One of the most widely studied and persistent stock market inefficiencies ever identified is the "accrual anomaly". It was first documented by Richard Sloan of the University of Michigan in 1996 whose ground-breaking paper found that shares in companies with small or negative accrual ratios vastly outperform (+10% annually) those of companies with large ones

Sloan was apparently involved with auditing speculative mining companies before going into academia, which may have inspired him. In order to test out the longstanding view that investors fixate too heavily on corporate earnings and not on cash generation, he decided to rank companies based on their "accrual ratio" for last year's results, i.e the size of non-cash earnings relative to total assets. He then measured how their shares performed in the year after the results were announced, effectively "going long" the top decile of stocks with the lowest accrual ratio and "going short" the bottom decile with the highest accrual ratio. 

What are Accruals anyway? 

Accruals are estimates made by accountants to align revenues and costs in a specific period. Theoretically, if all buyers and suppliers paid in cash when the services were provided, there would be no need for accrual accounting, but the reality of modern commerce is that, often, there is a mismatch between the timing / amounts of cash payments versus the delivery of services. As a result, a pound of company earnings may be comprised by varying amounts of non-cash earnings. The existence of such items creates a high degree of discretion in company accounts.

Let's imagine that earnings for a company last year were £1000 but the increase in the corporate bank balance, i.e. cash-flow, was £750. That £250 difference derives from a lot of messy accrual adjustments, such as depreciation or changes in receivables. Unusually high accruals due to aggressive accounting will maximize current earnings but by necessity will likely result in lower earnings later (assuming no growth) whereas low accruals due to conservative accounting may minimize current earnings but will result in higher earnings later.

Does Accrual Screening Work?

As already mentioned, Sloan’s work found that companies with low accrual ratios massively outperform companies with high accrual ratios. For the 40-year period between 1962 and 2001, he found that the strategy resulted in an average annual compounded return of almost 18%, more than double the S&P 500’s 7.4% annual return over the…

Unlock the rest of this Article in 15 seconds

or Unlock with your email

Already have an account?
Login here