[PDF] cash flow indicators as predictors of publicly listed companies

40114_319933709.pdf CASH FLOW INDICATORS AS PREDICTORS OF PUBLICLY LISTED COMPANIES

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A Thesis

Presented to the Faculty

of ISM University of Management and Economics in Partial Fulfillment of the Requirements for the Degree of

Master of Financial Economics

By

Tatjana Kimlyk

May 2014

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Abstract

Master Thesis: financial economics. Vilnius, ISM University of Management and Economics, 2014. This thesis aims to investigate whether cash flow indicators can provide valuable information on selecting firms which would outperform market index. After reviewing academic literature free cash

flow was identified as one of the most accurate indicators to show how much actual cash is generated

from operations and can be freely distributed to shareholders or invested in future projects. Using annual statements publicly listed firms on US stock exchanges with positive free cash flows, low leverage and low cash flow multiples are selected. Conducted empirical research shows that firms chosen in portfolios outperformed market index in 7 out of 9 years (from 2004 to 2013). Analyzed

monthly returns show that results are statistically significant and are achieved without any

considerable increase in volatility of returns. Fama-French three factor model confirms that portfolio

returns are not related to the increased systematic risk, size or value factors, but rather consistent

superior performance of selected firms. Keywords: free cash flow, market value, abnormal returns

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Table of Contents

List of figures ................................................................................................................................ 4

List of tables .................................................................................................................................. 5

Introduction ................................................................................................................................... 6

1. Literature Review.................................................................................................................... 9

1.1 Market Pricing and Valuation of Stocks ............................................................................ 9

1.2 Cash Flow and Accrual Components of Earnings ............................................................ 14

1.2.1 Accrual anomaly. .................................................................................................... 15

1.2.2 Free cash flow anomaly. .......................................................................................... 19

1.3 Agency Problems of Free Cash Flows ............................................................................. 20

2. Research Methodology .......................................................................................................... 24

2.1 Hypotheses and Research Design .................................................................................... 24

2.2 Data and Sample Definition ............................................................................................ 27

2.3 Portfolio Construction and Rebalancing .......................................................................... 30

2.3.1 Free cash flow definitions and measures................................................................... 33

2.3.2 Valuation ratios. ...................................................................................................... 37

2.4 Fama-French three factor model ..................................................................................... 38

3. Empirical Research Results and Discussion ........................................................................... 42

3.1 Fundamental Analysis of Constructed Portfolios ............................................................. 42

3.2 Market Valuation of FCF Portfolio ................................................................................. 45

3.3 Portfolio and Market Returns over the Sample Period...................................................... 47

3.4 CAPM and Fama-French three Factor Model .................................................................. 53

3.5 Testing Ranges of the Free Cash Flow Multiple .............................................................. 55

3.6 Sensitivity Analysis of Selected Variables....................................................................... 58

3.7 Discussion ..................................................................................................................... 60

3.7.1 Significant research findings and linkage to existing literature. ................................. 60

3.7.2 Limitations and implications. ................................................................................... 63

Conclusions ................................................................................................................................. 65

References ................................................................................................................................... 67

Appendices .................................................................................................................................. 72

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List of figures

Figure 1. Empirical research steps and methods ............................................................................ 26

Figure 2. Available firms for further free cash flow filtering criteria .............................................. 28

Figure 3. Breakdown of selected firms by economic sector ........................................................... 32

Figure 4. Breakdown of constructed portfolios by period and sector .............................................. 42

Figure 5. Annual buy-and-hold returns (%) of FCF portfolio and market index .............................. 48

Figure 6. Cumulative returns of FCF portfolio, Market and S&P 500 indices ................................. 49

Figure 7. FCF portfolio returns based on MV/FCF multiples ......................................................... 50

Figure 8. FCF portfolio returns based on Total Debt/FCF multiple ................................................ 51

Figure 9. FCF portfolio returns based on market cap (1 smallest, 10 largest) ............................ 52

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List of tables

Table 1 Summary of results on monthly excess returns of value stocks, in percentage ..................... 10

Table 2 Summary of findings on value/glamour market anomaly ................................................... 13

Table 3 Summary of studies and findings on accrual anomaly ....................................................... 16

Table 4 Number of companies in constructed portfolios by year .................................................... 31

Table 5 Mean of financial ratios of constructed portfolios by year ................................................. 43

