[MUSIC] Learning Outcomes. After watching this video, you will be able to understand the intuition behind the concept of accruals. [MUSIC] Hi. Now we are going to start this new strategy which is accrual anomaly. If you remember, Petroski class, the course on Petroski's dating strategy, we spoke about this accrual, right. Pause a bit and think. Did we not say one score which is delta accrual, which is what? ROA minus, if you remember, I'll give you a second to think about it. It's ROA minus cash flows. Cash flows from operations. So that was the accrual number that you used. So we are going to build a strategy using this number, which is accrual, and see how it works. Before that, let me give you a broad economic intuition regarding why this accrual strategy works. As I've told you, all strategies here are based on economic intuition. It is not data mining, right. So why should this accrual thing work? What is accrual? Again, if you have seen that Petroski video carefully I have defined accrual for you. What happens in practice is that a transaction is recorded on accrual basis. That means when a legal liability is incurred, a transaction is recorded. Instead of making it simple, I think I am making it more and more complicated. Now let me attempt to make it simple. Assume that you have sold a good or a service to someone. Now, the payment may happen after three months, six months, a year, or whenever it is. But in your books, this transaction is recorded the moment the service is rendered. The moment this legal obligation to do a service and a legal obligation to pay for the service or sale of a good, once that happens, you make an entry. Now the cash may come later. That can happen later, so when you make an entry for a sale, you recognize income. So this is based on accrual. The concept of accrual is, you don't really wait for cash to be realized. So that's what you do in an accrual system of accounting. Now, [COUGH] What's the problem with this, what's wrong with this? This is how we do right? When you go to your regular shop keeper, you may not pay everyday, you may pay once in a week, once in a month, this is normal. Your salaries for example, you get it end of the month, right? That's accrual. But you earn it every day, but you get it end of the month. So what is wrong with that? The only problem is, there is a chance of default. As you may have sold a certain good to someone with a condition that that person has to pay after a month. And that after a month that person may not show up, he may not pay at all. There is a risk that cash may not be realized, that's one problem, but so what, if the cash is not realized you can record a loss at that time. Where is the score for a clearing strategy yet, you might be wondering. A clearing strategy comes from the fact that a lot of businesses use this sort of leeway in order to artificially shore up their earnings. Now why do they have to artificially shore up their earnings? Because now there are shareholders who like higher earnings and it's used as an indicator of a manager's performance. And therefore business managers have an incentive to show higher earnings quarter to quarter, year on year. There's a lot of research on that. We need to work Strategy on this idea itself. But, these business managers have this pressure to show higher earnings and they use accrual as a tool to window dress their account. Let me give you a concrete example. Think about a car seller, or cement seller, or any of these. A manufacturer of cars or a manufacturer of cement, or any product. Now all these managers in the company will have month end or year end targets, right? Now one way they achieve these numbers is to dump all this to their distributors. Now if they dump all this to their distributors and recorded a sale. Now what happens with that? Will the money come now? The distributor may not have the money. And ultimately the distributor may not be able to sell. And many of the goods may come back and you may have to pay the money back if you are. So but as on the end of this month, this dumping these people have done will get recorded as sales. And that will show us, once you have sales, you have higher income. Everyone is happy, share price goes up. So this is the purpose. Now what Richard Sloan, who for the first time wrote a paper on this accrual anomaly, what he figured out that the market fails to distinguish between earnings which are shored up because of accruals, and earnings which are driven by cash. Now, why this story, it looks so obvious right? If you have a company with say earnings of x, there's another with the same earnings of x. If this x is driven by accruals, the other one is driven by cash, the market should have differentiated between the two, right? Because the earnings company which has got earnings in cash has got that cash. Whereas the accrual person A has not realized these earnings. B, it could be window dressing, as well. But the surprising thing is, market fails to differentiate between these stocks in the short term. [COUGH] That's the key. You do not a thing. They will distinguish. There is a window of opportunity after announcement of a result where a firm, which announces higher earnings because of higher accrual. And a firm, which announces earnings because of higher cash earnings. Higher earnings because of higher cash, would react positively. Now, given that you're gone through three, four trading strategies, I will give you a few seconds to think about a possible trading strategy using this. What you should, how you can make money if this is how market behaves. Think about it. Assume there are two companies whose expected earnings is, lets say, X per share. Both companies expected earning was X per share. And what gets realized, what gets reported is one and half X, both companies. The difference between the two companies is in one of the companies, the one and half x came because of accruals, in other company it came because of cash. Now, both companies stock price goes up by 5%. Do you have a trading strategy here? By now you should develop this intuition to think about developing a trading strategy in such a situation. You should ask yourself, pause this video, write down this and think, can you