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Separating Winners from Losers Among Low Book-to-Market Stocks Using Financial Statement Analysis Insights

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Separating Winners from Losers Among Low Book-to-Market Stocks Using Financial Statement Analysis” by Partha S. Mohanram investigates the potential of employing financial statement analysis to discern between successful and underperforming growth stocks in terms of future performance.

Through the creation of an index called G_SCORE, which considers traditional fundamentals like earnings and cash flows and growth firm-specific measures, such as stability of earnings, growth, R&D intensity, capital expenditure, and advertising, the study assesses the efficiency of a strategy involving buying high G_SCORE stocks and shorting low G_SCORE stocks.

Notably, these strategies consistently yield significant excess returns. The results are robust in various scenarios, such as controlling for risk factors and anomaly factors, implying the potential mispricing in the stock market.

The paper thus explores the viability of adopting a modified fundamental analysis strategy to identify mispricing opportunities and harness substantial abnormal returns.

Abstract Of Paper

This paper tests whether a strategy based on financial statement analysis of low book-to-market (growth) stocks is successful in differentiating between winners and losers in terms of future stock performance. I create an index (G_SCORE) based on a combination of traditional fundamentals such as earnings and cash flows and measures appropriate for growth firms such as the stability of earnings and growth and the intensity of R&D, capital expenditure and advertising. A strategy based on buying high G_SCORE firms and shorting low G_SCORE firms consistently earns significant excess returns. The results are robust across partitions based on size, stock price, analyst following, exchange listing and prior performance and are not affected by the inclusion or omission of IPO firms. The excess returns persist after controlling for well documented risk and anomaly factors such as momentum, book-to-market, accruals and size. The stock market in general and analysts in particular are much more likely to be positively surprised by firms whose growth oriented fundamentals are strong, indicating that the stock market fails to grasp the future implications of current fundamentals. Further, the results do not support a risk based explanation for the book-to-market effect as the strategy returns positive returns in all years, and firms that ex-ante appear less risky have better future returns. To conclude, one can use a modified fundamental analysis strategy to identify mispricing and earn substantial abnormal returns.

Original paper – Download PDF

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Author

Partha S. Mohanram
Rotman School of Management, University of Toronto

Conclusion

As the invaluable research paper “Separating Winners from Losers Among Low Book-to-Market Stocks Using Financial Statement Analysis” by Partha S. Mohanram concludes, the study establishes that a strategy centered on financial statement analysis can effectively distinguish between winning and losing growth stocks concerning future performance.

The developed G_SCORE index, which combines traditional fundamentals with growth firm-specific measures, serves as a foundation for a strategy that consistently yields significant excess returns. These findings prove resilient across multiple scenarios and persist even after accounting for risk and anomaly factors, demonstrating that the stock market faces challenges in understanding current fundamentals’ future implications.

Moreover, the results contradict a risk-based explanation for the book-to-market effect. In conclusion, the research has shown that a modified fundamental analysis strategy can be instrumental in identifying mispricing opportunities and achieving substantial abnormal returns.

Related Reading:

Fundamental Based Market Strategies

Technical, Fundamental, and Combined Information for Separating Winners from Losers

FAQ

Q1: What is the primary focus of the research paper by Partha S. Mohanram?

The research paper investigates whether a strategy based on financial statement analysis of low book-to-market (growth) stocks can effectively differentiate between winners and losers in terms of future stock performance. It introduces the G_SCORE index, incorporating both traditional fundamentals and growth firm-specific measures.

Q2: What is the G_SCORE index, and how does it contribute to the strategy discussed in the paper?

The G_SCORE index is created based on a combination of traditional fundamentals such as earnings and cash flows, and growth firm-specific measures including the stability of earnings, growth, R&D intensity, capital expenditure, and advertising. This index forms the basis for a strategy involving buying high G_SCORE firms and shorting low G_SCORE firms, consistently generating significant excess returns.

Q3: What are the key findings of the research, and how do they contribute to our understanding of stock market dynamics?

The study demonstrates that the strategy built on financial statement analysis and the G_SCORE index consistently yields significant excess returns. These results are robust across various scenarios and persist after controlling for risk and anomaly factors. The research suggests that mispricing opportunities exist in the stock market, and a modified fundamental analysis strategy can be instrumental in identifying such opportunities and achieving substantial abnormal returns.

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