25 Years of Fundamental Analysis

1
25 Years Of
Accounting-Based
Investment Strategies
From Ou and Penman (1989) to Ball et al. (2015)
Introduction
On this page, I provide an overview and discussion of the most important accounting-based
investment strategies that have been developed and studied over the past 25 years. Particularly, I focus
on the methodology, the documented results and I will advance some short conclusions with respect to
the effectiveness of each of these strategies. The studies are in chronological order:
1. Bernard and Thomas, Post-Earnings-Announcement Drift: Delayed Price Response or Risk
Premium? published in the Journal of Accounting Research in 1989. <to be discussed>
2. Ou and Penman, Financial Statement Analysis and The Prediction of Stock Returns published
in the Journal of Accounting Research in 1989.
3. Abarbanell and Bushee, Abnormal Returns to a Fundamental Analysis Strategy published in
The Accounting Review in 1998.
4. Piotroski, Value Investing: The Use of Historical Financial Statement Information to Separate
Winners from Losers published in the Journal of Accounting Research in 2000.
5. Beneish, Lee, and Tarpley, Contextual Fundamental Analysis Through the Prediction of
Extreme Returns published in the Review of Accounting Studies in 2001.
6. Mohanram, Separating Winners from Losers among Low Book-to-Market Stocks using
Financial Statement Analysis published in the Review of Accounting Studies in 2005.
7. Penman and Zhang, Modeling Sustainable Earnings and P/E Ratios Using Financial Statement
Information published as Working Paper in 2006.
8. Huang, The Cross Section of Cash Flow Volatility and Expected Stock Returns, published in
the Journal of Empirical Finance, 2009. <to be discussed>
9. Wahlen and Wieland, Can financial statement analysis beat consensus analysts
recommendations? published in the Review of Accounting Studies in 2010.
10. Dickinson and Sommers, Which Competitive Efforts Lead to Future Abnormal Economic
Rents? Using Accounting Ratios to Assess Competitive Advantage published in the Journal of
Business, Finance & Accounting in 2012.
11. Novy-Marx, The other side of value: The gross profitability premium published in The Journal
of Financial Economics, 2013. <to be discussed>
12. Ball et al., Deflating profitability published in The Journal of Financial Economics, 2015. <to
be discussed>
http://www.stevendeklerck.com/25-years-of-accounting-based-investment-strategies.html
13. Foerster et al., Are Cash Flows Better Stock Return Predictors Than Profits", 2015. <to be
discussed>
14. Ball et al., Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock
Returns", 2015. <to be discussed>
Ou and Penman, 1989

This paper performs a financial statement analysis that combines a large set of financial statement
items into one summary measure which indicates the direction of one-year-ahead earnings changes.
(Ou and Penman, 1989, p. 295)
Name of investment strategy: Pr
Number of accounting variables used: 68
Use of statistical techniques: YES
Ou and Penman (1989) concerns the first important study trying to establish an investment strategy
based on fundamental accounting information. The researchers try to forecast whether a company will
realize an increase / a decrease in profits over the next fiscal year. For that purpose, Ou and Penman
(1989) select more than 60 (!) accounting variables. Through various statistical analyses (i.e.
univariate analyses and stepwise logistic regression), Ou and Penman (1989) model the relationship
between these accounting variables in year t on the one hand and the increase in profits realized
(indicated by a 1) or the decrease in profits realized (indicated by a 0) on the other in year t+1.
Afterwards, this modelled statistical relationship is used in order to predict the probability of an
increase in profits regarding a new fiscal year (e.g. year t+2) for each company; Ou and Penman
(1989) denote this probability by Pr.
In a next step, the companies are sorted based on their predicted probability. It is understood that as an
investor, you are mainly interested in buying the companies with the highest probability of an increase
in profits and selling the companies having the highest probability of a decrease in profits. Ou and
Penman (1989) establish stock portfolios three months after fiscal year end. This choice might
introduce a look-ahead bias if not all companies have published their annual accounting statements
within three months after fiscal year end.
