Transcription

• Speaker #0

  So we often think being well-informed is just about keeping up with the daily news cycle, right?

• Speaker #1

  Yeah, absolutely. But what if truly understanding what's going on, especially financially, meant seeing these underlying patterns?

• Speaker #0

  Patterns that could maybe signal where a company's stock is headed?

• Speaker #1

  Exactly. That's the kind of deeper level we're getting into today. We actually got a really interesting piece of academic research sent in by one of you listening.

• Speaker #0

  Oh, great.

• Speaker #1

  Yeah, and it looks into just that kind of pattern. Maybe a surprising clue. about future stock performance.

• Speaker #0

  Okay, I like the sound of that. So today we're doing a deep dive into something called high accruals momentum.

• Speaker #1

  Sounds a bit technical, maybe.

• Speaker #0

  It does, it does. But the core idea, I think, is pretty insightful. The research is behind the paper. It's titled High Accruals Momentum.

• Speaker #1

  Shouting Hao, Juwan Zhang, and Yunzhu Li.

• Speaker #0

  Right. They basically suggest that if a company consistently reports high levels of what they call discretionary accruals. four years straight. Four years, yeah. That could actually be a pretty big warning sign for investors.

• Speaker #1

  And this isn't just a small study either. They looked at a lot of data. We're talking 1980 right through to 2016. Wow. Yeah, covering NYSE, Amex, Nasdaq, common stocks. So it's pretty robust.

• Speaker #0

  Okay, so our mission today then is to unpack this. What is high accruals momentum? What are these discretionary accruals anyway? Why might it matter to you listening? And, you know, what did the research actually find about the impact on stock returns?

• Speaker #1

  We want to make it clear, right? Give you those actionable insights without drowning you in accounting jargon.

• Speaker #0

  Exactly. Aiming for clarity. So, OK, let's start at the beginning. Accruals. In accounting, what are we talking about?

• Speaker #1

  OK, simply put, accruals are basically about a timing difference. It's the gap between when a business transaction actually happens.

• Speaker #0

  Like making a sale or providing a service.

• Speaker #1

  Right. And when the cash actually changes hands. So you might record revenue when you earn it. even if the customer pays you later. That difference is managed through accruals.

• Speaker #0

  Okay, got it. So it reflects the business activity, not just the cash in the bank account rate this second. Now, the research specifically mentions discretionary accruals. What makes them discretionary?

• Speaker #1

  Yeah, this is the key part. So some accruals are pretty standard, very predictable based on how the business operates. Think like standard accounts receivable. But there's another component where management has more judgment. more flexibility in how they estimate and report things. That's the discretionary piece.

• Speaker #0

  Ah, so it's less automatic, more subjective.

• Speaker #1

  Exactly. And researchers, like in this paper, use specific accounting models. You might hear names like the Jones model or the modified Jones model to try and estimate that part. They're trying to isolate the atrules that reflect management's choices.

• Speaker #0

  Okay, choices. So why might management use this flexibility, this discretion? What's the incentive?

• Speaker #1

  Well, the big implication, and what the research digs into, is the potential to manage reported earnings.

• Speaker #0

  Oh, okay. So smoothing things out, maybe making performance look a bit better or more consistent than the raw cash flow might suggest.

• Speaker #1

  That's the idea. It's about potentially influencing how the company's performance is perceived.

• Speaker #0

  Okay, interesting. So we have accruals and this discretionary part management can influence. How does this connect to the main idea, high accruals momentum?

• Speaker #1

  Right. So the study defines high accruals momentum very clearly. It's when a company doesn't just have high discretionary accruals in one year, but consistently reports high levels for four years in a row.

• Speaker #0

  Four consecutive years, that feels like a deliberate pattern, not just a one-off adjustment.

• Speaker #1

  Exactly. The researchers see it as a sustained pattern, potentially indicating that management is consistently using these accounting judgments, perhaps to inflate reported earnings over time.

• Speaker #0

  Is this something you see a lot? Is it common for companies to have this four-year streak?

• Speaker #1

  Well, that's actually one of the interesting findings. No, it's relatively rare. Oh. Yeah. Across that whole period, 1980 to 2016, they found high accruals momentum in only about 1% of all the company year observations they looked at.

• Speaker #0

  Only 1%. Wow.

• Speaker #1

  And on the flip side, low accruals momentum, consistently low discretionary accruals for four years. That was also pretty rare, maybe around 1.4%.

• Speaker #0

  So the fact that it's uncommon might make it a stronger signal when you do see it?

• Speaker #1

  That's the thinking. It's not just noise. It's a distinct pattern that stands out. When it does happen, the research suggests maybe we should pay attention. OK,

• Speaker #0

  that makes sense. So what kinds of companies tended to show this rare pattern? Did the research identify any common characteristics?

• Speaker #1

  Yes, they did find some common traits among these high accruals momentum firms. They tended to be smaller companies, lower market capitalization. OK,

• Speaker #0

  smaller firms.

