Accruals, Capital Investments, and Stock Returns

K.C. John Wei and Feixue Xie

Financial Analysts Journal, 2008, vol. 64, issue 5, 34-44

Abstract: The evidence from this study shows that the “accruals anomaly” and the “capital investment anomaly” are distinct, even though capital investments and accruals may be related in a certain way. The results also indicate that, after adjustment for the Fama–French three risk factors, investors earn substantially higher returns by using a strategy that exploits both anomalies at the same time than by exploiting either anomaly alone. Using current accruals as the measure of accruals produced similar results to using total accruals, and the results are robust to various measures of return. The evidence suggests that managers in companies ranked highest in both accruals and capital investments may be overly optimistic about future demand for their products.This study examined whether the “accruals anomaly” and the “capital investment anomaly” capture the same underlying force. Both anomalies may be linked by way of managers’ overly optimistic expectations about future product demand that lead to a buildup of production capacity and inventory. We further examined whether one anomaly provides new information not provided by the other even if both anomalies are driven by the same expectation of future demand. If both signals are incrementally valuable, an investor can obtain additional abnormal returns by basing a strategy on combining the anomalies, so this possibility should be of great interest to practitioners and investors.Using data from the CRSP/Compustat Merged Database for the period 1972–2005, we found that the two anomalies are distinct from each other and that investors can earn substantially higher returns by using a strategy that exploits both anomalies at the same time. Specifically, a trading strategy of buying the shares of companies in the lowest quintile formed on the basis of total accruals and the lowest quintile formed on the basis of capital investments and simultaneously shorting the shares of companies in the highest total accruals quintile and the highest capital investment quintile would have generated a risk-adjusted return of 12 percent per year, on average, in the sample period. The return to such a strategy is substantially larger than the returns from exploiting either the investment anomaly–based strategy (7.66 percent) or the total accruals–based strategy (6.74 percent) alone. Using current accruals as an alternative measure of accruals produced similar results. Moreover, we showed that our results are robust to the measure of returns.An important implication of this study is that portfolio managers and investors should exploit the capital investment anomaly and the accruals anomaly at the same time to enhance their trading profitability.

Date: 2008
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DOI: 10.2469/faj.v64.n5.5

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