08:54.853 --> 00:08:55.494
They went deeper.

300
00:08:55.513 --> 00:08:58.355
They broke down total accruals into normal accruals,

301
00:08:58.356 --> 00:08:59.238
the more predictable,

302
00:08:59.617 --> 00:09:00.340
routine kind,

303
00:09:00.379 --> 00:09:02.804
and abnormal or discretionary accruals.

304
00:09:03.000 --> 00:09:03.883
Discretionary,

305
00:09:04.203 --> 00:09:07.289
meaning where management has more wiggle room in the accounting.

306
00:09:07.367 --> 00:09:07.765
Pretty much.

307
00:09:08.047 --> 00:09:08.828
More potential for,

308
00:09:09.000 --> 00:09:09.375
let's say,

309
00:09:09.609 --> 00:09:10.422
earnings management.

310
00:09:10.750 --> 00:09:14.578
They also decomposed cash flows into things like changes in the cash balance itself,

311
00:09:14.687 --> 00:09:15.968
money paid out to shareholders,

312
00:09:16.093 --> 00:09:16.578
dividends,

313
00:09:16.640 --> 00:09:17.218
buybacks,

314
00:09:17.500 --> 00:09:18.797
and money paid to debt holders.

315
00:09:19.140 --> 00:09:21.515
And did this finer analysis give more clues?

316
00:09:22.156 --> 00:09:22.312
Which

317
00:09:22.443 --> 00:09:24.385
specific parts were driving the effect?

318
00:09:24.745 --> 00:09:25.085
It did.

319
00:09:25.486 --> 00:09:30.571
They found the enhanced momentum effect was mainly driven by those abnormal accruals.

320
00:09:30.712 --> 00:09:31.751
The discretionary ones.

321
00:09:31.853 --> 00:09:32.134
Yes.

322
00:09:32.696 --> 00:09:35.618
And also by net distributions to equity holders.

323
00:09:35.853 --> 00:09:37.900
So dividends and buybacks.

324
00:09:38.501 --> 00:09:38.845
Interesting.

325
00:09:38.861 --> 00:09:47.767
So the market seems particularly susceptible to mispricing around companies with maybe more aggressive accounting or companies.

326
00:09:48.015 --> 00:09:50.075
actively returning cash to shareholders.

327
00:09:50.155 --> 00:09:51.577
That's what the evidence suggests.

328
00:09:51.616 --> 00:09:56.895
It's like these specific components are where the investor fixation or misinterpretation is strongest.

329
00:09:57.161 --> 00:09:58.137
Fascinating stuff.

330
00:09:58.200 --> 00:09:58.340
Now,

331
00:09:58.661 --> 00:10:01.754
good research always considers alternative explanations,

332
00:10:01.817 --> 00:10:02.036
right?

333
00:10:02.622 --> 00:10:04.036
Did they look into other possibilities?

334
00:10:04.082 --> 00:10:05.957
Maybe this isn't really about accruals per se.

335
00:10:06.145 --> 00:10:07.067
They absolutely did.

336
00:10:07.301 --> 00:10:07.973
Rigorous work.

337
00:10:08.223 --> 00:10:10.504
One big one they tackled was the growth anomaly.

338
00:10:10.801 --> 00:10:11.114
Growth.

339
00:10:11.504 --> 00:10:12.223
How does that relate?

340
00:10:12.426 --> 00:10:12.582
Well,

341
00:10:12.707 --> 00:10:14.879
there's this idea that the accrual effect itself

342
00:10:15.123 --> 00:10:17.915
might just be picking up on characteristics of high-growth companies.

343
00:10:18.298 --> 00:10:20.258
High growth often involves more investment,

344
00:10:20.359 --> 00:10:21.158
more estimates,

345
00:10:21.478 --> 00:10:23.039
maybe naturally higher accruals.

346
00:10:23.140 --> 00:10:23.258
OK,

347
00:10:23.461 --> 00:10:25.679
so maybe accruals are just a proxy for growth.

348
00:10:25.980 --> 00:10:26.800
That was the question.

349
00:10:27.363 --> 00:10:34.183
They tested a momentum strategy based purely on growth in net operating assets and found it did produce comparable profits.

350
00:10:34.894 --> 00:10:35.566
And interestingly,

351
00:10:36.097 --> 00:10:39.425
the enhanced accrual based momentum strategy we've been discussing,

352
00:10:39.879 --> 00:10:42.441
it was actually more pronounced in high growth stocks.

353
00:10:42.941 --> 00:10:46.629
So growth is definitely part of the story tangled up with accruals.

354
00:10:47.030 --> 00:10:47.990
It seems intertwined.

355
00:10:48.030 --> 00:10:48.230
Yes.

