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Magazine Issues » March 2010

INSIDE VIEW: a word to the wise

Research finds that conventional wisdom about earnings-led strategies may not be so clear cut, say Xavier Gerard and Christos Koutsoyannis of State Street Global Advisor

owl.jpgFund managers who employ an earnings-quality strategy based on accruals rather than realised cash flows tend to perform well when investor sentiment is high, but often perform poorly when investor sentiment is low. This clashes with investment wisdom.

For many professional investors, strategies based on the concept of earnings quality (buy high-quality firms and sell low-quality ones) have become a prevalent investment theme. Furthermore, professional investors have come to see earnings-quality strategies as a way to protect their portfolios during difficult market conditions.

Earnings quality refers to the ability of reported earnings to represent a company’s future earnings. As such, earnings quality is an important aspect of evaluating a firm’s financial health. In light of recent high-profile accounting scandals, it is no surprise that regulators and investment professionals have been giving a great deal of attention to this measurement.

Earnings quality can be measured by distinguishing a company’s earnings into two broad components: its cash earnings and its accrued earnings. The former are the cash flows from operations (CFO) or those that have actually materialised. The latter, also known as accruals, are those that are based on logged transactions but have yet to materialise. Accruals can be viewed as the difference between net income and cash earnings.

Unlike the cash component of earnings, accruals are estimated and hence contain a degree of subjectivity. Moreover, accruals are prone to manipulation by managers who wish to boost their reported earnings numbers. High accruals could be taken to indicate that the future strength of the firm is not guaranteed. These firms are most at risk of experiencing negative earnings surprises and adverse market performance in the future. Conversely, a high cash component of earnings is suggestive of a lower level of earnings management or estimation error.

The traditional view is that accruals and cash flow should be negatively correlated, since accruals help smooth out noisy fluctuations in earnings caused by the timing and matching problems of realised cash flow. As a result, it is typically assumed that a CFO-based investment strategy that buys high CFO firms and sells low CFO firms should be positively correlated and produce similar returns to an accruals-based investment strategy that buys low accrual firms and sells high accruals firms.

However, in recent years some academic papers have cast doubt on this assertion, arguing that the link between accruals and cash flow is far from clear. In line with the principle of conservative accounting, firms in distress will often record large negative accruals. Since these firms also typically have low cash flows, a positive relationship between the two components of earnings might be observed.

To take the debate forward, SSGA conducted an in-depth analysis of the relationship between cash flows and accruals using the US and UK stock markets as research samples. The findings, which appear in a recent paper entitled A Tale of Two Strategies: Cash Flow, Accruals and the Role of Investor Sentiment, starkly contradict conventional wisdom.

First, as with previous studies, there is a significant proportion of negative cash flow firms in both the high and low accruals portfolios. Although the presence of negative cash flow firms in the high accruals portfolio is expected from the smoothing function of accruals, the presence of negative cash flow firms in the low accruals portfolio is surprising. The analysis shows that firms with both negative accruals and negative cash flows are an important driver of the performance of both the accruals and the cash flow-based strategies. When these firms perform well, the performance of the accruals strategy is strong while the performance of the cash flow strategy is weak. Conversely, when they perform poorly, the reverse is true. Firms with negative accruals and negative cash flows have characteristics of distressed securities. They are small in size and have high balance sheet risk as evidenced by low Altman’s Z scores as well as high default probabilities as implied by the Merton’s model.

Second, the asymmetric exposures of the accruals and cash flow-based strategies to firms in distress lead to a strong and pervasive negative correlation between the returns of each strategy. From the cumulative returns of the accruals and cash flow-based strategies in our US and UK samples, it is apparent that the negative correlation between these two earnings quality strategies was at its strongest point during the post-bubble period. However, in other periods as well, the correlation between the cash flow and the accruals-based strategies appears surprisingly low for two supposedly similar proxies for earnings quality.

Third, the analysis examines the performance of these earnings quality-based strategies under various market environments. Conventional wisdom would suggest that quality-based strategies should perform well during turbulent times, when investor sentiment is low. We construct a sentiment index using readily available proxies of investor sentiment, and examine periods of high and low investor sentiment over the last two and a half decades in different regions.

Crucially, in contrast to common belief, we find that a strategy based on accruals (avoiding firms that report high accruals) tends to perform well only when investor sentiment is high. A cash flow strategy, however, tends to perform well only when sentiment is low.

Our findings on the asymmetric role of investor sentiment in the performance of the two strategies can be linked to their asymmetric exposures to financially distressed securities. These firms, which constitute highly speculative investments, are particularly sensitive to investor sentiment. When sentiment is high, they tend to perform well. When sentiment is low, they tend to perform poorly.

The results have important implications for academics and portfolio managers alike. They address the relationship between cash flow- and accruals-based strategies from a different perspective compared to previous studies and as a result make a significant contribution to the understanding of both strategies as well as the dynamics between them.

The conclusions for the accruals-based strategy, along with previous findings that such an investment strategy has a positive exposure to financially distressed firms, cast some serious doubts on the widely held view in the investment community that accruals measure earnings quality and might offer some protection to investors during turbulent times. The study shows that the accrual component of earnings, the traditional proxy of earnings quality, has historically offered little protection during difficult times.

Finally, the research highlights the significant impact of investor sentiment on the performance of accruals- and cash flow-based strategies. Practitioners might find this useful for dynamically allocating between the two as a function of expected sentiment.  Alternatively, investment managers could reduce the sensitivity of a quality strategy to market sentiment by combining accruals and cash flow strategies and in so doing take advantage of diversification benefits.

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