The accruals anomaly – can implementable portfolio strategies be developed that are profitable net of transactions costs in the UK?

Abstract

In this paper, we provide evidence related to the existence, or otherwise, of the accruals anomaly in the UK stock market. Specifically, we find that average annual abnormal returns generally decline as prior period accruals move from low to high. This outcome can be interpreted as broadly consistent with the accruals anomaly via which investors overweight the persistence of accruals and underweight the persistence of cash flows in predicting next period's earnings. Our results suggest that to make money out of any mispricing based upon ranking firms by accruals generally requires a portfolio strategy with long and, in particular, short positions in portfolios featuring relatively small capitalisation firms. When taking into account conservative estimates of trading costs, the investment strategy is seen to generate losses if an initially equally‐weighted investment approach is used or positive, but not statistically significant, abnormal returns if a value‐weighted approach is followed. Overall, we conclude that, whilst there is evidence of mispricing consistent with the accruals anomaly, the profitable exploitation of the anomaly is not necessarily possible when transactions costs are taken into account. Thus, the accruals anomaly is not so egregious in the UK as to challenge the semi‐strong version efficient markets hypothesis.

Keywords:

• market efficiency
• accruals anomaly
• portfolio strategies
• transaction costs

Notes

The authors are both at Manchester Business School (Nuno Soares is also at Faculdade de Engenharia, Universidade do Porto, Portugal). This paper has benefited from the comments of the two anonymous reviewers, Pauline Weetman (the editor), participants at the 2006 and 2007 British Accounting Association Conferences, the 2007 European Accounting Association Annual Congress, the 2007 European Financial Management Doctoral Colloquium, the 2008 American Accounting Association Annual Conference, seminar participants at the London School of Economics (November 2007) and Colin Clubb, Asad Kausar, Edward Lee, Peter Pope, Norman Strong and Martin Walker. All remaining errors are those of the authors.

Correspondence should be addressed to: Professor Andrew W. Stark, Manchester Business School, Booth Street West, Manchester, M15 6PB, UK. E‐mail: [email protected]. Tel: [phone].