356
00:10:48.270 --> 00:10:50.551
It doesn't fully explain away the accrual finding,

357
00:10:50.930 --> 00:10:52.590
but growth is clearly relevant.

358
00:10:52.890 --> 00:10:53.332
What else?

359
00:10:53.570 --> 00:10:56.676
Did they consider maybe it's just harder to trade these stocks?

360
00:10:56.769 --> 00:10:56.996
Yes.

361
00:10:57.113 --> 00:10:58.715
The limits to arbitrage idea.

362
00:10:58.972 --> 00:10:59.230
Right.

363
00:10:59.332 --> 00:11:01.613
Meaning even if there's a clear mispricing,

364
00:11:01.676 --> 00:11:06.629
maybe it's too costly or risky for big investors to actually trade on it and make it disappear.

365
00:11:06.894 --> 00:11:07.379
Exactly.

366
00:11:07.754 --> 00:11:09.816
So they looked at things like transaction costs,

367
00:11:09.941 --> 00:11:11.035
bid ask spreads,

368
00:11:11.394 --> 00:11:12.597
how liquid the stocks were,

369
00:11:12.816 --> 00:11:13.722
trading volume,

370
00:11:13.972 --> 00:11:16.504
institutional ownership and also arbitrage risk.

371
00:11:16.834 --> 00:11:18.814
Measured by things like idiosyncratic volatility,

372
00:11:19.154 --> 00:11:23.636
how much the stock price bounces around for reasons unrelated to the overall market.

373
00:11:23.894 --> 00:11:25.093
And what was the verdict there?

374
00:11:25.234 --> 00:11:28.539
Did these trading frictions explain the enhanced momentum profits?

375
00:11:28.976 --> 00:11:30.195
Actually it was kind of the opposite.

376
00:11:30.398 --> 00:11:38.765
They found the enhanced momentum strategy performed better generated higher profits among stocks with high transaction costs or high arbitrage risk.

377
00:11:38.859 --> 00:11:45.781
So the very things that make it hard to arbitrage might be allowing these accrual related mispricings to persist longer?

378
00:11:46.274 --> 00:11:47.315
That's the interpretation.

379
00:11:47.896 --> 00:11:51.838
The difficulty in trading these stocks might be protecting the anomaly in a sense.

380
00:11:51.881 --> 00:11:51.998
OK,

381
00:11:52.158 --> 00:11:52.541
interesting.

382
00:11:52.740 --> 00:11:54.299
But what about the big one risk?

383
00:11:54.783 --> 00:12:02.049
Maybe this enhanced strategy is just way riskier in ways standard models don't capture and the higher returns are just fair compensation.

384
00:12:02.393 --> 00:12:05.486
The million dollar question always they hit this hard.

385
00:12:05.908 --> 00:12:11.002
They ran the results through a whole battery of risk adjustments and standard asset pricing models.

386
00:12:11.018 --> 00:12:12.033
Like the CAPM

387
00:12:12.596 --> 00:12:13.580
Fama French models.

388
00:12:13.627 --> 00:12:13.736
Yep.

389
00:12:13.994 --> 00:12:14.615
CAPM,

390
00:12:14.695 --> 00:12:15.375
the Palma-French

391
00:12:15.715 --> 00:12:16.737
3-factor, the

392
00:12:17.118 --> 00:12:19.319
5-factor, Carhartt's 4-factor model,

393
00:12:19.338 --> 00:12:20.702
which includes momentum itself,

394
00:12:21.081 --> 00:12:22.221
even the Q-factor model.

395
00:12:22.620 --> 00:12:22.963
Basically,

396
00:12:23.065 --> 00:12:26.963
the standard toolkit for checking if returns are just explained by known risk factors.

397
00:12:27.104 --> 00:12:30.432
Did the extra returns disappear once they accounted for all that risk?

398
00:12:30.791 --> 00:12:30.963
Nope.

399
00:12:31.698 --> 00:12:32.307
The alphas,

400
00:12:32.635 --> 00:12:35.870
that's the measure of excess return after accounting for risk,

401
00:12:36.276 --> 00:12:40.135
remained positive and statistically significant across these different models.

402
00:12:41.557 --> 00:12:42.526
strongly suggests

403
00:12:42.670 --> 00:12:45.172
that while risk is always part of the equation,

404
00:12:45.753 --> 00:12:50.696
this enhanced momentum effect isn't just a reward for taking on more standard forms of market risk.

405
00:12:51.219 --> 00:12:52.797
There seems to be something else going on.

406
00:12:52.962 --> 00:12:53.079
OK,

407
00:12:53.258 --> 00:12:54.680
so let's try and pull this all together.

408
00:12:54.821 --> 00:12:56.407
What's the big takeaway here for you,

409
00:12:56.547 --> 00:12:57.805
the learner listening to this?