Ou and Penman (1989) document a buy-and-hold hedge return of 16.8 percent over a 24-months
period for their investment strategy over the (limited) period 1973-1983. The biggest part of the hedge
return originates from the short position. Long portfolios are characterized by a significantly higher
debt ratio and consequently they are more risky compared to short portfolios.
Later studies identify various shortcomings related to the Ou and Penman (1989) fundamental
investment strategy. A brief overview:
1. Holthausen and Larcker (1992) document that the Pr measure does not predict stock returns very
well after 1983, which is due to an overfitting of the data in Ou and Penman (1989).
2. Greig (1992) finds that the positive association between the Pr measure and subsequent stock
returns becomes insignificant and even negative when size is controlled. Greig (1992) concludes that
the Ou and Penman (1989) results are another manifestation of the size effect rather than new
evidence of market inefficiency. Similar findings have been documented by Bernard, Thomas and
Wahlen (1997). They also find considerable volatility in returns through time and a high risk of loss.
3. Abarbanell and Bushee (1998) identify three important disadvantages of the Ou and Penman (1989)
approach. First, Ou and Penman (1989) do not attempt to identify a priori conceptual arguments for
studying any of their 68 accounting variables. Secondly, the Ou and Penman (1989) approach retains a
large number of explanatory accounting variables, many of which fail to inspire any obvious businesseconomic logic as to why the retained variables would be good predictors of the change in one-yearahead earnings. Finally, the set of accounting predictors changes from one short estimation period to
the next, making it both difficult to identify the business-economic forces reflected in these variables
and to exploit a consistent fundamentals-based investment strategy across time.
4. Piotroski (2000) considers the use of complex methodologies and a vast amount of historical
accounting information to make the necessary predictions to be serious shortcomings of the Pr
measure.
Otherwise said, based on the Ou and Penman (1989) study, in general we dont learn much about the
relationship between critical accounting items and future stock returns. Despite the lack of robustness
on the US dataset (e.g. Holthausen and Larcker, 1992), the Ou and Penman (1989) Pr measure has
been found to be effective in South-Korea by Chung, Kim and Lee (1998) and in New Zealand by
Goslin, Chai and Gunasekarage (2012). In light of these international results, some readers might be
interested to pursue the Ou and Penman (1989) strategy in greater depth. The study by Goslin, Chai
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and Gunasekarage (2012) provides an accessible and recent paper to become familiar with the Ou and
Penman (1989) Pr measure.
To conclude, it is important to indicate that Ou and Penman (1989) see significant research
opportunities with respect to the improvement of their fundamental investment strategy. One of these
improvements is the contextual analysis of the financial statements. A contextual analysis of the
financial statements implies that the financial analyst also takes into account characteristics such as
the type of industry in which the company operates as well as the life-cycle phase of the company.
Dickinson and Sommers (2012) is the first study that actually strictly responds to this research
opportunity in a comprehensive manner.
Further, [our analysis] was based on a pooling of all firms and one suspects that industry-specific or
firm-specific models would produce improvements. (Ou and Penman, 1989, p. 328)
Abarbanell and Bushee, 1998

It lasted about ten years following Ou and Penman (1989) for a truly new fundamental investment
strategy to be introduced in the accounting literature. The next attempt was made by Abarbanell and
Bushee in 1998.
Name of investment strategy: /
In 1993, Lev and Thiagarajan argued that the purely statistical approach, the computation of an
extensive set of detailed accounting variables (68 accounting variables in Ou and Penman (1989)) and
the employment of intricate statistical methodologies are important disadvantages of the Ou and
Penman (1989) Pr strategy. As a consequence, Lev and Thiagarajan (1993) abandon the statistical
search procedure and appeal to the analyses of financial analysts in The Wall Street Journal, Barrons,
Value Line, in order to compile a list of relevant accounting signals for stock selection. Their socalled guided search procedure yielded twelve fundamental signals; the signals are shown in the
following table.
Nine out of these twelve signals are used by Abarbanell and Bushee (1998) in the development of a
fundamentals-based investment strategy. The most important signals deal with relative changes in
inventories, accounts receivables, capital expenditures, gross margins and selling and administrative
expenses. The other variables set forth by Lev and Thiagarajan (1993) are from my point of view
either too fine-grained to be (internationally) relevant and/or result in a massive reduction of the
number of available companies due to the lack of data availability.
