0:13

Learning Outcomes.

Â After watching this video,

Â you will be able to implement the accrual trading strategy.

Â [MUSIC]

Â >> Let's quickly recap what we have done so far.

Â We have calculated accrual component.

Â And then, we have learned how to segregate accrual and

Â cash component from total earnings, right?

Â Now with that, we are actually equipped

Â to sort companies based on a cruel components.

Â In other words, if you are given a list of say 100 companies,

Â you can actually calculate this component for each and every company and then,

Â rank these companies based on accrual or cash component, whichever way, right?

Â In fact, that's the first part of this trading strategy.

Â Now, let me describe the actual trading strategy that people use,

Â using this cruel anomally.

Â The first step is compute this ratio for

Â each and every company either accrual or cash.

Â So throughout this example, what I'll do is I will take up a accrual ratio.

Â So If I'm taking accrual ratio, please remember, rule of thumb,

Â higher accrual is bad, low accrual is good.

Â If you are taking cash ratio, you have to do the opposite, that's all.

Â So let me take accrual ratio throughout this example.

Â So what you do is as soon as results are announced,

Â the first step to do is for each company compute this accrual ratio.

Â That means, compute the accrual component and divide it by total assets.

Â 2:11

Please remember, when you are backtesting, you should always create

Â an environment as if which is replicable in real trading in future as well.

Â What do I mean by that?.

Â Supposed, if there is a two month gap between announcement of results,

Â end of the quarter or end of the year and actual announcement of your results,

Â you should actually start trading from the time where the figures are available.

Â I already talked about this while doing Piotroski.

Â Suppose you want to test whether accrual works in 2013 and

Â let's say, end of the year is December 31st, 2012,

Â you should not start your backtesting on 1st January 2013.

Â Why, answer is simple.

Â On 1st January 2013, you did not know

Â about these numbers neither was the broader market aware of.

Â Remember, in all our trading strategies, we do not

Â assume that you have some kind of priority information that's not required.

Â So, keep this in mind always in all our trading strategies,

Â when you do back tests, you have to behave as if you know this

Â is future because you think now you can pick up on January.

Â You can do calculations.

Â Taking January, on January 1st, 2013 using December 31st,

Â 2013 to a numbers, that is possible now because you know both the numbers.

Â But then, I saw in January 1st, 2013, you did not know these numbers.

Â 3:49

So in other words, if I want to do this for 2018, January 1st,

Â on January 1st 2018, you will not know December 31st, 2017 numbers.

Â That's what I'm trying to say.

Â Let's get back to study.

Â 4:02

Each company you calculate, this is accrual issue, you have this number,

Â now rank this companies, very simple.

Â Once you rank this companies then, categorize them into deciles so

Â you obviously will get 10 categories, 1 to 10.

Â Now what's the trading strategy that's loan test?

Â What loan does is that, now we're talking under accrual, right?

Â I think it's a good time for you to pause and think what should we long and

Â what should we short because by now, since you have seen many strategies,

Â you should have got this understanding of what we will short, what we will long.

Â 4:53

Firms where earnings are driven by cash, these earnings are more sustainable.

Â But the market behaves as if there is no difference between cash and

Â accrual companies, right?

Â So that's the whole idea behind this strategy.

Â 5:15

So in this ratio, suppose you are doing in an ascending order.

Â So, the last design is the one,

Â the category of last decile is the one that's need to be shorten.

Â And we go long on those firms with lower accrual which is the first decile so

Â this is a strategy which is slow in rising.

Â Please remember, this part is not casting short.

Â The whole thing that you understand from this strategy, there is a difference in

Â our needs persistence between accrual and cash and market fail to recognize this.

Â Now, it need not necessarily be first decile and the last decile.

Â It could be the first quartile or the last quartile also.

Â Or it could be below medium and above medium also.

Â You can try all this combination and

Â see what works best in the economic settings that you're examining but

Â then what's loan does is it picks up deciles and the first and the last decile.

Â Suppose, you're using this cash ratio, cash component, how would you get it?

Â Income from continuing operations minus accrual, right?

Â [COUGH] Suppose you are using that, then what do you do?

Â High cash is good, low cash is bad.

Â And, if you have arranged your firms in an ascending order of this ratio,

Â so you will go long on the top decile and go short on the bottom decile.

Â So that's going to be the strategy.

Â Now, what as loan form?

Â No, what loan does is he takes a period between, I think,

Â 30 year period between 1962 to 1991 and

Â he test this strategy where he holds this, he does this low decile,

Â high decile portfolio long, short portfolio and this hold this for a year.

Â 7:03

And every year he does it.

Â And what he finds is that, very interesting,

Â on an average returns are about 10%.

Â Now you may think, what is great about 10%?

Â Even a fund which just buys and

Â holds an index may make 10% most of the time, right?

Â What so great about 10%?

Â It is great because you have invested nothing.

Â Yeah, it is true because, what are you doing?

Â You're going long on decile and you're going short on a decile.

Â So you buy something, sell something.

Â So what have we invested?

Â Zero, so technically the expected return, if the markets were perfect, is zero.

Â You should not have made any return because you've not invested anything.

Â But then you made 10%, this is huge.

Â 7:54

Remember, although in you invested zero,

Â in real life you will have to put some margin for going short.

Â You can figure this out from your broker.

Â The rules differ from country to country.

Â There is no point in talking about it in this video.

Â There is no generalized rule here.

Â That you can figure out, and again,

Â it depends on the economic setting that you trade in.

Â But then, the investment is very low.

Â Either it is zero or it as a margin that you want to put up.

Â The returns that loans finds in the US is more than 10% for a 30 year period.

Â And more interestingly, I think only two of those 30

Â years he finds negative returns, now, this is fabulous.

Â Remember this, a lot of strategies work well on an average but

Â then, as I've warned you before in one of the earlier videos.

Â We have explained that if you have a strategy that makes money on an average

Â but then there are years where you make large losses such strategy may not be

Â sustainable.

Â 9:07

You may not be able to continue or

Â hold on until that period when you make that large gain.

Â But here, that is not the case.

Â You make regular gains and occasional losses and

Â that to the occasional losses are not huge.

Â Now remember, this is in the past.

Â There's no guarantee that this is going to happen in the future.

Â That's true with any targeting trading strategy.

Â But this is the 30 year period.

Â A number of people have tested after that.

Â This strategy doesn't work as well in the US market now because people

Â have figured it out but then, in other markets, emerging markets,

Â we have tested this on India, it works very well.

Â This strategy works.

Â So, what do you have to do now?

Â 9:56

In your respective countries or whichever country where you want to trade,

Â pick up the income statement and balance sheet of firms,

Â calculate these three ratios of income from continuing operations, accrual ratio,

Â cash ratio, of course, first you have to calculate the accrual component itself.

Â Divide the firms into the sides and then, execute your strategies.

Â Go long on shot or top or

Â bottom decile based on whether you're sorting them using cash or accruals.

Â 10:33

Remember one thing, you have to check whether sorting is allowed in that

Â country where you're trading.

Â In many cases, shorting is not allowed.

Â Then, you may have to restrict yourself to only those forms where

Â you are allowed to go short, that's one thing that you will have to check.

Â And then, you can execute this strategy.

Â Again, I recommend that you first back test this strategy for

Â a number of years and once you're reasonably confident that this works,

Â you can test this on a mock portfolio and then, implement this with real money.

Â So any questions, any doubts on this, you can write to us.

Â We will move onto the next strategy now.

Â