Table 6 Mean of financial ratios of constructed portfolios by sector .............................................. 44

Table 7 Valuation ratios of FCF portfolio and S&P 500 index ...................................................... 46

Table 8 Monthly returns from 2004-04 to 2013-04 period ............................................................. 53

Table 9 CAPM model regression statistics, using 108 monthly observations .................................. 54

Table 10 Fama-French three factor model regression statistics, using 108 monthly observations ... 54

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Introduction

Problem

Cash flow indicators become a popular measure of firm performance among practitioners. Some

investors prefer cash flow indicators since they believe it gives a better picture of the wealth and

value firms generate. While earnings numbers were increasingly important to investors during the past decades, publicly listed firms came up with ways to manage their reported income statement numbers through accruals and non-cash charges to avoid negative shocks. Cash flow statement is harder to manipulate and gives a better understanding on how much cash company generates through their operations each year. Even though it was introduced by IAS 7 in 1994 as addition to IFRS, the academic literature and use of it in financial analysis and audit is relatively new.

Literature review

The use of financial statements to evaluate future company performance is a widely discussed and analyzed topic among scholars and researchers. One of the pioneer researches on financial statement analysis was deducted by Ou and Penman in 1989. In their study they have derived a summary

measure from large set of financial information data that predicts future stock returns. Their research

suggests that financial statements capture information that is not reflected in stock prices and

therefore signals possibility to gain excess return in the market. The results of the next study (Ou,

1990) indicate that nonearning numbers provide incremental use about future earnings changes not

reflected in the current and previous earnings. The study results in the UK market of Charitou & Panagiotides (1999) are consistent with Ou & Penman (1989) US research, that financial statements

analysis enables to predict one-year ahead earnings. It also complements the research by adding cash

flow components in the model to overcome the issue of earnings manipulation with accruals.

Another set of studies investigate the further use of cash flow measure to construct portfolio,

outperforming market indices. Hackel, Livnat, & Atul Rai (2000), for instance, have built the

portfolio of companies with consistent free cash flows and low leverage ratios and compared it with

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7 similar size and beta portfolios of S&P 500 firms. Their results show, that constructed portfolio

yields superior returns and confirm the need for proper financial statement analysis instead of

focusing on earnings only. (2006) have re-examined Hackel et. al (2000) study in the Finnish market setting and found that so called free cash flow anomaly was also present in

research suggests that free cash flow investment strategy is particularly attractive in the period of

market decline. Hirshleifer, Hou, Teoh & Zhang (2004) took a different approach of the research: authors employ the parsimonious measure of net operating assets to predict stock returns under the simple hypothesis that investors overestimate the performance of balance sheet ratios and earnings at the cost of neglecting the incremental information of cash flow measures. Finally, Kim, Lipka & Sami (2012) have tested four hypotheses that low PE (undervalued) firms exceed market portfolio returns using accounting earnings, cash flows and working capital measures. They report that all three measures provide useful information for building superior performing portfolios and decline the hypothesis

that return on accounting earnings exceeds returns based on cash flows and capital. In contrary, the

carried research provides strong evidence, that cash flow based portfolio significantly exceeds

accounting earnings returns. Authors also suggest that future research should be carried out to find

out if their findings hold in different market settings and using other measures, such as

comprehensive incomes or free cash flow. The proposed study aims to fill in the gaps of the current state of knowledge on the use of cash flow indicators as an incremental addition to

valuation and the tool for constructing portfolios with superior returns. Hence, the main goal of this

research is to evaluate the use of cash flow indicators excess returns. Objectives leading to achievement of the aim are the following:

1. Identify previously documented market anomalies and their market valuation.

2. Evaluate the most critical cash flow criteria for constructing superior performing portfolio.

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3. Analyze risk and return premium of free cash flow portfolios and relation to previously

documented anomalies.

4. Perform sensitivity analysis to evaluate the impact of individual financial indicators.

Research design

The main interest of this research is to find out whether cash flow indicators provide valuable

information necessary for selecting companies performing better than market indices. For this

long-term value creation will be selected. -adjusted performance and possibility to outperform the market.

Methods of data collection and analysis

Annual data on balance sheet, income and cash flow statements will be collected from the

Morningstar database. The statements will be derived for the firms publicly listed on US Nyse, Nasdaq and Amex stock exchanges. Firms will be screened by criteria of low financial leverage, market capitalization and positive operating and free cash flows.

