Combining Fundamental FSCORE and Equity Short-Term Reversals

The short-term reversal in stock returns is already a well known and a well established anomaly that appears to contradict the weak-form market efficiency. Strategy based on this anomaly buys past winners and sells past losers. A possible and sensible explanation of the short-term reversal phenomenon is the overreaction of investors. Research in the past focused primarily on noise trading and ignored the important role of fundamental information. Curiously, new research suggests that there is a need to study the impact of fundamental news on short-term return reversals. Where a nonparametric metric of fundamental strength (FSCORE) is used to measure the impact from fundamental information. The need to measure the aforementioned impact is clear - there is an overwhelming evidence that investors underreact to fundamental news. Moreover, fundamental information metric has a persistent predictive effect on stock returns, what is consistent with the hypothesis of the slow diffusion of information and investor underreaction. Simply said, high FSCORE firms tend to earn much higher returns than low FSCORE firms. The paper has found significant evidence that recent losers with strong fundamental strength and recent winners with weak fundamental strength experience stronger reversals than other reversal portfolio strategies. A fundamental-anchore reversal strategy exploits this finding and this reversal strategy could generate a high significant average monthly returns that outperform the profit from the unconditional and traditional reversal strategy. The paper primarily studies all common stocks, however we present the data about large stocks since the small stocks bear their own unique features.

Fundamental reason

There are three reasons to use FSCORE. Firstly, FSCORE is a comprehensive metric of a firm’s fundamental strength, because this score synthesizes information from nine signals along three dimensions of a firm’s financial performance (profitability, change in financial leverage and liquidity, and change in operational efficiency). Secondly, the fundamental information is gathered directly from the financial statements, which obviates the measurement error problem. And lastly, FSCORE is a nonparametric measure, comparing with a parametric approach, FSCORE is more robust and helps to reduce concerns over potential estimation biases. Moving into reasons for functionality of the proposed strategy, results support the hypothesis that short-term reversals are influenced by both noise trading and investor underreaction to fundamental information. Also results from regression analysis suggest that both noise trading and fundamental information significantly influence stock returns in the short horizon. No doubt, there is an conclusion that investor underreaction to fundamental information coupled with a noise trading can explain the observed empirical patterns in short-term reversals. Moreover, results indicate that the bid-ask spread cannot be the main source of the profitability for short-term reversals and the results are not particularly sensitive to alternative definitions of fundamental strength. Last but not least, simple short-term reversal and industry-adjusted reversal strategies fail to be profitable in the presence of transaction costs, however fundamental anchored reversal strategies are economically profitable even in the presence of transaction costs.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Monthly
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification, common stocks (share code 10 or 11) listed in NYSE, AMEX and NASDAQ exchanges. Stocks with prices less than $5 at the end of formation period are excluded.
Complexity evaluation
Very complex strategy
Notes to Complexity evaluation
Financial instruments
stocks
Backtest period from source paper
1984-2015
Indicative performance
12.01%
Notes to Indicative performance
data from table 6, Panel A, Large stocks, annualized monthly performance (0,95%)
Estimated volatility
20.61%
Notes to Estimated volatility
data from table 6, Panel A, Large stocks, annualized monthly volatility computed from t-stat (3,08)
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.39

Keywords:

reversal, equity long short, financial statements effect, stock picking

Simple trading strategy

The investment universe consists of common stocks (share code 10 or 11) listed in NYSE, AMEX and NASDAQ exchanges. Stocks with prices less than $5 at the end of formation period are excluded.

The range of FSCORE is from zero to nine points. Each signal is equal to one (zero) point if the signal indicates positive (negative) financial performance. A firm scores one point if it has realized a positive return-on-assets (ROA), a positive cash flow from operations, a positive change in ROA, a positive difference between net income from operations (Accrual), a decrease in the ratio of long-term debt to total assets, a positive change in the current ratio, no issuance of new common equity, a positive change in gross margin ratio and lastly a positive change in asset turnover ratio. Firstly, construct a quarterly FSCORE using the most recently available quarterly financial statement information.

Monthly reversal data are matched each month with a most recently available quarterly FSCORE. Firm is classified as a fundamentally strong firm if the firm’s FSCORE is greater than or equal to seven (7-9), fundamentally middle firm (4-6) and fundamentally weak firm (0-3). Secondly, identify the large stocks subset - those in the top 40% of all sample stocks in term of market capitalization at the end of formation month t. After that, stocks are sorted on the past 1-month returns and firm’s most recently available quarterly FSCORE. Take a long position in past losers with favorable fundamentals (7-9) and simultaneously a short position in past winners with unfavorable fundamentals (0-3). Strategy is equally weighted and rebalanced monthly.

Hedge for stocks during bear markets

Yes - Equity reversal strategies are usually type of "liquidity providing" strategies and as such they usually perform well during market crises. However, reversal strategies are also naturally a "short volatility" strategies, their returns increase mainly in the weeks following large stock market market declines. Traders must be catious during crisis during days with a high volatility as reversal strategies usually force traders to buy stocks which performed especially bad (and to sell short stocks with an extremelly positive short term performance). This position is emotionally hard to open and risk management of reversal strategies must be also very strict during these days. We recommend reading research paper by Nagel: "Evaporating Liquidity" to gain insight into behaviour of reversal strategies during crises.

Source Paper

Zhu, Zhaobo and Sun, Licheng and Chen, Min: Noise Trading, Slow Diffusion of Information, and Short-Term Reversals: A Fundamental Analysis Approach
https://ssrn.com/abstract=3097420
Abstract:
Contrary to the conventional wisdom that short-term return reversals are rooted in investors’ overreaction to fundamental news or driven by liquidity-based noninformational shocks alone, we find strong evidence that both noise trading and investor underreaction to fundamental information contribute to the reversal. With help from a comprehensive and nonparametric measure of firms’ fundamental strength, we document that an enhanced short-term reversal strategy that buys past losers with strong fundamentals and sells past winners with weak fundamentals significantly outperforms the unconditional reversal strategy. Our findings are consistent with the predictions of theoretical models where investors underreact to slowly diffusing fundamental information.

Hypothetical future performance

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