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Learning Outcomes.

After watching this video,

you will be able to implement the accrual trading strategy.

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>> Let's quickly recap what we have done so far.

We have calculated accrual component.

And then, we have learned how to segregate accrual and

cash component from total earnings, right?

Now with that, we are actually equipped

to sort companies based on a cruel components.

In other words, if you are given a list of say 100 companies,

you can actually calculate this component for each and every company and then,

rank these companies based on accrual or cash component, whichever way, right?

In fact, that's the first part of this trading strategy.

Now, let me describe the actual trading strategy that people use,

using this cruel anomally.

The first step is compute this ratio for

each and every company either accrual or cash.

So throughout this example, what I'll do is I will take up a accrual ratio.

So If I'm taking accrual ratio, please remember, rule of thumb,

higher accrual is bad, low accrual is good.

If you are taking cash ratio, you have to do the opposite, that's all.

So let me take accrual ratio throughout this example.

So what you do is as soon as results are announced,

the first step to do is for each company compute this accrual ratio.

That means, compute the accrual component and divide it by total assets.

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Please remember, when you are backtesting, you should always create

an environment as if which is replicable in real trading in future as well.

What do I mean by that?.

Supposed, if there is a two month gap between announcement of results,

end of the quarter or end of the year and actual announcement of your results,

you should actually start trading from the time where the figures are available.

I already talked about this while doing Piotroski.

Suppose you want to test whether accrual works in 2013 and

let's say, end of the year is December 31st, 2012,

you should not start your backtesting on 1st January 2013.

Why, answer is simple.

On 1st January 2013, you did not know

about these numbers neither was the broader market aware of.

Remember, in all our trading strategies, we do not

assume that you have some kind of priority information that's not required.

So, keep this in mind always in all our trading strategies,

when you do back tests, you have to behave as if you know this

is future because you think now you can pick up on January.

You can do calculations.

Taking January, on January 1st, 2013 using December 31st,

2013 to a numbers, that is possible now because you know both the numbers.

But then, I saw in January 1st, 2013, you did not know these numbers.

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So in other words, if I want to do this for 2018, January 1st,

on January 1st 2018, you will not know December 31st, 2017 numbers.

That's what I'm trying to say.

Let's get back to study.

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Each company you calculate, this is accrual issue, you have this number,

now rank this companies, very simple.

Once you rank this companies then, categorize them into deciles so

you obviously will get 10 categories, 1 to 10.

Now what's the trading strategy that's loan test?

What loan does is that, now we're talking under accrual, right?

I think it's a good time for you to pause and think what should we long and

what should we short because by now, since you have seen many strategies,

you should have got this understanding of what we will short, what we will long.

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Firms where earnings are driven by cash, these earnings are more sustainable.

But the market behaves as if there is no difference between cash and

accrual companies, right?

So that's the whole idea behind this strategy.

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So in this ratio, suppose you are doing in an ascending order.

So, the last design is the one,

the category of last decile is the one that's need to be shorten.

And we go long on those firms with lower accrual which is the first decile so

this is a strategy which is slow in rising.

Please remember, this part is not casting short.

The whole thing that you understand from this strategy, there is a difference in

our needs persistence between accrual and cash and market fail to recognize this.

Now, it need not necessarily be first decile and the last decile.

It could be the first quartile or the last quartile also.

Or it could be below medium and above medium also.

You can try all this combination and

see what works best in the economic settings that you're examining but

then what's loan does is it picks up deciles and the first and the last decile.

Suppose, you're using this cash ratio, cash component, how would you get it?

Income from continuing operations minus accrual, right?

[COUGH] Suppose you are using that, then what do you do?

High cash is good, low cash is bad.

And, if you have arranged your firms in an ascending order of this ratio,

so you will go long on the top decile and go short on the bottom decile.

So that's going to be the strategy.

Now, what as loan form?

No, what loan does is he takes a period between, I think,

30 year period between 1962 to 1991 and

he test this strategy where he holds this, he does this low decile,

high decile portfolio long, short portfolio and this hold this for a year.

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And every year he does it.

And what he finds is that, very interesting,

on an average returns are about 10%.

Now you may think, what is great about 10%?

Even a fund which just buys and

holds an index may make 10% most of the time, right?

What so great about 10%?

It is great because you have invested nothing.

Yeah, it is true because, what are you doing?

You're going long on decile and you're going short on a decile.

So you buy something, sell something.

So what have we invested?

Zero, so technically the expected return, if the markets were perfect, is zero.

You should not have made any return because you've not invested anything.

But then you made 10%, this is huge.

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Remember, although in you invested zero,

in real life you will have to put some margin for going short.

You can figure this out from your broker.

The rules differ from country to country.

There is no point in talking about it in this video.

There is no generalized rule here.

That you can figure out, and again,

it depends on the economic setting that you trade in.

But then, the investment is very low.

Either it is zero or it as a margin that you want to put up.

The returns that loans finds in the US is more than 10% for a 30 year period.

And more interestingly, I think only two of those 30

years he finds negative returns, now, this is fabulous.

Remember this, a lot of strategies work well on an average but

then, as I've warned you before in one of the earlier videos.

We have explained that if you have a strategy that makes money on an average

but then there are years where you make large losses such strategy may not be

sustainable.

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You may not be able to continue or

hold on until that period when you make that large gain.

But here, that is not the case.

You make regular gains and occasional losses and

that to the occasional losses are not huge.

Now remember, this is in the past.

There's no guarantee that this is going to happen in the future.

That's true with any targeting trading strategy.

But this is the 30 year period.

A number of people have tested after that.

This strategy doesn't work as well in the US market now because people

have figured it out but then, in other markets, emerging markets,

we have tested this on India, it works very well.

This strategy works.

So, what do you have to do now?

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In your respective countries or whichever country where you want to trade,

pick up the income statement and balance sheet of firms,

calculate these three ratios of income from continuing operations, accrual ratio,

cash ratio, of course, first you have to calculate the accrual component itself.

Divide the firms into the sides and then, execute your strategies.

Go long on shot or top or

bottom decile based on whether you're sorting them using cash or accruals.

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Remember one thing, you have to check whether sorting is allowed in that

country where you're trading.

In many cases, shorting is not allowed.

Then, you may have to restrict yourself to only those forms where

you are allowed to go short, that's one thing that you will have to check.

And then, you can execute this strategy.

Again, I recommend that you first back test this strategy for

a number of years and once you're reasonably confident that this works,

you can test this on a mock portfolio and then, implement this with real money.

So any questions, any doubts on this, you can write to us.

We will move onto the next strategy now.