Sequence of the intended research

The sequence of the intended research will be carried out as follows. To answer the first and second

objectives of the paper first chapter will cover the summary and critical analysis of the previous studies on financial statements use for investment decisions, with emphasis on cash flow measures.

Chapter two will include methodological framework and approach to financial data collection,

portfolio collection and analysis. In the last part the results of empirical research will be presented

and discussed.

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1. Literature Review

Researchers have long studied the information contained in stock return and a growing body of

evidence suggests that market efficiency hypothesis does not hold. Investors tend to concentrate their

attention on earnings ratios, which have a number of questionable assumptions: firstly, accountants

can manage their earnings to make ratios look more attractive to investors; secondly, market can fail

to detect accrual and cash components of earnings. This chapter of thesis will concentrate on previously documented market anomalies, their reasoning

and detection. Whilst the first part of the thesis will provide the overall market valuation of stocks,

the following chapter will concentrate more on cash flow indicators. Both advantages and drawbacks of using cash flow as opposed to earnings and other income statement and balance sheet statement indicators will be analyzed.

1.1 Market Pricing and Valuation of Stocks

The debate on the usefulness of various financial statement indicators have been widely discussed

and analyzed by researchers. Yet, as it will be demonstrated further on, the literature is still

controversial regarding what are the best predictors of future firm performance and profits. One set

of studies find evidence that accounting earnings explain the most of the information about future earnings and cash flows. Another set of studies reports the incremental value of analyzing cash flows, dividends and other factors along with earnings for better predictions. Kim, Lipka & Sami (2012) compared three popular financial statement measures: earnings, working capital and cash flows. They found that all of the strategies proved to earn abnormal return on the

market; however cash flow portfolio yielded significantly better returns. The discussion on earnings

and cash flow information of stock prices is further analyzed. Fama & French (1992) have analyzed value and glamour stocks returns over the period of 1941-

1990. Authors formed 12 portfolios based on book-to-market and earnings-to-price ratios. The

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highest B/M stocks are perceived as glamour stocks and lowest as value companies. Table 1

summary of three studies on the difference of monthly returns of glamour and value stocks. The highest P/M (1a value portfolio) stocks outperformed glamour stocks on average by 1.53 % monthly

return, with portfolios built by P/B ratios and by 0.68% when by ES ratio. The beta for all portfolios

did not vary significantly, which implies that the superior returns of value stocks cannot be explained

by systematic risk. Their test on the market overreaction on glamour stocks do not confirm the irrational investor hypothesis, thus authors suggest that value stocks bare additional risk.

Table 1

Summary of results on monthly excess returns of value stocks, in percentage Book-to-market Earnings-to-price ratio

Cash-flow-to-price

ratio

Chan et al. (1991) 1.1 0.4 0.8

Fama & French (1992) 1.53 0.68 -

LSV (1994) 0.47 0.29 0.74

Note. Financial

Analysts Journal, 60(1), 71--

Journal Of Finance, 47(2), 427-

Porta, R., Lakonishok, J., Shleifer, A., & Vishny, R. (1997). Another study conducted by Lakonishok, Shleifer & Vishny (1994) (further LSV) has similar results regarding the outperformance of value stocks in the period of 1968-1990, however on the contrary to

Fama & French (1992) do not find evidence of additional risk of value stocks. Authors also introduce

additional indicator CF/P (cash flow-to price), based on which portfolio yielded best results and the

biggest difference with the favored stocks (see Table 1). The statistical test that did not prove risk

explanation of value investing returns raises question as to why the value/glamour anomaly is still

present and not arbitraged away. Authors explain this in terms of preferences of both individual and

institutional investors. First of the few psychological biases of individual investors that LSV (1994) mention is believing

that high growth of glamour stock will persist or even get higher in the future. Second, investors tend