develop a trading strategy in this situation. What we have thought about this and figured out a possible trading strategy. Let me suggest the following. What is my idea? The idea, not my idea by the way. That's what Sloan found in his famous paper. In the PPT, you can see the link to this paper, where you can download this, I encourage you to download indeed the paper. So, what you found is interesting. Market in the short run does not distinguish between the two companies but in the long term run it does, that's key. Imagine even in the long run it does not distinguish within these two companies, then you don't have a strategy. Now, here is an opportunity. Suppose you buy this stock, where earnings is dominated by cash. Where there is cash flow, it supports earnings. And sell this stock where earnings are dominated by accruals, where there is not enough cash to support these earnings, and hold this portfolio for some time. So you are going long or buying a stock where the positive earnings surprise is driven by cash, and going short on a stock where the positive earnings surprise is driven by accruals. Now you expect or Sloan finds that after a period of time, market corrects this anomaly, right. So if market initially fails to distinguish between the two, both would have gone up. But once the market realizes that the stock where the earning is driven by accruals, earnings is not sustainable, then that stock will fall. At least relatively it will fall. So now what will happen? The stock that you buy will go up, and the stock you will sell may not go up as much, or it may fall. So that will generate profits for you. Please understand- you may be wondering why we are always telling you to buy something and sell something else. All our strategies have this long/short feature, right. This is because sometimes the stocks may move because of directional reasons. Suppose, say, as I gave you an example earlier, if oil prices crash, even a good oil marketing company, the stock price will fall. So it's always better to have a long and a short so that all the systemic factors are taken care of. That's the idea. So now, if you long a firm with low accruals, and short a firm with high accruals, and hold on, the moment the market realizes the difference between these two companies, your portfolio will start making money. So this is the concept of this accrual anomaly. So what I'll do next is I'll take you through the abstract of the paper. Remember abstract completely summarizes the paper in four or five lines. We're not going to do it with every trading strategy. Because this is important, because this is conceptual, there are a number of variants of this accrual anomaly. We're going to do the basic paper, Sloan's basic paper. After that there have been hundreds of papers written on this topic. We encourage you to go through these papers so that you can improvise and innovate on your strategy. So I'll take you through that stack, and then I'll obviously tell you the formula and the trading strategy. That's the plan. Let's start with the paper. You can see the paper in my hand. As I've told you we already given you a link earlier. You can download the paper. I strongly advised that you have the paper in your hand or in your laptop whatever medium you're using right now. The title of the paper is do stock prices fully reflect information in accruals and cash flows about future earnings. It's a scary title. It's like title itself has some 10, 15 words. So this is why we did this module on how to read an academic paper, right? Normally, people get scared while looking at these kind of titles themselves. In fact, that's one of the reasons why these strategies work. So the title is long but the idea is very simple. These are paper where we charge this loan from the University of Pennsylvania. And it's published in The Accounting Review, which is, again, one of the top journals in accounting. It's called TAR. Academicians call it Tar which is the journal of accounting review. So the reason why it, I emphasize on publication and where it is published because these papers go through refereeing process and it's important. Sometimes you may find a random paper, working paper, unpublished paper lying somewhere. And an unpublished paper is a paper which has not gone through this refreeing process where peers have not validated their findings. A published paper is one where a refree who's equally qualified as the author, has looked at these papers and have found the findings to be sound. Again, it's not that it's full proof, and it will work all the time, that's not the case. I've given enough disclaimers. We made a complete module on disclaimers. But that's not the idea, but the standards are higher and the more impactful the journal, higher is the standard. That's the benefit of published papers. So given two papers of everything being the same, I would prefer experimenting with a published paper than an unpublished paper. But then, [LAUGH] obviously there is a con to it. The unpublished paper will be new, and a published paper is likely to be old. Lot more people are likely to use. Or these are costs and benefits one has to look at. Anyway let's come back to this paper, by Richard Sloan about accrual anomaly. So I'll take you through abstract. So I suggest that you read the abstract word by word, it's very important basically it'll summarize the entire paper, in about 150 words. So what does he say? This paper investigates whether stock prices reflect information about future earnings. Now, as I told you, this is mostly for academic audience is telling why this strategy works but you should understand this. He is saying there is information about future earnings, which is out there. And his question is whether that information is getting reflected in stock prices. Now remember our whole thing is that market is not strong form efficient. So strong or super strong form efficient where the current information which is coming out is not always reflected in the price. So that is why these strategies work. So he's saying information which is there, out there, whether it gets reflected in stock prices. Now, where is this information coming from? Information, next line he says, contained in accrual