To The Moon

Hello Tigers!

In the previous session, I introduced you to a practical behavioral finance strategy: the long-term reversal strategy, which essentially follows the principle of "what goes up for too long must come down, and what goes down for too long must go up." Now, in this lesson, I'll introduce a new concept: "anomaly," and explain the investment opportunities it presents.

1.Anomaly factors in financial reports

First, let me explain what an "anomaly" is.

An anomaly refers to abnormal phenomena that contradict the traditional finance theory of risk-return correspondence. In traditional finance theory, we are often "taught" that the higher the return, the greater the risk.

However, behavioral finance has found that in practice, it's often possible to find strategies or methods to gain more profit without increasing risk. There's a specialized term in academia to describe this—anomaly.

You might ask, if you can increase returns without increasing risk, isn't that a huge boon?

Absolutely, in reality, behavioral finance strategies aim to find such trading opportunities. These anomalies that can generate excess returns are highly confidential to various asset management institutions or fund companies. They are constantly discovering the latest anomalies and relying on these anomaly factors to earn excess returns.

In fact, finding anomalies isn't difficult. Generally, experienced investors can identify these anomalies based on their trading experience. Therefore, anomalies occur frequently in trading and exist in almost all trading strategies.

Today, we'll mainly discuss the "anomaly" factors in financial reports.

2."Accrual Anomalies" in Financial Reports

For the vast majority of stock investors, financial reports are a crucial channel to understand the operating conditions of listed companies.

Generally, a simple financial statement provides a true record of various aspects of a listed company's operations. Reading financial reports is a basic requirement for many value investors.

However, from another perspective, precisely because most investors believe that the data disclosed in financial reports is true and reliable, few people think there are errors in them.

Therefore, as long as there are errors, anomalies can be found, and behavioral finance trading strategies can be formulated based on them.

So, where are the "anomalies" in financial reports?

Let me introduce you to a famous anomaly called the accrual anomaly. "Accruals" refer to accounting items that should be included in financial statements but have not yet been paid, mainly including accounts receivable, accounts payable, and inventory.

In 1996, Professor Sloan, an accounting professor at the University of Pennsylvania, first discovered the accrual anomaly. He found that buying stocks of companies with fewer accrual items and shorting stocks of companies with more accrual items can generate excess returns.

Why is this?

It turns out that many investors pay too much attention to the "earnings per share" indicator when looking at financial reports. They believe that the better this indicator, the better the future potential of the listed company.

However, just looking at this one indicator is far from enough. For example, do you know if a company with earnings per share of $2 is definitely worth more than a company with earnings per share of $1? But if both companies have earnings per share of $1, are they equally valuable?

The answer is: even if the profits are the same, the quality of earnings may be different because the operating conditions of the two companies may be very different. So, just looking at the earnings per share indicator is actually not enough.

You should also look at accrual items, which indirectly reflect the true value of a company's stock.

In fact, most investors in the market cannot see the difference in the quality of earnings between two companies, so they make the same valuation mistakes. Therefore, many financial institutions use the fact that "companies with high accrual items will have worse future earnings" to formulate behavioral trading strategies.

Professor Sloan used the above phenomenon to formulate a behavioral trading strategy. He first ranked all stocks by the size of their accrual items, then bought the group of stocks with the fewest accrual items and shorted the group of stocks with the most accrual items.

The results showed that investors using this strategy could achieve positive excess annualized returns in 29 out of 30 years during the sample period.

It can be seen that the data in financial statements can be used to formulate trading strategies. And accrual items, as a very stable anomaly, can also provide reference for your trading strategy.

3."Earnings Anomalies" in Financial Reports

In addition to accrual anomalies in financial reports that can be used to formulate trading strategies, there are also certain regularities in the performance of stock prices.

Professors Bernard of the University of Michigan and Thomas of Columbia University observed when companies publish quarterly financial reports that companies announcing good news and companies announcing bad news tend to exhibit a regularity in their stock prices: good news tends to keep stock prices rising, while bad news tends to keep stock prices falling.

The impact of various news on stock prices is like a long-lasting drift. They call this phenomenon earnings anomalies and have developed behavioral finance trading strategies based on it, which have maintained an annualized return of over 10% for more than 10 years in a row.

What's the principle behind this strategy? Let me explain:

Whenever a company's annual report or quarterly report is released, many stock investors speculate, thinking of it as the "annual report" or "quarterly report" market. In fact, the post-earnings announcement drift strategy comes from this phenomenon. In simple terms, good news brings about a rise in stock prices, while bad news brings about a decline in stock prices.

So, what constitutes good news and bad news?

For example, if one company reports a profit growth of 100%, and another company reports a profit growth of 200%, which piece of news is better?

Is it the latter? Not necessarily! The key is whether it exceeds expectations.

Analysts make profit forecasts for corporate financial statements before they are released. Therefore, if the profit growth of the latter company of 200% is fully expected, while the profit growth of the former company of 100% is completely unexpected, then the profit news of the former company is better.

So, when building a strategy, you should rank by "unexpected profit growth," that is, subtract the expected part from the actual profit growth. Bernard and Thomas ranked all stocks according to this method, then bought the high-surprise group and shorted the low-surprise group.

The results showed that generally, over 60 days after the financial reports were released, excess returns of over 10% could be obtained, and in a sample period of 13 years, profits were obtained in only 3 quarters.

It can be seen that learning to use the "earnings anomalies" in financial reports is also a very good behavioral finance strategy!

With that, this lesson comes to an end. In the next lesson, we'll talk about how to achieve long-term success using behavioral finance.

See you in the next lesson~