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11 to believe that well-run companies with known products are good investment, regardless of the market price. Institutional preference for glamour stocks according to authors can be explained by

the agency issues. Institutional investors might find it easier and less risky to justify their investments

in favored stocks, rather than out-of-favor, even though authors find proof that value stocks are not

riskier, yet more profitable. Another reason on why the value strategy was not arbitraged away by

investors is that both individual and institutional investors cannot allow the long-term pay off with

short-term underperformance. Another quoted study was performed by Chan, Hamao & Lakonishok (1991) to evaluate the existence of value anomaly in Japan. Researchers analyzed data on companies listed on Tokyo stock

exchange from 1971 to 1988. In contrast to previously discussed studies, Chan et al. (1991) find that

the most important variables are B/M and CF/P (see Table 1). Authors also find little support for the

hypothesis that small-cap stocks outperform larger stocks. Surprisingly, one of the most popular indicator earnings-to price was also not statistically significant. As a possible reason on the superior information content of B/M and CF/P, they suggest the Japanese market specifics. Since in

Japan there are more accounting depreciation allowed, cash flow indicators should have more

valuable information about future firm performance than earnings. Earnings might be boosted by depreciation and accruals accounting practices.

What is more, the monthly standard deviation of firms in extreme glamour and extreme value

portfolios do not differ significantly, which also questions the explanation of additional risk

associated with value stock, but rather points to behavioral biases of investors. Further studies that are summarized in Table 1 have extended previous findings in more specific

areas. To shed some light on the controversial findings regarding the interpretation of excess value

investing returns La Porta et. al (1997) test whether investors make errors while pricing stock after

earning surprises. They find that post earnings announcement returns are significantly higher (annual

difference of 25-30%) for value stocks and lower for glamour stocks. The findings contradict with

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12 that of Fama & French explanation for additional risk. Authors also find evidence, that value stock

returns are persistent; however for larger firms the difference of earnings surprises is smaller.

Authors suggest similar conclusions as LSV (1994) regarding institutional and individual preferences

of investors. Doukas et. al (2002) on the other hand, argue that La Porta et. al (1997) do not directly measure

expectation errors, since they use earnings growth indicator to form stock into portfolios, whereas all

value/glamour literature was based on book-to-market, earnings-to-price-ratio or cash flows-to-price.

Therefore, authors aim to re-examine extrapolation hypothesis. They find that investors are not much

more optimistic about growth stocks than value stocks. In addition, authors imply that value stocks have higher forecast errors than glamour stocks. Skinner & Sloan (2002) take a different approach in analyzing expectation errors of investors. They test whether superior performance of value stocks can be explained by just one factor investors tend to be over optimistic about growth stocks and react asymmetrically to their negative earnings

surprises. Authors also imply that such asymmetrical reaction of investors to negative earnings

surprises might provoke managers of glamour stock to manage their earnings, hoping to avoid major stock declines. Desai et al. (2004) found that if CFO/P ratio is counted as additional value-glamour proxy, then accrual anomaly is expanded value-glamour stock version. Authors also stress the importance of valuation of cash flows while pricing stocks. It is often confused in literature that earnings plus depreciation do not fully capture accruals management, which is usually done via working capital

instead. Thus authors claim, that both anomalies together yield better returns than one separately is

explained by error in calculating and evaluating operational cash flows. Reasearch of Chan, Hamao & Lakonishok (1991) also supports hypothesis that superior returns of

value strategy cannot be attributed to risk exposure. What is more, authors find that even after taking

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into account the 1990s which were bad years for value stocks, in the long-term value portfolio still

outperforms growth. The bad returns of the 90s can be explained by overoptimistic sentiment

regarding technology, media and social industry.

Table 2

Summary of findings on value/glamour market anomaly

Authors Purpose Area Findings

La Porta,

Lakonishok,

Shleifer & Vishny

(1997)

To examine if investors are

mispricing stocks after earnings announcements

Expectation

errors

Long-term superior returns of value

stocks portfolio can be attributed to the expectation error about future earnings

Doukas, Chansog

Kim & Pantzalis

(2002)

To test the investor extrapolation

hypothesis in terms of value/growth stocks

Expectation

errors

Found no support for the

extrapolation hypothesis: larger forecast errors are made for small cap value stocks than for large cap glamour stocks

Skinner & Sloan

(2002)

To investigate if the returns are

explained by over pessimistic reaction to growth stocks negative earnings surprises

Expectation

errors

After controlling for the large

negative response to bad news of growth stocks, there is no differential between glamour and value stocks

Desai, Rajgopal &

Venkatachalam

(2004)

To examine if accrual and

value/glamour market anomalies are inter-related

2 Anomalies Main finding is that both anomalies

can be explained by one variable -

CFO/P

Chan &

Lakonishok

(2004)

