Spring 2009 NBA 5060

Lecture 13 – Predicting stock returns with fundamental analysis

1. Defining Abnormal Returns

2. Quality of Earnings and the Accrual Anomaly

3. The Predictable Cost of Earnings Manipulation

4. Identifying Overvalued Equity

5. Value-Glamour Strategies

6. A Refined Value Strategy

7. Intrinsic Value Calculations (RIM Shortcut) and Future Returns

Review Sessions (B01) Tuesday, March 3 Thursday, March 5

6-7pm Odelia D’Mello Manish Bhargava
7-8pm David Wu Ruchit Agarwal

Final Exam: Friday, March 6, 3pm to 6pm

Exam Rooms: Last Name Room

A through E B06
F through L B09
M through R B10
S through Z B05

No laptops. Bring a hand-held calculator. The exam is open-book, open-notes.

Lecture 13 Page 1 of 11
Does financial statement analysis allow you to profit from
stock selection?

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

Lecture 13 Page 2 of 11
Trading on the Quality of Earnings and Accruals

Recall the TATA ratio:

Net Incomet - Cash From Operations t

Total Accruals to Assets (TATA) =
Total Assets t

Strategy:

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

Lecture 13 Page 3 of 11
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 the
lowest M-Score (least likely to be a manipulator) and a short position in the 10% of firms
with the highest M-Score (most likely to be a manipulator).

Sample period: 1994-2003.

Lecture 13 Page 4 of 11
 Annual Abnormal Returns to PROBM Decile Portfolios

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%

-8.00%

-10.00%

-12.00%
Lowest 2 3 4 5 6 7 8 9 Highest
PROBM Portfolio Ranking

Lecture 13 Page 5 of 11
Identifying Overvalued Equity

Overvalued firms have not only a high likelihood of manipulation, but also the following
characteristics: negative operating cash flows, high sales growth, acquisitions over the
past 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 next
twelve months.

Strategy: Short firms having all five characteristics

Sample period: 1994-2003.

Lecture 13 Page 6 of 11
 One year ahead buy and hold size-adjusted returns for O-Score by MVE

15.00%

10.00%

5.00%

0.00%

-5.00%
Oscore=0
Oscore=1
-10.00%
Oscore=2
Oscore=3
-15.00% Oscore=4
Oscore=5
-20.00%

-25.00%

-30.00%

-35.00%
MVE < $100M $100M < MVE < $250M $250M < MVE < $500M $500M < MVE < $1000M < MVE
$1000M

Value-Glamour Strategies

Since Graham and Dodd (1934), academics and investment managers have argued
that stocks with high ratios of fundamentals to price (value stocks) such as book-to-
market (B/M) and earnings-to-price (E/P) outperform stocks with correspondingly low
fundamentals-to-price (glamour stocks).

Strategy: Take a long position in the 10% of stocks with the highest E/P or B/M ratios
and a short position in the 10% of stocks with the lowest E/P or B/M each year.

Sample period: 1973-1997

Lecture 13 Page 7 of 11
A Refined Value Strategy

Value firms could have low prices relative to fundamentals due to poor prospects (such
as financial distress), or because they are neglected by the market (recall lecture 11
notes).

Academic research examines the usefulness of fundamental analysis in separating the

eventual winners (those that are simply neglected but are otherwise fundamentally
sound businesses) from the eventual losers (those that have poor prospects).

Among firms with high book-to-market, identify those with the following characteristics:

Profitability Leverage, Liquidity, Source of Funds

ROA > 0 ΔLeverage < 0
CFO > 0 ΔLiquidity > 0
ΔROA > 0 Equity Issues = 0
CFO/TA > ROA
Operating Efficiency
ΔMargin > 0
ΔTurnover > 0

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

Lecture 13 Page 8 of 11
 Returnsto High B/M Firmsby F_SCORE
35.00%
30.00%
25.00%
20.00%
15.00%
10.00% Small
5.00% Medium
-AR
rn d
ju
te
s

0.00%
Large
-5.00%
M

-10.00%
re
ta
k

-15.00%
-20.00%
F-Score = 0 1 2 3 4 5 6 7 8 9

Trading on intrinsic value estimates (using the shortcut residual income model)

Use a three period expansion (we covered the 12 period expansion in the CBRL
shortcut RIM template in class)

Compare the intrinsic value estimate to the current stock price.

Buy and hold -- wait for the stock price to gravitate toward economic value.

Lecture 13 Page 9 of 11
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
Lecture 13 Page 11 of 11