Multiple factors are explaining abnormal equity returns, which could be used to build a profitable equity long-short strategy. The most common are momentum, value, short-term reversal, size factors, etc..

We present an academic research paper that shows additional useful factor – earnings quality. Stocks with high quality (defined via multiple ratios) outperform stocks with low quality. Earnings quality factor portfolio has low to negative correlation to other factor portfolios and could be therefore used as a valuable diversifier in a multifactor long-short equity strategy.

Fundamental reason

The effect is explained mainly by investors’ behavioral defects. The majority of investors usually overly fixate on actual earnings, and they do not investigate the quality of earnings scrutinizingly. The in-depth analysis, therefore, allows exploiting this inefficiency.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Strong

Backtest period from source paper
1988-2012

Notes to Confidence in Anomaly's Validity

Indicative Performance
7.95%

Period of Rebalancing
Yearly

Notes to Indicative Performance

per annum, annualized (geometrically) monthly return of 0.6399%, data from table VIII for “Mix” portfolio in US


Notes to Period of Rebalancing

Estimated Volatility
5.91%

Number of Traded Instruments
1000

Notes to Estimated Volatility

estimated from t-statistic 9.09, data from table VIII for “Mix” portfolio in US


Notes to Number of Traded Instruments

more or less, it depends on investor’s need for diversification


Maximum Drawdown
0%

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

not stated


Notes to Complexity Evaluation

Sharpe Ratio
0.67

Simple trading strategy

The investment universe consists of all non-financial stocks from NYSE, Amex and Nasdaq.

Big stocks are defined as the largest stocks that make up 90% of the total market cap within the region, while small stocks make up the remaining 10% of the market cap. Investor defines breakpoints by the 30th and 70th percentiles of the multiple “Earnings Quality” ratios between large caps and small caps.

The first “Earnings Quality” ratio is defined by cash flow relative to reported earnings. The high-quality earnings firms are characterized by high cash flows (relative to reported earnings) while the low-quality firms are characterized by high reported earnings (relative to cash flow).

The second factor is based on return on equity (ROE) to exploit the well-documented “profitability anomaly” by going long high-ROE firms (top 30%) and short low-ROE firms (bottom 30%).

The third ratio – CF/A (cash flow to assets) factor goes long firms with high cash flow to total assets.

The fourth ratio – D/A (debt to assets) factor goes long firms with low leverage and short firms with high leverage.

Investor builds a scored composite quality metric by computing the percentile score of each stock on each of the four quality metrics (where “good” quality has a high score, so ideally a stock has low accruals, low leverage, high ROE, and high cash flow) and then add up the percentiles to get a score for each stock from 0 to 400. He then forms the composite factor by going long the top 30% of small-cap stocks and also large-cap stocks and short the bottom 30% of the small-cap stocks and also large-cap stocks and cap-weighting individual stocks within the portfolios.

The final factor portfolio is formed at the end of each June and is rebalanced yearly.

Hedge for stocks during bear markets

Yes - Based on the source and related research papers (see, for example, tables 4.2 and 3.5 from paper Jensen-Gaard: Equity Investment Styles – Recent evidence on the existence and cyclicality of investment styles), strategy has a positive return during recession months therefore probably can be used as a hedge/diversification to equity market risk factor during bear markets.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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