PRICE MOMENTUM ANOMALY

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CHAPTER 3 OVERVIEW OF THE ACCRUAL ANOMALY AND FUNDAMENTAL DATA LITERATURE

INTRODUCTION

This chapter reviews the literature of the accrual anomaly initially documented by Sloan (1996:289-315) and a wide array of fundamental literature. The accrual anomaly is closely related to the fundamental literature given that it is a manifestation of fundamental analysis. The accrual anomaly is the most robust, researched and perhaps only fundamental anomaly. A large body of literature focuses on different aspects of fundamental analysis, claiming to have discovered different fundamental anomalies. These include but are not restricted to aggregating fundamental signals to predict future share price returns, calculating probabilities of bankruptcy using fundamental data and testing the implications of the different uses of free cash flows. Fundamental analysis has provided significant insight into what drives future earnings and it is this insight that is critical in understanding what drives fundamental momentum of future earnings.
The remainder of this chapter is structured as follows: Section 3.2 reviews the accrual anomaly literature. A brief history of the anomaly is discussed in Section 3.2.1. This is followed by Section

defining the accrual component of earnings, which has evolved

over time. Sections 3.2.3 and 3.2.4 review the literature and discuss possible explanations of why the anomaly has not been arbitraged away. Section 3.2.5 discusses whether the accrual anomaly is prevalent in markets around the world. Section 3.3 reviews literature on fundamental analysis, which has made significant contributions to understanding the drivers of future earnings.

ACCRUAL ANOMALY

In its simplest form, accrual accounting allows a company to record expected future cash flows or expenses in the current financial period. A company’s earnings are therefore divided into two parts – an accrual component, which is an estimate of future cash flows accounted as earnings today, and a cash flow component, which shows the portion of earnings that were actually brought in by way of cash receipts. Given that the accrual component is an estimate of future cash flow, the reliability of the accuracy of the estimate is questionable. For this reason, Sloan (1996:289-315) undertook a study to test the persistence of future earnings given varying compositions of accruals and cash flows in current earnings. While the results of the study indicated that the level of persistence of earnings was lower as the accrual component of earnings increased, what was more fascinating was that investors appeared to be ignorant of this fact, and thus the accrual anomaly was discovered. Over the years, as investors have become more aware of the accrual anomaly, it is argued that the anomaly has been arbitraged away (Green, Hand & Soliman, 2011:803).

Brief history of the accrual anomaly

The accrual anomaly is largely credited to Richard Sloan following his 1996 research paper. Sloan (1996:289-315) initially set out to test the hypothesis that investors fixate too heavily on earnings and fail to take into account information contained in the accrual and cash flow component of a company’s earnings. This is what has subsequently become known as the earnings fixation hypothesis (EFH). To test this hypothesis, the level of earnings persistence needed to be tested based on the composition of the earnings. Therefore, Sloan (1996:291) first tested the hypothesis that the accruals of companies with soaring inventory and receivables turn out to be worth less than their original carrying value, which, in turn, results in their earnings being of lower quality and, therefore, less likely to persist into the future. To test the hypothesis that earnings driven by accruals are of lower quality than those driven by cash flows, Sloan (1996:301) first ranked companies and placed them into decile portfolios based on their level of earnings. He then tested to see whether earnings were persistent around the ranking year by comparing the earnings in the five years leading up to the ranking year and the five years following the ranking year. The results of the event-time plot show that earnings are persistent in the sense that, if a firm produces a high (low) level of earnings, on average, this year, they are likely to have produced a high (low) level of earnings in recent years, and are likely to continue to produce a high (low) level of earnings in the near future.
Next, Sloan formed two more sets of decile portfolios by ranking stocks on their level of accruals and their level of cash flows, and then compared the persistence of the earnings of the highest and lowest ranked decile portfolios on a time plot. Again, while a high (low) level of earnings remained persistent for both sets of portfolios, they were far more persistent when the high (low) level of earnings were accompanied by a high (low) level of cash flows as opposed to high (low) level of accruals. The outcome of the study indicates that the accrual component of earnings results in future earnings which are less persistent than they otherwise would have been if they were attributable to the cash flow component. Thus, while both components of current earnings are shown to contribute to future earnings, future earnings are less likely to persist if they are primarily attributable to the accrual component as opposed to the cash flow component (Sloan, 1996:301).
The critical part of Sloan’s (1996:289-315) research, which is discussed in Section 3.2.3, was determining whether the EFH was accepted or not, because it was this hypothesis that determined whether there was an anomaly or not. Suffice it to say that the accrual anomalywas found to exist. Over the years following Sloan’s original research, a great deal of interest in the accrual anomaly has been generated. To name but a few, the definition of accruals has been expanded beyond that of working capital only; the anomaly has been tested across markets around the world; the different components of the accruals have been researched to try and understand which component accounts for the majority of Sloan’s (1996:301) findings and whether the anomaly is actually profitable in practice.