To review and update research on

value/glamour investment strategies Risk/Behavior Abnormal returns of value stocks cannot be attributed to additional risk

Sharma, Hur &

Lee (2008)

To research the preferences of

institutional and individual preferences regarding value and glamour stocks

Institutional and

individual preferences

Institutional investors seemed to

prefer glamour stock over value stocks and vice versa for individual investors

Piotroski & So

(2012)

To test if value/glamour effect is

concentrated among firms with expectations errors and if there is risk explanation to returns

Incongruent

expectation errors

Returns of conditional on

incongruent expectations portfolio are significantly larger than on traditional strategy Note Sharma, Hur & Lee (2008) extend LSV (1994) research in terms of institutional and individual

preferences. Their institution specific research supports LSV hypothesis that institutions tend to

favor glamour stocks over value stocks. This implies that institutional investors have little superior

information both about value and glamour stocks. Further analyzing the reasoning of value stocks

outperformance, Piotroski & So (2012) find that the significant part of returns is explained by

that are not adequate to the performance. Authors also claim that when

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among firms whose fundamental strength is congruent with the expectations, the value/glamour

effect is close to zero. Even though researchers do not seem to agree on whether it is additional risk or mispricing that

causes superior returns, more evidence tends to explain the behavioral bias of investors, rather than

exposure to risk. Surprisingly enough, sophisticated institutional investors are not an exception and

tend to overinvest in glamour stocks and sell undervalued stocks. While individual investor expects growth stocks to grow even more and believe in well-run companies that are sometimes overpriced or in products they know better. Further studies expand the research in the area of inve cash flow mispricing and ability to differentiate cash flow and accrual components of earnings.

1.2 Cash Flow and Accrual Components of Earnings

The first study to document that stock prices reflect only naive expectations about earnings was done

by Sloan (1996), who is quoted in most of the related literature. Author suggests, that if the market

fails to distinguish reported earnings from the cash firm actually generates it can be used as a proxy

for finding undervalued and overvalued firms. Main argument for this reasoning is the fact, that

while both accruals and cash flow components of earnings contribute to current earnings,

performance is less likely to persist if it is more related to the accrual component of earnings as opposed to cash. Sloan (1996) proved the hypothesis that investors do not distinguish accrual and cash components of

earnings. His portfolio with the long position in stock with higher levels of cash and short position in

firms with high level of accruals has earned abnormal returns in the market. However as a limitation

he points out, that the results of this investment strategy could just have been due to in-depth

financial statements analysis rather than only mispricing of accruals. The investment strategy used by Sloan (1996) has been quoted in two different set of studies: with attention on accruals and on free cash flow. Both market anomalies were tested in different market

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with some modifications to the portfolio formation rules. Most of the studies reported excess return

of their portfolios when compared to the similar index or market returns. Further, the use of both portfolio strategies in the literature is discussed and analyzed.

1.2.1 Accrual anomaly.

The cash and accrual components of earnings are widely examined and well documented anomaly in academic and practitioner literature with different settings, assumptions and implications. Table 3 summarized the relative studies in the area followed by the analysis of findings.

Findings summarized in the table are only a small portion of the extensive literature on the accrual

anomaly. The accrual anomaly firstly discovered in US market has been documented in international settings, both in emerging and developed countries. Pincus et al. (2007) found that even though accrual anomaly is present in many countries in pooled samples, it is only concentrated in four

countries out of twenty: Australia, Canada, UK and US. The results are surprising to the extent, the

capital markets of these countries are perceived as most efficient. As an explanation authors suggest,

that investors in these 4 countries are more concentrated on earnings data than others (Pincus et al.,

2007, p. 200). After examining what country and institution specific characteristics may be

attributable to higher probability of accrual anomaly, authors find the combination of the following:

existence of common law legal tradition, permission of more extensive use of accounting accruals,

lower concentration of share ownership and weaker outside shareholder rights (Pincus et al., 2007, p.

171). On top of that, they find, that the phenomena of accrual anomaly can be best explained by

earnings management. Another research in international setting was conducted recently by Fan & Yu (2013). In contrast with Pincus et al. (2007), author document that accrual anomaly yields abnormal significant returns

in both emerging and developing countries for a long period. Fan & Yu (2013) also study the

attribution of idiosyncratic risk to the excess return of the investment strategy. Consistent with

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previous research, they find that idiosyncratic risk is positively correlated with abnormal returns after

controlling for country characteristics. In addition Fan & Yu (2013) find that the same level of idiosyncratic risk has more impact on the excess returns of emerging markets than developing.