• Speaker #1

  Anything else? They also typically had lower leverage ratios, so less reliant on debt financing.

• Speaker #0

  Interesting. Smaller, less debt.

• Speaker #1

  What else? And interestingly, they often had higher book to market ratios, you know, the kind of ratios sometimes associated with value stocks. And they also showed a higher ROA return on assets.

• Speaker #0

  That's a bit of a mixed bag. Smaller, less debt, but high book to market and seemingly high profitability based on ROA. Any theories on why these traits cluster together with high accruals momentum?

• Speaker #1

  Well, the researchers speculate a bit. For smaller firms, maybe there's just less scrutiny, fewer analysts following them, perhaps giving management more leeway. Right.

• Speaker #0

  Less spotlight.

• Speaker #1

  The lower leverage maybe means less pressure from creditors or maybe it's linked to the way they're managing earnings, perhaps making them look like they don't need debt. And the high ROA, well, that could create pressure, couldn't it? Pressure to keep reporting strong numbers, maybe leading them to use discretionary accruals if the underlying business isn't quite keeping up.

• Speaker #0

  OK, that paints a picture. So we know what it is. Who tends to show it? Now, the big question, what did the research find about future stock performance? Is this pattern actually a red flag?

• Speaker #1

  This is really the core of the study. And yes, the findings are pretty stark. Firms identified with high accruals momentum tended to have significantly lower stock returns. and the following periods.

• Speaker #0

  Lower returns.

• Speaker #1

  Okay. And what about the opposite, the low accruals momentum firms?

• Speaker #0

  They found the reverse. Firms with consistently low discretionary accruals tended to experience higher subsequent stock returns.

• Speaker #1

  So it really seems like the market eventually reacts negatively to that sustained high accruals pattern.

• Speaker #0

  It suggests that, yes, the market might initially be fooled or maybe just slow to recognize the pattern, but eventually it seems to catch up.

• Speaker #1

  Can we put some numbers on that? How significant was the difference in returns?

• Speaker #0

  They tested a strategy basically going long the low accruals momentum stocks and shorting the high accruals momentum stocks.

• Speaker #1

  A hedge portfolio, yeah.

• Speaker #0

  Exactly. And they found the strategy generated statistically significant positive abnormal returns, meaning returns above what you'd expect given the risk over the next three, six and 12 months.

• Speaker #1

  And the size of those returns?

• Speaker #0

  Well, one calculation they ran suggested an annualized abnormal return of around 13.2%.

• Speaker #1

  13%. That's not trivial. That's a substantial potential edge if this holds.

• Speaker #0

  It's definitely a number that makes you sit up and take notice. Absolutely. So, okay, why? Why does this happen? The researchers dug into two main possibilities, right? Was it just earnings management or something else?

• Speaker #1

  That's right. They considered two main hypotheses. The first, as we've kind of hinted at, is the earnings management explanation.

• Speaker #0

  The idea that managers are actively manipulating the numbers and eventually the market figures it out or there's a correction.

• Speaker #1

  Precisely. Maybe future earnings disappoint or there are restatements and the stock price adjusts downwards. The second idea was the growth anomaly.

• Speaker #0

  Ah, the puzzle where high growth stocks sometimes underperform lower growth or value stocks.

• Speaker #1

  Exactly. So the question was, maybe these higher cruels are just a sign of a high growth company and the subsequent low returns are just part of that phenomenon. Not necessarily related to shady accounting.

• Speaker #0

  OK, two plausible stories. How did they try to disentangle those? How did they test whether it was really about earnings management or just growth?

• Speaker #1

  They did some clever analysis. They looked at the relationship between accruals, momentum and future returns. But then they specifically controlled for various measures of actual company growth.

• Speaker #0

  What kind of measures?

• Speaker #1

  Things like the book to market ratio again. Right. But also asset growth, growth in the number of employees trying to get a handle. on how much these firms were really expanding.

• Speaker #0

  OK, so they separated the firms based on growth. What happened then? Did the low return effect disappear for the high growth firms that also had high accruals momentum?

• Speaker #1

  Actually, no, it was kind of the opposite. This was a key finding. The negative link between high accruals momentum and future returns was stronger, more pronounced for firms. that actually had low growth according to those indicators. Wow.

• Speaker #0

  Okay. So if you have high accruals momentum and you're not actually a high growth company, the market reacts even more negatively later.

• Speaker #1

  That's what the evidence suggests.

• Speaker #0

  So what does that tell us about the two explanations?

• Speaker #1

  It strongly points toward the earnings management explanation being more likely. If it were just a proxy for growth, you wouldn't expect the effect to be stronger in low growth firms.

• Speaker #0

  Right. It suggests investors become particularly skeptical when they see high accruals that aren't backed up. by strong underlying business growth. It raises questions about the quality of those earnings.

• Speaker #1

  Exactly. It makes the high accruals look less like investment for the future and more like, well, something else.