Defining accruals

Depending on which research paper one reads, the definition and calculation of accruals vary. Tracing the definition back to Healy (1985:86), accruals were originally defined as the difference between reported earnings and cash flows from operations. Perhaps a slightly more informative, yet very broad, definition of accruals states that accruals account for future expected cash flows that will flow as a result of net assets that are currently held or owned. Sloan (1996:293) uses a narrower definition in that the definition includes net operating assets only, and excludes non-operating assets, non-operating liabilities and financial assets and liabilities.
The obvious shortcoming of Sloan’s (1996:289-315) research lies in the narrow definition of accruals, given that many accruals which relate to non-current operating assets, non-current operating liabilities, non-cash financial assets and financial liabilities are omitted (Richardson et al., 2005:445). Without accrual accounting, the only balance sheet item would be cash and thus Richardson et al. (2005:446) expanded on Sloan’s original definition of accruals, by employing a far more comprehensive definition, which includes those previously excluded line items. Excluding such items from the definition removes the future benefits that would otherwise accrue to a company as a result of the balance sheet items. This is an erroneous oversight given the fact that they all form part of the accrual accounting process.
Richardson et al.’s (2005:446) definition of accruals consists of three sub-components, forming a complete decomposition of the balance sheet. The first sub-component focuses on the nature of the underlying business activity, reported by the change in non-cash working capital. The second sub-component is the change in non-current operating accruals, consisting of the change in non-current assets less the change in non-current liabilities. This sub-component of accruals has been ignored in the literature up to this point. The final sub-component is the change in net-financial assets excluding cash. Thus, their definition of accruals is as follows:
The first term of Richardson et al.’s (2005:446) definition is the core of Sloan’s (1996:293) definition discussed above. The three terms of Richardson et al.’s (2005:446) definition are further decomposed into their asset and liability components. However, this is discussed in Chapter 5.
A further improvement was proposed by Hirshleifer, Hou, Teoh and Zhang (2004:303), who argue that a better measure of earnings quality is produced by aggregating accruals over the life of a company. The methodology of Richardson, Sloan, Soliman and Tuna (2006:727) disagrees with Hirschleifer et al.’s (2004:303) definition, given that their methodology requires aggregate accruals in the current year to be divided by aggregate accruals in previous years, which is essentially the same as measuring accruals over one year, given that the denominator and numerator will cancel each other out. Richardson et al. (2006:727) found that earnings quality was best measured by aggregating accruals over the past two years. The vast body of literature recording the accrual anomaly is proof that despite the definition employed, the accrual anomaly persists. Despite the numerous definitions of accruals that have been employed over the years, the results and conclusions drawn from the various studies discussed do not deviate substantially from one another. Thus, despite the definition, the persistence of earnings is stronger when those earnings are backed by a high degree of cash flow, as opposed to accruals, and are thus higher quality earnings.

Accruals and the anomaly

Investors need to be able to profitability exploit the accrual and cash flow findings of Sloan’s (1996:289-315) research in order for it to be termed an anomaly, otherwise it remains interesting research from an accounting perspective, with no real-world implications for capital market theory. Therefore, the second hypothesis of Sloan’s (1996:289-315) research nvolved testing whether market participants understood the impact of accruals on the persistence of future earnings, and whether or not it was accurately reflected in share prices. Share price returns are susceptible to a large number of factors over the short to medium term; however, it is widely accepted that the underlying driver of share price returns in the long run is earnings. Therefore, if investors are aware that companies with a high level of accruals today are likely to have a lower level of future earnings, they should be pricing this information timeously so that there are no abnormal future returns when the lower level of future earnings materialises. Likewise, for companies with a high level of cash flows, future earnings are expected to be more persistent, which should be reflected in current share prices to avoid future abnormal returns. Persistent failure to recognise the accrual and cash flow effects on future earnings will result in abnormal future returns and, in turn, what researchers refer to as an ‘anomaly’. Sloan (1996:292) developed three sub-hypotheses under the hypothesis, questioning whether share prices fully reflect the information contained in accruals and cash flows. The first sub-hypothesis deals with whether earnings expectations embedded in share prices reflect the persistence of earnings based on the level of accruals and cash flows. The second sub-hypothesis tests whether abnormal share returns can be generated by forming a hedge portfolio by going long on shares with a low level of accruals, while simultaneously, going short on shares with a high level of accruals. The final sub-hypothesis tests whether the abnormal returns are clustered around earnings announcement dates. The results of the above three sub-hypotheses unequivocally indicate that share prices do not reflect the information contained in accruals and cash flows and their subsequent effect on future earnings (Sloan, 1996:303), that a hedge portfolio constructed on the level of accruals generates abnormal returns (Sloan, 1996:306) and that over 40% of the abnormal return is generated around the earnings announcement (Sloan, 1996:312).