and cash flow components. Now there is, as we have seen during there is an accrual component of your earnings, there is cash component of his earnings. Sloan says, Richard Sloan says, you get some information, some useful information from this accrual component and cash component. Now his question is whether that information is already embedded in stock price. That's the question, right? So he asks, this paper investigates whether stock prices reflect information about future earnings, contained in accrual and cash component of current earnings. So, see, accrual and cash component of current earnings contain information about future earnings. This is what he says. So, this is very important. Please note. All that you need to know is accrual and cash component of current earnings, this is the good news. You need not know future earnings. This point is this, these two components have information about future earnings. Now the question is that the information that you can extract from these earnings statements can. Is it already placed in? Now if it is already placed in, nothing much you can do about it. But what if it is not placed? That is where your have a trading strategy. So that's the question slow on addresses. Let's move on, then he says, the extent to which current earnings performance persists into the future. Is shown to depend on the relative magnitudes of the cash and accrual components of current earnings. These papers tend to have long sentences and there's always a lot of jargon in between. As I've told you before, this is intended towards academic audience. But still, this is not that difficult. Let's start on the sentence. It says, the extent to which current earnings performance persist. See, suppose a company has a good earnings performance in a particular quarter. Now what are you interested in basically? You are interested in is whether these are earnings performance sustainable? Are you going to get the same kind of earnings in the future? Good or bad? One sort of thing which we are not considered so far is all our example that are good earnings. No, this could be bad as well. So can you say that by looking at the earnings number this quarter, this kind of earnings are going to sustain in future? So that is a kind of information that he's looking at. So they asked the extent to which current earnings performance persist into the future is shown to different on the relative magnitude of cash and accrual components of [INAUDIBLE]. He claims that this table shows that the extent to which your current earning performance persist, that's going to continue, good or bad. Depends on the proportion of cash and accruals in your total earnings. So that is what this paper shows. Now you may wonder how does it matter? Earning performance persist or nor persist because of cash or accrual because everybody know about it. This information is public. So what's the big deal? Where is the trading strategy? Here comes the next line. However, stock prices are found to act as if, this is very key, this word is key, as these two words are key. As if investors fixate on earnings, failing to reflect fully information contained in the accrual and cash flow components of current earnings. Let me stop here. He has very, very long sentences, you lose track and it's better to break these sentences in two parts. And try understanding one part at a time. Let's take the first part. However, stock prices are found to act as if as if investors fixate on earnings. What is he saying? Does the way stock market reacts to an earnings announcement, it is as if investors don't see this difference. Investors look at these total earnings. You have these earnings of $100. $50 may be cash, $50 may be accruals. But the way the market reacts to this earnings number is as if investors fixate on current earnings. Failing to reflect fully information contained in accrual and cash flow components. So investors, when these earnings are announced fail to distinguish between the persistence of earnings when it is driven by cash and when it is driven by accruals. They treat them same. In an extreme case, if the entire earnings of a company comes from accruals or entire earnings of another company comes from cash. The market reaction more or less as likely to be the same. But then go back to the previous sentence which Sloan said. What he finds? He finds that persistence actually depend on whether earnings are coming from accruals, earnings are coming from cash. Actually, his finding is that accrued earnings do not persist, cash earnings persist. So failing to reflect fully information contained in accrual and cash flow components of current earnings until that information impacts future earnings. Now is it that people will never understand this? No. Until this information actually gets impact future earnings. Now this is what these effects is. So what does it mean? Point number one, persistence of your current earnings depends on whether your earnings are caused by accruals or it is driven by cash. Point number one. The finding from this paper, which it does not mention in the abstract, is that if earnings are driven by accruals, they are unlikely to be persistent. Earnings driven by cash are likely to be persistent. That is the second finding. Point number three, markets immediately when the earnings are announced, markets do not distinguish between cash and accrual, this is very, very surprising. He test this on the US market, it is supposed to be the most efficient market. And we all looked at this in many emerging market settings and that's what we find more or less in line with Sloan. So that's the third point. Fourth point is that this kind of anomalous behavior, this kind of the sort of ignoring of the signals which one could have detected, persists until future earnings get actually impacted. So you have this time between announcement of current earnings to announcement of future earnings to make money in this strategy. So this is the message that I do get from Sloan's paper. Let's carry on in the next phase, I will tell you the exact strategy. How does he create this accrual variable? And then we'll take you to an example. We will tell you the numbers, what we get when we analyze this on India.