Table 3

Summary of studies and findings on accrual anomaly

Authors Purpose Findings

Nam, Brochet &

Ronen (2012)

To re-examine the role of cash and accrual components as predictors of future cash flows Portfolios formed on stock return predictions from current CFO and accruals yield significantly positive returns

Liǀnat Θ López-

Espinoza (2004)

To analyze the contribution of quarterly

accruals to abnormal returns and investigate whether accrual anomaly is present in all or specific industries. CFO are superior to Accruals in association to abnormal returns; CFO is significant signal in most of the industries

Shon & Ping

(2010)

To test and compare accruals and asset

growth anomaly Portfolios formed using abnormal accruals strategy earn higher returns than accrual or asset growth anomalies alone

Desai, Rajgopal,

&

Venkatachalam

(2004)

Investigate the relation between value-

glamour and accrual anomalies Ratio CFO/P captured abnormal returns to all traditional value-glamour proxies and can be attributable to both documented anomalies

Lev & Nissim

(2006)

To examine institutional and individual

reaction to accruals and persistence over time The anomaly is still existent in markets, even though it is traded by institutional investors

Soares & Stark

(2009)

To provide evidence if accruals anomaly can

be profitable in UK market, net of transaction costs Accrual-based investing strategy have negative or insignificantly positive abnormal returns, when all costs are taken into account

Li, Niu, Zhang,

& Largay (2011) To edžamine whether firms͛ regulation is associated with detecting accrual anomaly in

China

Earnings management produces accrual anomaly

when it is related to market pressures rather than regulatory

Clinch, Fuller,

Govendir &

Wells (2012)

To re-examine the existence of accrual

anomaly in Australia in a broader sample and for a longer period Support for existence of accrual anomaly in Australian market, which is driven not only by overestimating accruals, but also underestimating cash flows

Pincus,

Rajgopal, &

Venkatachal

(2007) To investigate 20 countries to test whether accrual anomaly is applicable to other then

US markets

Accrual anomaly was documented in Australian, US,

UK and Canadian markets

Fan & Yu (2013) To investigate accrual anomaly in capital markets around the world Investment strategy produces significant abnormal returns in both developed and emerging economies, which strongly depends on idiosyncratic risk Note The country-specific study on the accrual anomaly in China focuses on different types of earnings

management: one induced from delisting regulatory requirements; other responding to market

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17 pressures. When two types of earnings management are not distinguished, the evidence of accrual ement

prompted by regulatory pressures was excluded, Li, Niu et al. (2011) find that mispricing of accruals

in capital markets of China is also present. Their results also suggest that market mispricing of

accounting accruals and earnings management in emerging markets can be very specific and

different in nature, which is difficult to account for and compare in a broad cross-country study.

Clinch et al. (2012) support the evidence of Pincus et al. (2007) in a sense that accrual anomaly is

present in Australian markets. Their study contributes to the literature in few aspects: firstly, authors

find that Australian market not only overvalues the impact and persistence of earnings, but also underestimates the value of cash flows firms generate. Also, by using a larger sample of companies

and for a longer period, they find that accrual investment strategy is only significant in the first year

of portfolio formation and decreases over time. A more critical assessment of accrual anomaly in UK market was done by Soares & Stark (2009).

Authors not only test if the existence of accrual anomaly in UK, but also if it is profitable, net all

transaction and commission costs. Soares & Stark (2009) document that UK stock markets misprice

the accruals component of earnings, thus anomaly exists and is able to earn abnormal returns.

However, when they account for all fees and transaction costs, that are associated with expensive

(especially short positions in stocks) strategy portfolio fails to be profitable. Similar findings are

reported by Lev & Nissim (2006). Authors question the persistence of accrual anomaly: if it was so widely discussed and documented significant abnormal returns in different market settings, why was not it already arbitraged by sophisticated investors? There is still evidence that market misprices accruals and cash components of earnings (Lev & Nissim, 2006, p. 196).

