- Speaker #0
OK, let's let's dig into this. Thinking back, you know, to the early 2000s. Oh, yeah. Enron, WorldCom, Tyco, ESOL. It just felt like, wow, another accounting scandal every other week.
- Speaker #1
It really did. And suddenly those big numbers everyone focused on earnings balance sheets.
- Speaker #0
Yeah. They just didn't feel solid anymore, did they? People got really skeptical.
- Speaker #1
There was even that quote floating around, I think, from an analyst saying the statement of cash flows. was maybe the only thing you could actually trust.
- Speaker #0
Right. Which, you know, leads us straight to this really fundamental question we're tackling today.
- Speaker #1
Does the market like actually punish companies where there's this consistent gap, you know, between the earnings they report and the cash that's actually moving?
- Speaker #0
Exactly. It's one thing to feel suspicious, but does it does it actually hit the stock price long term?
- Speaker #1
That's the core of it.
- Speaker #0
And that is precisely what we are getting into today. We've got some some really interesting research focusing on. Something called accrual volatility.
- Speaker #1
Okay, sounds a bit technical maybe.
- Speaker #0
It does, but the idea behind it is, well, pretty straightforward actually. Accruals are basically the non-cash bits of accounting,
- Speaker #1
right? Right, like sales you booked but haven't collected cash for yet, or expenses you owe but haven't paid, stuff like that.
- Speaker #0
Exactly. So what these researchers did was measure how much those accruals bounce around, you know, quarter to quarter.
- Speaker #1
As a way to see how consistently the reported profit lines up with the actual cash flow.
- Speaker #0
Precisely. Because the thinking is over the long run, these accruals should kind of wash out. They should revert towards zero.
- Speaker #1
OK.
- Speaker #0
So if you see these really big persistent swings in accruals, it kind of flags a consistent difference between the profit a company claims and the cash it's really pulling in.
- Speaker #1
So the key isn't just having accruals. It's how much they jump around the volatility.
- Speaker #0
Yes. Why the focus on volatility specifically?
- Speaker #1
Well, it's that consistency of the difference that seems to matter. A company might have high accruals one quarter for perfectly normal timing reasons, you know? Sure.
- Speaker #0
A big sale at quarter end or something.
- Speaker #1
Exactly. But if there's repeatedly a big gap between earnings and cash flow quarter after quarter, that signals something different. Accrual volatility captures that ongoing pattern.
- Speaker #0
Okay. That makes sense. And here's where it gets, well, really fascinating. The main finding, the big takeaway from this research. is a really strong and long-lasting negative link between this accrual volatility and future stock returns.
- Speaker #1
Negative. So higher volatility means lower returns later on.
- Speaker #0
That's it. They found that if you hypothetically built a strategy, buying stocks with low accrual volatility and shorting stocks with high volatility, you could have potentially seen an average annual risk-adjusted return around 10%.
- Speaker #1
Wow. 10% risk-adjusted. That's... That's significant.
- Speaker #0
It really is. Now, obviously, we're not giving investment advice here. Don't run out and do this. Right.
- Speaker #1
Standard disclaimer.
- Speaker #0
But it strongly suggests that maybe paying closer attention to how earnings and cash flow relate could be pretty valuable looking at companies.
- Speaker #1
And connecting back, it really implies the market does seem to notice this disconnect over time. It penalizes firms where earnings and cash are consistently out of whack.
- Speaker #0
And what's striking, like you said, this isn't just about the Enrons and Worldcoms, the big fraud cases.
- Speaker #1
No, not at all. They looked at a huge range of companies, NYSE, NASDAQ, AMMX listed firms.
- Speaker #0
Yeah, over 20 years, right? 1988 to 2008.
- Speaker #1
That's right. And they found this deviation was widespread. It wasn't just a few bad apples.
- Speaker #0
And the numbers really show it. Across all those companies, the average connection, the correlation between quarterly earnings changes and quarterly cash flow changes was only, what, 0.55?
- Speaker #1
Yeah, about that. Kind of moderate.
- Speaker #0
But then the average link between changes in quarterly accruals and cash flow changes was... strongly negative, minus 0.78.
- Speaker #1
Minus 0.78,
- Speaker #0
whoa. It really drives the point home, doesn't it? When cash flow changes, it's actually more likely to be offset by an opposite move in accruals than it is to just flow through to the earnings number.
- Speaker #1
The accruals are acting like a buffer almost, smoothing things out.
- Speaker #0
Maybe sometimes smoothing things out a bit too much. It's almost like that post-Enron skepticism, you know, questioning the earnings numbers. Maybe it was tapping into something real and broader. even outside of outright fraud.
- Speaker #1
That's a really interesting way to put it. So, OK, what does this all mean for you listening in?
- Speaker #0
Well, it suggests that earnings, the number that grabs all the headlines, might not always give you the full, unbiased story of a company's real financial pulse.