• Speaker #0

  OK, that's a really important distinction. Now, you mentioned earlier this general idea, the accruals anomaly, that high accruals often mean lower future returns. That's been around a while. But didn't the study say something about that maybe fading?

• Speaker #1

  Yes, that's another fascinating layer to this. There's other research suggesting that the general accruals anomaly, just looking at one year's worth of accruals, might have weakened or even disappeared in the U.S. market, particularly after maybe 2004 or so.

• Speaker #0

  Maybe because investors got wise to it. Or Sarbanes-Oxley changed things.

• Speaker #1

  Could be a combination of factors. Markets adapt, regulations change. But the basic idea is that the simple one-year accrual signal might not be as potent as it once was.

• Speaker #0

  OK, so if the general anomaly faded, what about this momentum version? Did the four-year pattern also lose its predictive power?

• Speaker #1

  And this is the kicker? No, it didn't. The researchers found that the predictive power of high accruals momentum, that four-year streak, remains strong and significant. even in the periods after the general anomaly seemed to dissipate.

• Speaker #0

  Whoa. Okay, so this isn't just the old anomaly in disguise. It's something distinct.

• Speaker #1

  That's what it looks like. It suggests that looking at the consistency, the multi-year pattern, provides different information, information that the market still seems to react to, even if it's gotten better at pricing in single-year accrual levels.

• Speaker #0

  That's really interesting. So the persistence of the behavior matters.

• Speaker #1

  It seems so. A sustained pattern sends a different, perhaps stronger, signal.

• Speaker #0

  Did they look at anything else like how this interacts with, say, earnings surprises?

• Speaker #1

  They did. They wanted to see if the market's reaction changed depending on whether a company hit, beat, or missed its earnings targets.

• Speaker #0

  And does a negative surprise make things worse for a high accruals momentum firm?

• Speaker #1

  Yes. They found the negative relationship between high accruals momentum and subsequent returns was significantly more pronounced for companies that also reported negative earnings surprises.

• Speaker #0

  That makes intuitive sense. If you've got this history of... of potentially aggressive accounting, and then you miss your numbers. Right.

• Speaker #1

  Kind of validates the skepticism, doesn't it? Investors might think, ah, see, those high accruals weren't sustainable, and react more strongly. It suggests maybe investors scrutinize that accrual history more closely when things start to go wrong operationally. OK.

• Speaker #0

  And just to be thorough, they did all the usual checks, right? Robustness tests, making sure this wasn't just some fluke in the data or how they measured things.

• Speaker #1

  Oh, absolutely. Standard practice and good academic research. They tried measuring momentum over three years, five years, not just four. Looked at total accruals, not just discretionary. Even looked at non-discretionary accruals momentum. Okay. They checked pre and post Sarbanes-Oxley. Across the board, the main finding generally held up. High discretionary accruals momentum consistently pointed towards lower future returns.

• Speaker #0

  And did they find anything interesting about the non-discretionary part, the more operational accruals?

• Speaker #1

  Yes, actually. they found that consistently low non-discretionary accruals momentum could also be seen negatively, which kind of makes sense if the basic operational accruals are consistently low. Maybe that signals weakness in the core business itself.

• Speaker #0

  Huh. So it's not just about the discretionary choices. Extremely low operational accruals might be a different kind of warning sign about fundamental health.

• Speaker #1

  Potentially, yes. It adds another layer of nuance.

• Speaker #0

  Okay. So wrapping this all up, what's the main takeaway here for you? listening to this deep dive.

• Speaker #1

  I think the big message is that consistency matters. A sustained pattern in this case, four years of high discretionary accruals seems to be a pretty meaningful negative signal for future stock performance.

• Speaker #0

  And it's not just capturing the old accruals anomaly. It seems to be providing distinct information, possibly linked to sustained earnings management that persists even when the market might have adjusted to simpler signal.

• Speaker #1

  Exactly. It's that multi-year aspect that seems key.

• Speaker #0

  So practically speaking, while obviously not investment advice, this suggests that looking beyond just one quarter or one year's financials could be really valuable. Watching for these kinds of persistent patterns, especially maybe in those smaller, lower leverage firms the study highlighted.

• Speaker #1

  Right. It encourages digging a bit deeper, looking at trends over time and how a company reports its performance. It's another piece of the puzzle to consider when you're evaluating a company.

• Speaker #0

  Definitely food for thought. It really makes you wonder, doesn't it, what other multi-year patterns, maybe beyond just accruals, might be hiding clues about a company's future that we should be looking for.

• Speaker #1

  That's a great question to ponder. Are there other consistent signals in financial statements, maybe in cash flows or investment patterns, that can tell a similar story over time?

• Speaker #0

  Something for all of us to think about. And hey, if you come across research or have thoughts on that or anything else you'd like us to explore, please send it our way. We love getting suggestions for future deep dives.

• Speaker #1

  Absolutely.

• Speaker #0

  keep them coming thanks everyone for joining us for this depth dive into hyacruel's momentum