Returns Accrue When Accruals Don't

As many of you may know, I hold the CFA (Chartered Financial Analyst) designation. I am very proud to have completed this rigorous program. For many of us, the deeper learning and understanding only begins after this point. Continuing education through seminars, workshops, abstracts, and our professional journal, The Financial Analysts Journal (FAJ) is available. For those who are serious about investing as a career, it is the credential of choice. Please contact the CFA Institute, for further information.

In two interesting articles in the current FAJ, the issue of earnings quality is examined. Previous pioneering work by Richard Sloan indicated that net operating cash flow is more closely associated with future income and stock returns than accruals. His work examined annual accruals.

In the current edition, Joshua Livnat and Massimo Santicchia looked at quarterly accruals and found that what has become known as the "accrual anomaly" applies to quarterly information as well. "Companies with extremely high (low) current quarterly accruals have significant and negative (positive) abnormal returns through the subsequent four quarters." In other words, stocks with earnings which show high accruals tend to provide low returns. In the second article, Qiao Liu and Rong Qi study the persistence of the accrual anomaly and why sophisticated investors have not taken advantage of this mispricing.

What are accruals and how can the average lay investor use this fact?

Accruals arise from GAAP...say a business expects great future sales and buys a pile of inventory to sell for future periods. It guesses wrong. In the calculation of earnings, the cost of inventory sold is matched against revenues generated. However, the excess inventory remains an asset on the balance sheet. In the operating section of the cash flow statement, the effect of the accumulation of excess inventory is a use of working capital that can be seen as a reduction in net operating cash flow.Accruals can be current operating assets and liabilities such as inventories, receivables, and accounts payable, but non-current operating accruals exist as well such as deferred taxes.

In short, most investors tend to view earnings reports quite literally and treat all aspects of reported earnings as having equal value, even though the accrual component of reported earnings has been demonstrated to be less reliable, and consequently have less value than the cash component.

How do you find out about accruals? Cramer will not scream them to you nor will Maria Bartiroma breathe them at you! You've got to dig for them yourself.

Go to the 10-Q in Edgar or in some cases, to the press release of the company. Ensure that net income for the period is less than cash flow from operations.

A quick and dirty solution to looking at cash flow from operations comes from Anumati.com. A free registration is required.Enter the symbol and turn to the cash flow statement for the appropriate period. Compare the top line, "Net Income" versus the bottome line of the operating section, "Cash From Operating Activities." Companies with very high accruals will show net income greater than Cash Flow from operating Activities.

In truth, the analysis of the CFFO is a little more intensive than this. Various components of cash flow from operations (which in the past, have arisen from tax effects of stock options) may complicate or overstate CFFO.

But as a first step toward better understanding the economics of the business in which you invest, this is important analysis.

When accruals tend to be low, returns tend to be higher than one would expect. When accruals are high, the market values these "earnings" as having lesser quality, and returns are lower than one would expect.

In short, returns accrue when accruals don't!