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Does financial statement analysis allow you to profit fromstock selection?

There is a lot of research on the ability to generate abnormal returns. What doesthis mean?

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Trading on the Quality of Earnings and Accruals

Recall the TATA ratio:

t

tt

AssetsTotalOperationsFromCash-IncomeNet(TATA)AssetstoAccrualsTotal =

Strategy:

Take a long position in the 10% of firms with the smallest (most negative) accruals, and anoffsetting short position in the 10% of firms with the largest (most positive) accruals.

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Trading on the M-Score

Recall the M-Score indicates whether a company has characteristics of a manipulator.

Compute the M-Score for all firms. Take a long position in the 10% of firms with thelowest M-Score (least likely to be a manipulator) and a short position in the 10% of firmswith the highest M-Score (most likely to be a manipulator).

Sample period: 1994-2003.

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Annual Abnormal Returns to PROBM Decile Portfolios

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

Lowest 2 3 4 5 6 7 8 9 Highest

PROBM Portfolio Ranking

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Identifying Overvalued Equity

Overvalued firms have not only a high likelihood of manipulation, but also the followingcharacteristics: negative operating cash flows, high sales growth, acquisitions over thepast five years, and abnormal stock issuances over the past two years.

Firms meeting this profile lose a substantial amount of their market cap over the nexttwelve months.

Strategy: Short firms having all five characteristics

Sample period: 1994-2003.

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-35.00%

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

MVE < $100M $100M < MVE < $250M $250M < MVE < $500M $500M < MVE 0 Leverage < 0CFO > 0 Liquidity > 0

ROA > 0 Equity Issues = 0CFO/TA > ROA

Operating EfficiencyMargin > 0Turnover > 0

Give the firm 1 point for each these nine characteristic. Sum the number of points tocreate an F_Score.

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Market Efficiency Research Summary

What are potential concerns with this line of research?

Where do you think these strategies work the best?Lecture 13 Page 10 of 11

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