- Speaker #1
Which brings us to the mission for this deep dive. We want to understand this, this accrual volatility anomaly.
- Speaker #0
Yeah. Why does this consistent gap between earnings and cash seem to predict? lower stock returns in the future.
- Speaker #1
And maybe more practically for you, how can you use this knowledge to, you know, be a smarter investor without getting lost in super complex financial weeds?
- Speaker #0
Okay, so we have this really intriguing pattern. High accrual volatility, lower future returns. The big question is why? What's going on underneath?
- Speaker #1
Right, what's the mechanism? The researchers explored a couple of main possibilities. The first one is something they call the earnings fixation hypothesis.
- Speaker #0
Earnings fixation.
- Speaker #1
Yeah, it connects right into investor psychology, which is always fascinating.
- Speaker #0
How so?
- Speaker #1
The idea is basically that investors tend to get really fixated on that reported earnings number. You know, the bottom line.
- Speaker #0
Sure, it's the headline figure.
- Speaker #1
Exactly. And maybe they don't fully grasp or perhaps appreciate the difference between the cash part of that number and the non-cash part, the accruals. OK. So for companies with high accrual volatility or maybe earnings are temporarily pumped up by aggressive accrual accounting, investors might get too optimistic. Right. They overvalue the stock because they're focused on that possibly inflated earnings number.
- Speaker #0
And the flip side. For low volatility companies.
- Speaker #1
Conversely, yeah. For companies where earnings trap cash flow more closely, low accrual volatility investors might actually underappreciate that stability and quality. They might undervalue those stocks.
- Speaker #0
OK, so it's like a potential mispricing based on focusing too much on the reported earnings and not enough on the, let's say, the quality or cash backing of those earnings.
- Speaker #1
Pretty much. The other main explanation they looked into revolves around information uncertainty.
- Speaker #0
Information uncertainty. How does accrual volatility create uncertainty?
- Speaker #1
Well, think about it. If a company's reported profits consistently look quite different from its actual cash coming in, it kind of suggests that management has more wiggle room, more discretion in how they paint the financial picture through accounting choices.
- Speaker #0
Ah, okay. More choices mean maybe less clarity for outsiders.
- Speaker #1
Exactly. That flexibility. While sometimes perfectly legitimate and necessary for accounting rules, can also make it tougher for investors to get a really clear, objective view of the underlying business reality.
- Speaker #0
Leading to uncertainty. Right.
- Speaker #1
And interestingly, the research did find that accrual volatility tends to be higher in companies where, for example, financial analysts disagree more about future earnings forecasts.
- Speaker #0
That makes sense. More disagreement means more uncertainty.
- Speaker #1
And also where the stock price itself is just generally more volatile day to day. It all kind of fits together.
- Speaker #0
It does. If it's harder to pin down the true performance, investors likely feel less sure-footed. They might demand a higher return or essentially pay a lower price to compensate for that extra uncertainty or risk.
- Speaker #1
Precisely. Now, we've talked about this pattern looking at groups of stocks, portfolios, but they also drilled down to see if it holds for individual companies. They did,
- Speaker #0
yeah, using, what was it, Fama-Macbeth regressions.
- Speaker #1
That's the one. It sounds complex, but think of it as a statistical way to test the impact of accrual volatility while controlling for other things we already know affect stock prices.
- Speaker #0
Like company size, value characteristics, book to market, momentum, the usual suspects.
- Speaker #1
Exactly. It's like trying to isolate the effect of just the accrual volatility stripping out those other influences.
- Speaker #0
And what did they find?
- Speaker #1
Even after accounting for all those other factors, they still found that yes, Higher accrual volatility was statistically linked to lower future returns for individual stocks. It wasn't just explained away by size or value effects.
- Speaker #0
OK, that's pretty compelling. And they were also careful to check if this was just like a different version of the standard accrual anomaly, weren't they?
- Speaker #1
Oh, absolutely. Critical point. The standard accrual anomaly is about the level of accruals companies with high total accruals tend to underperform.
- Speaker #0
Right. So you might think, well, maybe companies with high accruals just naturally have more volatile accruals, too.
- Speaker #1
That's the potential overlap you need to check. But they showed it's distinct. They did things like sorting stocks based on both the level of accruals and the volatility. Yeah. And they found the negative link between volatility and returns held up even within groups of stocks that had similar levels of accruals. High volatility hurt returns whether overall accruals were high or low.
- Speaker #0
I see. So it's not just the same thing measured differently.
- Speaker #1
No. They also checked the correlation between the two measures, high level versus high volatility, and found it wasn't super high. They seem to be capturing different aspects of the financial reporting.
- Speaker #0
Did they look at different types of accruals, too, like operating accruals versus maybe more discretionary ones? Yeah,
- Speaker #1
they did. They broke it down to see if the effect was stronger for certain types, maybe ones where management has more judgment involved.
- Speaker #0
And the results were consistent.