Lev & Nissim (2006) find that even though they find evidence, that the strategy is used by

institutional investors, characteristics of high accrual firms are usually undesirable to short. The

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18 firms are usually small and have questionable liquidity potential. What is more, they conclude that the transaction and information costs are too high for individual investors. Another set of studies examine if accrual anomaly is a part or addition to another accounting or market anomalies. Desai et al. (2004) found that if CFO/P ratio is counted as additional value- glamour proxy, then accrual anomaly is expanded value-glamour stock version. Authors also stress

the importance of valuation of cash flows while pricing stocks. It is often confused in literature that

earnings plus depreciation do not fully capture accruals management, which is usually done via working capital instead (Desai et al., 2004, p. 358). Asset growth and accrual anomalies were analyzed by Shon & Ping (2010). If accrual anomaly is more associated with earnings management and shot-term growth, the asset growth anomaly is more related to long-term growth of net operating assets. It was documented, that investors also fail to

understand the negative side of assets growth and declining marginal return on investments. In

contrast to Desai et al. (2004) study, they find that two anomalies are of different nature and can be

used simultaneously to earn excess returns on the market. Their study has two additional important

findings: first authors find that shorting on abnormal accruals indicator yields better returns than total

accruals. Secondly, by implementing both abnormal accruals and asset growth strategy, investors can earn higher risk-adjusted return, than one of those anomalies alone.

Hong (2001) also

is explained by abnormal (or discretionary) accruals rather than normal cycle accruals. Author finds

-discretionary or total accruals,

since the first are more closely related to earnings management and do not support the persistency of

earnings in future. To sum up, even though abnormal returns on accrual strategy were documented by many researchers, the market anomaly has a number of drawbacks and concerns. Firstly, most of the times after stock

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19 screening for shorting strategies were done only small cap firms were left. This might imply

liquidity problems and thus questions the ability to short-sell the stocks at all. Secondly, as

researchers suggest, the major part of abnormal returns is earned due to the earnings management of

such type of firms. Lastly, after controlling for high costs of this long/short investment strategy, most

of the analyzed portfolio returns do not exceed market and might even decrease profitability to the level when it is not worth investing. Some of the authors find evidence, that cash flow indicators

contribute to the abnormal returns more than accruals which leads to another market anomaly,

discussed in the following chapter.

1.2.2 Free cash flow anomaly.

Free cash flow anomaly is less researched and investigated phenomenon that firstly was documented

by Hackel et al. (2000). Authors propose their own investment strategy that differs from the

previously used in a number of ways. Firstly they construct a portfolio holding long positions only,

because firms with negative free cash flows does not necessarily should be shorted if the cash is used

to invest in high-value projects. Also, shorting is an expensive instrument in terms of fees. For stock

screening authors use such measures as high market cap, positive 4 year average free cash flow, net operating cash flow, growth in operating cash flow, low leverage and bound for free cash flow multiples. The described portfolio strategy outperformed both market index and the S&P 500 similar size and beta portfolios. (2006) aimed to re-examine Hackel et al. (2000) anomaly in the Finnish market

setting. They suggest, that since there is evidence that reported earnings in Finland are more

associated with earnings management, the investment strategy might prove to earn excess returns. Authors propose a more simplified model and selection criteria due to limited number of available

firms on Finnish stock exchange and test it in both bull and bear markets. The yearly reported return

on average outperformed market index by 11.8% and worked well both in up and downturn economic cycles.

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20 Barone & Magilke (2009) have conducted a research combining both accrual and cash flow anomaly, since they are inter-related. Authors aimed to find whether the abnormal returns of the

strategies are explained by accrual or cash flow component of earnings. Consistent with Desai et al.

(2004), they document that after controlling for cash flow mispricing there is no evidence of accrual

anomaly. Furthermore, they find evidence that the mispricing occurs only among individual

investors, thus more sophisticated investors value both accruals and cash flows of earnings correctly.

From both accrual and free cash flow anomaly it can be concluded and cash components is important and provides additional value in choosing better performing stocks

or shorting the heavy on accruals stocks. To have a full picture of the free cash flow impact on firms

performance the next chapter focuses on the main drawback of free cash flows that was documented by academic agency problems associated with the value-adding distribution of the cash in contrast

1.3 Agency Problems of Free Cash Flows

Number of studies has concentrated their attention on the potential agency problems of firms with

high FCF and limited growth opportunities. One of the first authors to test free cash flow hypothesis

was Jensen (1986), when analyzing manager and shareholder conflict in the context of cash payouts.

ILUP