ACKNOWLEDGEMENTS
ABSTRACT
LIST OF TABLES 
CHAPTER 1 INTRODUCTION 
1.1 INTRODUCTION
1.2 PROBLEM STATEMENT
1.3 RESEARCH QUESTIONS.
1.4 IMPORTANCE AND BENEFITS OF THE STUDY
1.5 CONTRIBUTION OF THE STUDY.
1.6 DELIMITATIONS.
1.7 ASSUMPTIONS
1.8 STRUCTURE OF THE STUDY
CHAPTER  2 OVERVIEW OF PRICE MOMENTUM AND EARNINGS MOMENTUM
2.1 INTRODUCTION
2.2 PRICE MOMENTUM ANOMALY
2.3 EARNINGS MOMENTUM ANOMALY
2.4 SUMMARY
CHAPTER 3 OVERVIEW OF THE ACCRUAL ANOMALY AND FUNDAMENTAL DATA LITERATURE
3.1 INTRODUCTION
3.2 ACCRUAL ANOMALY
3.3 FUNDAMENTAL DATA ANALYSIS
3.4 SUMMARY
CHAPTER 4 OVERVIEW OF THE SOUTH AFRICAN MARKET AND RELEVANT LITERATURE
4.1 INTRODUCTION
4.2 RELEVANT LITERATURE
4.3 SUMMARY
CHAPTER 5 RESEARCH DESIGN AND METHODS 
5.1 INTRODUCTION
5.2 NATURE OF PANEL DATA.
5.3 DATA
5.4 CURRENT RESEARCH
5.5 SUMMARY
CHAPTER 6 THEORETICAL EXPECTATIONS
6.1 INTRODUCTION
6.2 SIZE AND VALUE FACTORS
6.3 PRICING FUNDAMENTAL MOMENTUM OF EARNINGS
6.4 EXPLAINING FUNDAMENTAL MOMENTUM OF EARNINGS
6.5 INTERPRETING THE FUNDAMENTAL MOMENTUM REGRESSION RESULTS
6.6 SUMMARY
CHAPTER 7 RESULTS ANALYSIS: PRICE MOMENTUM
7.1 INTRODUCTION.
7.2 PROFITABILITY OF PRICE MOMENTUM STRATEGIES ON THE JSE
7.3 RISK FACTORS AND PRICE MOMENTUM
7.4 SUMMARY
CHAPTER 8 RESULTS ANALYSIS: EARNINGS MOMENTUM 
8.1 INTRODUCTION.
8.2 PROFITABILITY OF EARNINGS MOMENTUM STRATEGIES ON THE JSE
8.3 RISK FACTORS AND EARNINGS MOMENTUM
8.4 SUMMARY
CHAPTER 9 RESULTS ANALYSIS: PRICING FUNDAMENTAL MOMENTUM
9.1 INTRODUCTION
9.2 PPROFITABILITY OF FUNDAMENTAL MOMENTUM STRATEGIES ON THE JSE.
9.3 RISK FACTORS AND FUNDAMENTAL MOMENTUM
9.4 FUNDAMENTAL MOMENTUM OVER CONSECUTIVE YEARS
9.5 SUMMARY
CHAPTER 10 RESULTS ANALYSIS: FUNDAMENTAL MOMENTUM OF THE UNDERLYING EARNINGS COMPONENTS
10.1 INTRODUCTION
10.2 DESCRIPTIVE STATISTICS
10.3 MEAN REVERSION
10.4 FUNDAMENTAL MOMENTUM MODELS
10.5 SUMMARY
CHAPTER 11 RESULTS ANALYSIS: PRICE MOMENTUM, EARNINGS MOMENTUM AND FUNDAMENTAL MOMENTUM
11.1 INTRODUCTION.
11.2 PRICE MOMENTUM AND FUNDAMENTAL MOMENTUM
11.3 EARNINGS MOMENTUM AND FUNDAMENTAL MOMENTUM
11.4 SUMMARY
CHAPTER 12 CONCLUSION AND RECOMMENDATIONS
12.1 INTRODUCTION
12.2 PRICE MOMENTUM AND EARNINGS MOMENTUM ON THE JSE
12.3 FUNDAMENTAL MOMENTUM AS A NEW TRADING STRATEGY
12.4 FUNDAMENTAL MOMENTUM OF EARNINGS COMPONENTS
12.5 FUNDAMENTAL MOMENTUM, EARNINGS MOMENTUM AND PRICE MOMENTUM
12.6 LIMITATIONS
12.7 RECOMMENDATIONS FOR FUTURE STUDIES
13 APPENDICES 
Appendix
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