410
00:12:58.305 --> 00:13:00.563
I think the core insight is really powerful.

411
00:13:00.751 --> 00:13:03.016
It's that combining different approaches,

412
00:13:03.485 --> 00:13:04.688
fundamental analysis,

413
00:13:04.797 --> 00:13:07.297
like digging into the quality and persistence of earnings.

414
00:13:07.516 --> 00:13:08.891
Looking beyond the headline number,

415
00:13:09.157 --> 00:13:11.204
checking accruals versus cash flow.

416
00:13:11.391 --> 00:13:11.844
Exactly.

417
00:13:12.334 --> 00:13:18.141
Combining that with technical strategies like price momentum can potentially lead to really significant improvements,

418
00:13:18.399 --> 00:13:19.359
not just higher returns,

419
00:13:19.422 --> 00:13:21.106
but better risk-adjusted returns,

420
00:13:21.160 --> 00:13:21.324
too.

421
00:13:21.481 --> 00:13:23.387
So it's not enough just to chase stocks going up.

422
00:13:23.388 --> 00:13:24.488
You need to look under the hood.

423
00:13:24.809 --> 00:13:25.746
It really seems that way.

424
00:13:26.285 --> 00:13:33.238
Understanding what's driving the earnings and how sustainable that driver is appears crucial for refining a momentum approach.

425
00:13:33.895 --> 00:13:41.723
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.

426
00:13:42.018 --> 00:13:42.598
on the table.

427
00:13:42.838 --> 00:13:43.358
This has been,

428
00:13:43.558 --> 00:13:43.699
well,

429
00:13:43.898 --> 00:13:45.958
a genuinely fascinating deep dive.

430
00:13:46.340 --> 00:13:49.098
It really shows how digging into academic research,

431
00:13:49.180 --> 00:13:53.477
even stuff that sounds complex like accruals can yield practical insight.

432
00:13:53.563 --> 00:13:54.063
Absolutely.

433
00:13:54.219 --> 00:13:56.219
It shows the market isn't always perfectly efficient,

434
00:13:56.258 --> 00:13:56.485
right?

435
00:13:56.680 --> 00:14:04.282
There could be opportunities when investors perhaps systematically overlook or misinterpret certain fundamental signals like earnings quality,

436
00:14:04.844 --> 00:14:06.860
especially when combined with strong price trends.

437
00:14:07.204 --> 00:14:08.000
So for you,

438
00:14:08.547 --> 00:14:09.688
the learner listening right now,

439
00:14:10.066 --> 00:14:12.869
Maybe the practical first step is just awareness.

440
00:14:13.090 --> 00:14:15.131
Like next time you look at a company's results,

441
00:14:15.611 --> 00:14:19.697
consciously check the difference between net income and cash from operations.

442
00:14:19.916 --> 00:14:20.900
That's a great starting point.

443
00:14:21.158 --> 00:14:23.556
Just noticing that difference can spark new questions.

444
00:14:23.978 --> 00:14:27.142
So here's the final thought to chew on as you digest all this.

445
00:14:28.298 --> 00:14:29.002
How might you,

446
00:14:29.502 --> 00:14:30.064
the learner,

447
00:14:30.627 --> 00:14:32.408
start incorporating this concept,

448
00:14:32.409 --> 00:14:34.564
this idea of earnings persistence,

449
00:14:34.705 --> 00:14:38.720
of earnings quality into how you think about companies and market trends?

450
00:14:39.406 --> 00:14:44.830
Are you currently relying only on past price moves or just that single EPS number?

451
00:14:45.471 --> 00:14:53.963
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.

452
00:14:54.221 --> 00:14:55.549
It certainly opens up avenues,

453
00:14:55.596 --> 00:14:55.987
doesn't it?

454
00:14:56.737 --> 00:14:58.830
Thinking more about financial statement analysis,

455
00:14:58.862 --> 00:14:59.940
behavioral finance,

456
00:15:00.346 --> 00:15:02.534
why investors might fixate on certain numbers.

457
00:15:02.971 --> 00:15:03.971
It connects a lot of dots.

458
00:15:04.034 --> 00:15:04.815
It really does.

459
00:15:04.909 --> 00:15:07.815
It's a reminder that there are always deeper layers to explore.

460
00:15:07.940 --> 00:15:08.596
Always more to learn.

461
00:15:08.890 --> 00:15:09.010
Well,

462
00:15:09.011 --> 00:15:10.734
thanks so much for joining us for this deep dive.

463
00:15:10.735 --> 00:15:12.920
We really hope it's given you some valuable food for thought.

464
00:15:12.959 --> 00:15:13.400
Hope so too.

465
00:15:13.662 --> 00:15:15.127
Until our next exploration,

466
00:15:15.326 --> 00:15:16.189
keep digging deeper.