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Free Cash Flows and Price Momentum Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

In the forthcoming Journal of Accounting, Auditing, and Finance research paper titled “Free Cash Flows and Price Momentum,” Jiajia Fu, Fangming Xu, Cheng (Colin) Zeng, and Liyi Zheng delve into the predictive power of free cash flows and price momentum (cross-sectional and time-series) on future stock returns. By evaluating the unique information derived from past returns and free cash flows, the authors uncover a positive correlation between these factors and future returns.

Furthermore, the study highlights the superior performance of a trading strategy that simultaneously buys past winners with high free cash flows and shorts past losers with low free cash flows, as opposed to traditional momentum trading strategies.

This improved performance is found to be unaffected by investor sentiment, time variations, and transaction costs. The research also reveals that the additional cash flow influence primarily stems from net distributions to equity or debt holders.

Overall, this in-depth analysis underscores the significance of incorporating corporate fundamentals into technical trading strategies and provides valuable insights for investors seeking to optimize their portfolio outcomes.

Abstract Of Paper

This study investigates the role of free cash flows and (cross-sectional and time-series) price momentum in predicting future stock returns. Past returns and free cash flows each positively predict future stock returns after controlling for the other, suggesting that cash flows and momentum both contain valuable and distinctive information about future stock returns. A strategy of buying past winners with high free cash flows and shorting past losers with low free cash flows significantly outperforms the traditional momentum trading strategy. The enhanced performance is not sensitive to investor sentiment, time variations, or transaction costs. Further analysis shows that the incremental cash flow effects are largely attributable to net distributions to equity/debt holders. Overall, our findings shed light on the role of corporate fundamentals in technical trading strategies.

Original paper – Download PDF

Here you can download the PDF and original paper of Free Cash Flows and Price Momentum.

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Author

Jiajia Fu
University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American)

Fangming Xu
University of Bristol

Cheng (Colin) Zeng
Hong Kong Polytechnic University

Liyi Zheng
University of Bristol

Conclusion

In conclusion, the research paper offers significant insights into the predictive capabilities of free cash flows and price momentum – both cross-sectional and time-series – concerning future stock returns. The study establishes that both past returns and free cash flows are positively correlated with future returns, emphasizing the unique and valuable information each factor provides.

Importantly, the authors demonstrate that a trading strategy focusing on purchasing past winners with high free cash flows and shorting past losers with low free cash flows significantly surpasses traditional momentum trading strategies. This superior performance remains robust irrespective of investor sentiment, time variations, and transaction costs. The incremental cash flow effects are predominantly attributed to net distributions to equity or debt holders.

Ultimately, these findings illuminate the crucial role of corporate fundamentals within technical trading strategies, highlighting the potential advantages of integrating these factors for informed investment decisions.

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Informed Trading of Out-of-the-Money Options and Market Efficiency

FAQ

Q1: What is the main focus of the research paper “Free Cash Flows and Price Momentum” by Jiajia Fu, Fangming Xu, Cheng (Colin) Zeng, and Liyi Zheng?

The research paper investigates the predictive power of free cash flows and price momentum, both cross-sectional and time-series, on future stock returns. The authors aim to understand the unique information provided by past returns and free cash flows, and their correlation with subsequent stock performance.

Q2: How does the trading strategy proposed in the study, buying past winners with high free cash flows and shorting past losers with low free cash flows, compare to traditional momentum trading strategies?

The study reveals that the proposed trading strategy outperforms traditional momentum trading strategies significantly. Buying past winners with high free cash flows and shorting past losers with low free cash flows demonstrates superior performance, and this advantage remains robust across various factors such as investor sentiment, time variations, and transaction costs.

Q3: What is the key insight regarding the incremental cash flow effects, and how do they contribute to the enhanced performance of the trading strategy?

The research finds that the incremental cash flow effects, primarily stemming from net distributions to equity or debt holders, play a crucial role in the enhanced performance of the trading strategy. This insight emphasizes the importance of considering corporate fundamentals, specifically free cash flows, in technical trading strategies and provides valuable implications for investors seeking to optimize portfolio outcomes.

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