Volume 1 April 2007

China in international imbalances
Yu Yongding

International trade and poverty: cause or cure?
L. Alan Winters

Making the boom pay
John Freebairn

Reforming Australian industrial relations
Joe Isaac

Minimum wages and inequality
Andrew Leigh

Does the Fair Pay Commission decision matter?
Mark Wooden

The corporate political environment and big business response
Geoff Allen

Stock return predictability in rational markets
Bruce D. Grundy

Passive profits from accounting indicators
John D. Lyon

A 'Battle of Ideas'
Tom Elliott

On painting one's life picture
Peter Yates

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By John D. Lyon

The research indicates that the answer to the question posed is ‘yes’. Over the past thirty years, research in accounting and finance has generated many cases where above-average returns appear to be earned by taking investment positions based on simple accounting measures. Examples of these measures abound, but they can simply be the proportional increase in year-to-date earnings or a measure of a firm’s level of accruals in a given year.

It is still not clear why this is possible. The current thinking, however, is that persistent above-average returns can be earned by passive investment in share market positions that utilise accounting measures. The interesting point is that this thinking has stepped beyond the realm of academic discussion, and we now see a growing number of US accounting researchers enjoying significant windfalls as employees of hedge funds designed to exploit these research findings.

Many of these findings have their root in the finance literature. Progressively, over the last 20 years, it has been documented that, for example, ‘small’ firms outperform ‘large’ firms, that stocks with ‘high’ book-to-market ratios outperform stocks with ‘low’ book-to-market ratios, or that stocks with a ‘high’ historical price momentum outperform stocks with a ‘low’ price momentum, to name a few. (The word ‘momentum’ refers to the use of past prices to predict future prices.) These findings are often classified as ‘stock market anomalies’. They are seen to be anomalies since taking a long position in, for example, ‘small’ stocks and selling short ‘large’ stocks, yields consistent positive returns to this zero-investment position.¹ Many hedge funds have now capitalised on permutations of these findings.

The accounting research literature has also identified a number of so-called anomalies. The most famous are those based on a firm’s ‘earnings momentum’ (using past earnings to predict future earnings) or its level of ‘accruals’ in a given accounting period. The first demonstrates that long investment positions taken in stocks whose earnings substantially beat earnings from the same quarter last year while selling short those that are the worst losers relative to last year will earn positive zero-investment returns over the ensuing twelve months. Similarly, long positions in firms who have a ‘small’ accruals component to their earnings while shorting firms with a ‘large’ accruals component earn positive zero-investment returns over the following twelve months.

There are two schools of thought that try to explain just what is occurring here. The first takes the view that our understanding of risk in the stock market is simply under-developed. That is, each of these investment strategies really just uncovers an element of risk for which we have no formal model at this stage of our knowledge. For example, ‘small’ firms are just ‘more risky’ than ‘large’ firms, even though our formal model of risk encapsulated by the capital asset pricing model does not recognise this. However, just what this element of ‘risk’ is, has eluded researchers to date.

The second school of thought has to do with individual decision-making biases in the stock market. Proponents of this school argue that stock markets are slow to recognise the full impact of information events simply because the nature of the information is not instantly transparent to all stock market participants. For example, the accruals anomaly occurs because stock market participants focus on the profit figure instead of analysing the true future cash flow impact of earnings. Because accountants report on dry, statistical information about the underlying operations of a firm, it takes some time for the stock market to fully appreciate the future performance of the firm. And so the stock market ‘under-reacts’ to accounting information.

How these points of view will be resolved is not clear. However, what is clear is that there is considerable capital currently flowing into hedge funds in the US designed to exploit these apparent excess returns. Unfortunately for academia, it has also meant an exodus of personnel to the private sector to capture excess returns to the detriment of academic knowledge.

¹To explain this concept in lay person’s language by an example. Suppose that you expect stock A to go up in price and B to go down. Acting on this expectation, you decide to buy A (called the long position) laying out $10,000 and, at the same time, buy B for the same amount of money by borrowing that sum on a promise to pay the amount in, say, twelve months time (the short position). These transactions would have effectively put you today in a zero-investment position. Suppose further that in three months time, the long position has risen by 10 per cent and the short position has fallen by 10 per cent. You could sell A for $11,000 and repay the loan from the sale of B, thus making a profit of $2,000 without effectively investing any money! This is the basis of hedge investing.

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