Quarterly Accruals or Cash Flows in Portfolio Construction?

Using quarterly and rolling four-quarter data, this study explores the incremental roles of accruals and net operating cash flows in generating abnormal returns for the full population of U.S. listed companies and specific industries. Quarterly net operating cash flow (OCF) is a stronger signal of the next quarter’s returns than are accruals. When rolling four-quarter OCF and accruals were used to construct portfolios held for a whole year, however, OCF dominated accruals only in the first three fiscal quarters. The industry-specific results are consistent with the results for the full population. For most industries, investment managers and financial analysts should focus on OCF more than on accruals. The accruals anomaly, in which a portfolio consisting of long (short) positions in stocks with the lowest (highest) accruals earns average abnormal annual returns of about 10 percentage points, has received considerable attention by academics and practitioners in the past decade. This anomaly may be attributable to the market’s failure to correctly evaluate the quality of earnings by ignoring the information embedded in the breakdown of earnings into net operating cash flows and accruals. Professional investors and analysts may be using either accruals or net operating cash flows in their investment decisions or when they forecast future earnings. Which of the two will yield higher future returns is ultimately an empirical question—with meaningful implications for practitioners. The academic literature on this topic is sparse, relates only to annual accruals and cash flows, and is inconclusive. We address this empirical question in this article. In this study, we extend this literature by exploring two questions: Are quarterly accruals associated with future abnormal returns after the information in net operating cash flows has been controlled for? Is the accruals anomaly stronger in certain industries, and as a related question, do net operating cash flows overshadow accruals as a signal for portfolio selection in some industries? In our study, we analyzed U.S. stocks on a quarterly basis for the 1993–2006 period. Our results show that quarterly net operating cash flow (OCF) is a stronger signal than accrual information of subsequent quarters’ returns. We found that this result is also true for rolling four-quarter OCF and accrual data. When these data were used to construct portfolios that were held for a whole year (as in most of the accruals literature), OCF dominated accruals in the first three fiscal quarters but not in the fourth quarter. Thus, this study shows the importance of using quarterly data to analyze signals based on accruals and OCF. Our analysis of the signals in specific industries showed that rolling four-quarter accruals were significantly and negatively associated with returns over the subsequent year in 5 of the 17 industries analyzed but that OCF was significantly and positively related to future returns in all but 1 industry. When the industry analysis was carried out with both signals used, OCF remained incrementally significant in 13 of 17 industries whereas accruals were incrementally significant in only 5 industries (and even in those cases, the sign was positive instead of the negative sign shown for the full population). Thus, OCF dominated accruals in the industry analysis. The results of this study can be used by investment professionals and financial analysts. The results show the superiority of net operating cash flows as a signal for forming portfolios and for assessing the future prospects of companies, even after accruals have been controlled for. And these results are applicable in most industries. The results also indicate, however, that accruals may provide additional relevant information beyond OCF about companies’ future prospects. So, a combination of the two signals may be the most valuable for investors. The study also has benefits for academic research into the role of accruals versus the role of OCF. Previous academic studies on this issue are inconclusive, but they have one common denominator: They all used annual data and investigated the effects of the signals on portfolios held for one year. Our study sheds light on the OCF and accruals signals from quarterly data, and our findings indicate that prior results are sensitive to the use of annual data. Moreover, practitioners are more likely to be interested in using quarterly data, when those data are available, than annual data.