- Speaker #1
Pretty much. Yeah. Across different ways of measuring accruals, the volatility effect kept showing up, which really reinforces the idea that it's acting as this broader signal about the potential disconnect. between earnings and cash reality.
- Speaker #0
Regardless of the specific accounting lever being pulled, maybe.
- Speaker #1
That seems to be the implication.
- Speaker #0
Okay, now, thinking practically, any strategy that involves short selling, well, it raises questions about real-world feasibility, doesn't it?
- Speaker #1
Definitely. These limits to arbitrage ideas... Can you actually do this? Is it too costly or too difficult to short the high volatility stocks?
- Speaker #0
Right. Some stocks are hard to borrow, expensive to short, or maybe just too risky for many investors to touch on the short side.
- Speaker #1
So the researchers looked at this directly. They considered things like how volatile a stock's individual return is, how easy it is to trade its liquidity.
- Speaker #0
Did the effect disappear for harder to trade stocks?
- Speaker #1
No. they found the accrual volatility effect was still significant even after controlling for those factors.
- Speaker #0
What about trading costs? Bid-ask spreads and stuff.
- Speaker #1
They looked at that too. Using measures of transaction costs, they concluded that yes, while costs eat into profits, the anomaly still seemed potentially profitable, especially if you held the positions for longer periods, not just trading in and out constantly. Okay. And they even checked if the effect held up specifically for stocks that have options traded on them, since those are generally easier and cheaper to short.
- Speaker #0
And it did.
- Speaker #1
It did. The negative relationship was still there. So it doesn't look like it's just some theoretical finding that vanishes once you factor in real world fictions.
- Speaker #0
So the evidence stacks up. It seems like this isn't just, you know, an academic curiosity. It looks like it has real implications for market pricing.
- Speaker #1
That's definitely the strong suggestion. And it gets even maybe more profound than that.
- Speaker #0
How so?
- Speaker #1
They explored this really intriguing idea. Could accrual volatility actually be a fundamental pricing factor in the market?
- Speaker #0
A pricing factor, like alongside size, SMB, and value, HML, in the Fama French models?
- Speaker #1
Kind of like that, yeah. Is it capturing some kind of systematic risk or characteristic that investors collectively demand compensation for?
- Speaker #0
Okay. How would you test that?
- Speaker #1
They created a sort of mimic portfolio designed to capture the returns you'd get from going long, low volatility stocks and short, high volatility stocks.
- Speaker #0
Right, that 10% potential return strategy we mentioned.
- Speaker #1
Exactly. And then they checked if the returns of that hypothetical portfolio could help explain the returns of other well-known strategies, like portfolios sorted by size and book-to-market value.
- Speaker #0
Even after accounting for the standard factors themselves. Yes.
- Speaker #1
And they found that this accrual volatility factor did seem to have some explanatory power for the returns of those other portfolios.
- Speaker #0
Wow. So it's not just a potential source of alpha like outperformance.
- Speaker #1
It might actually be part of the underlying structure of market returns itself, capturing some kind of risk or characteristic that the market prices across the board.
- Speaker #0
That is that's a pretty deep thought.
- Speaker #1
It really is. And it just highlights how these seemingly subtle details in accounting reports can potentially have quite significant ripples through the market.
- Speaker #0
OK, let's try and pull this all together then for you, our listener.
- Speaker #1
Right. The main takeaway.
- Speaker #0
The key point from this deep dive seems clear. Higher accrual volatility, meaning a bigger, more consistent gap between reported earnings and actual cash flow, tends to be linked with lower future stock returns.
- Speaker #1
And we touched on the likely reasons why. Maybe it's investors being too focused on earnings and mispricing the accrual part. That's the earnings fixation idea.
- Speaker #0
Or maybe it's that high volatility acts like a warning sign, signaling more uncertainty about the company's real financial picture, the information uncertainty effect.
- Speaker #1
And this isn't some fleeting thing. The research suggests this accrual volatility anomaly is pretty robust.
- Speaker #0
Yeah, it holds up against common risk factors. It's distinct from the standard accrual anomaly. It seems to survive transaction costs and short selling limits, at least over time.
- Speaker #1
And it persists, too. Not just over a few months, but... but potentially for years they found effects looking out up to five years.
- Speaker #0
Plus that really intriguing possibility we just discussed, that accrual volatility might even be a broader pricing factor, reflecting something fundamental about how the market values companies.
- Speaker #1
Yeah, shaping returns overall.
- Speaker #0
So to leave you with something to chew on, now that we've gone deep into accrual volatility, what other... Maybe less obvious accounting metrics might hold hidden clues about where a company is headed.
- Speaker #1
As someone who's now equipped with this insight, how might you start looking at financial statements differently?
- Speaker #0
Yeah, looking beyond just the big headline numbers, trying to understand more about the story behind those numbers. What's really going on under the surface?
- Speaker #1
It definitely encourages a more critical, maybe more insightful way of looking at financial data.
