How to beat the market with Sloan Ratios

Earnings are important drivers of share prices. Investors use earnings as basis to project how stocks are likely to be valued in the future.

The problem is, not all earnings are created equal.

Companies use accrual accounting to record any revenue or expense incurred, either as accounts receivables or payables, even if cash has not yet been received or paid.

Accruals are useful, in the sense that they help provide a more complete picture of a company’s financial situation, but its application is heavily dependent on the judgment of management, as well as their auditors.

In 1996, a professor from the Wharton School of University of Pennsylvania by the name of Richard Sloan suggested that investing in companies with low accruals were more profitable than companies with high accruals.

Sloan explained that low accrual companies tend to outperform the high accrual companies because they generate a higher cash flow component in their earnings.

The cash flow portion of a company’s earnings is a better determinant of future growth than the accrual component.

Sloan said investors normally focus too much on reported earnings and not on cash generation.

Because of this, investors overestimate the accrual portion of a company’s earnings when forming expectations by pushing up stock prices, only to be disappointed when the actual earnings fall short of projections.

To identify the accrual exposure of companies, Sloan proposed the use of a ratio that measures the accruals by deducting the free cash flow from a company’s net income and dividing it by its total assets.

We define free cash flow as the difference between the operating cash flows and investing cash flows, both of which you can find in the cash flow statement of a company.

A company is considered to be safe if its Sloan Ratio is between -10 percent and 10 percent, but if its ratio goes beyond -10 to -25 percent on the negative side, or 10 to 25 percent on the positive side, it means that accruals are increasing.

If we will apply this ratio to our stock market, using prepandemic 2018 data, we will find that the Sloan Ratio of stocks belonging to the Philippine Stock Exchange (PSE) Index is negatively correlated to their market capitalization.

This means that the higher the Sloan Ratio goes up, the lower the stock price of a PSE Index stock will be in three years in 10.7 percent of the time.

The results also show that stocks with high Sloan Ratios are also likely going to underperform those with low Sloan ratios.

Bloomberry Resorts, for example, was one of best performing stocks in 2017, but in 2018, its Sloan Ratio has increased to 21.1 percent. As predicted by the model, its stock price corrected by 29.5 percent after 2.5 years.

If we compare this to a low accrual and high cash flow company like ICTSI, we will see that its Sloan Ratio in 2018 was only 3.3 percent.

The stock was underperforming the market but investors eventually rewarded the stock with an 83-percent gain in less than three years.

Following this theory, we can say that high accrual stocks tend to enjoy strong market support at the start, until it becomes overvalued and subsequently earn low returns.

Similarly, low accrual stocks tend to become undervalued initially, and generate high returns afterwards.

If we look at the average Sloan ratio of the PSE Index, we can see a similar pattern too. The level of accrual activities of listed companies has been going down, along with the fall in the stock market.

In 2018, during the peak of the PSE Index, the average Sloan Ratio of the market was high at 4.7 percent. This started to decline to 2.6 percent in 2019 and 1.9 percent during the 2020 pandemic.

With the reopening of the economy this year, the recovery in revenues and profitability of companies also increased the average Sloan Ratio in the market to 3.0 percent.

Despite this, about one third of index stocks are still below average such as Aboitiz Equity, which has Sloan Ratio of 0.63 percent; GT Capital, -0.04 percent, and Megaworld, 1.27 percent.

Given that rising accruals historically predict negative stock returns, buying stocks with a focus on cash flow growth can help improve long-term investment returns. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 93rd batch of RFP program this January 2022. To register, email [email protected] or text at 0917-6248110