In contrast with the other papers, the explanations by Abarbanell and Bushee (1998) make it
impossible for me to replicate their study. Consequently, the obscureness of the methodology makes it
difficult to pronounce upon the effectiveness of their strategy. Given this observation and the fact that
the strategy has taken no prominent place in later literature (witness the lack of replications of the
strategy by other researchers (e.g. Goslin, Chai and Gunasekarage (2012)), among other arguments,
raises doubts about its effectiveness. I leave it to the reader whether he or she finds some added value
in the paper by Abarbanell and Bushee (1998).
Piotroski, 2000
A limitation of these two studies [Ou and Penman (1989) and Holthausen and Larcker (1992)] is the
use of complex methodologies and a vast amount of historical information to make the necessary
predictions. (Piotroski, 2000, p. 10)
Name of investment strategy: F-SCORE
Use of statistical techniques: NO
To the best of my knowledge, Piotroski (2000) is one of the very few researchers in the accounting
literature who appreciates the advantages and the elegancy of simple accounting-based investment
strategies (for individual investors). With simple, I mean the use of a limited number of broad
accounting variables and the lack of obscure statistical methods requiring the availability of the data
for all public companies over many years.
Piotroski (2000) investigates whether a much more simplified financial statement analysis enables to
discriminate between value stocks with a low and high future return. Companies are assessed on nine
binary accounting criteria that apply to profitability, leverage, liquidity, sources of funds and operating
efficiency respectively. This is shown in the following table.
Under F-SCORE profitable firms (in terms of net earnings and cash flow from operations) and firms
with a current improvement in business and financial fundamentals (i.e. profitability, solvency,
liquidity, profit margin and efficiency) are rewarded with a score of +1. Furthermore, and similar to an
increase in financial leverage, the issuance of common equity is considered to be a negative for future
firms performance. Finally, Piotroski (2000) entertains the accrual anomaly documented by Sloan
(1996). Sloan (1996) documents that the accrual component of earnings has lower persistence than the
cash flow component of earnings. Sloan (1996) also shows that investors fail to distinguish fully
between the different properties of the accrual and cash flow components of earnings.
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With respect to the accrual anomaly, it should be noted however that Green, Hand and Soliman
(2011) find that the cumulative raw annual hedge portfolio return to Sloans accrual definition is
negative over the 2000-2010 period. Raw annual hedge portfolio returns were negative in seven out of
the eleven years over the 2000-2010 period. Similar results are documented for size-adjusted returns.
Richardson, Tuna and Wysocki (2010) [a recent literature overview on fundamental analysis] and
Green, Hand and Soliman (2011) attribute the attenuated relationship between accruals and future
stock returns to the exploitation of the associated anomaly by hedge funds.
Piotroski (2000) computes F-SCORE as the simple sum of the nine binary accounting signals. As a
consequence, companies with a high (low) F-SCORE are characterized by a broad improvement
(decline) in financial performance during the previous fiscal year. Piotroski (2000) documents that
over the 1976-1996 period in a high book-to-market portfolio the average annual portfolio return can
be increased significantly by at least 7.4 percent through the selection of high book-to-market stocks
with high F-SCOREs. This means that within a value portfolio companies with the strongest overall
improvement in business fundamentals as measured by F-SCORE generate the highest returns.
The results for the raw returns are shown in the following table. We observe that value stocks with
high F-SCOREs realize a one-year raw return of 31.3 percent, significantly higher compared to value
stocks with low F-SCOREs (7.8 percent).
When looking at the fundamental signals underlying F-SCORE, we also see that the F-SCORE
strategy can be considered to be an underreaction strategy. The majority of the accounting signals
respond to the improvement or downswing in business and financial fundamentals over the previous
fiscal year. Handling this information by market participants will be done quicker when it concerns
large cap stocks followed by a considerable number of analysts and enjoying quite some media
attention (e.g. Hong, Lim and Stein, 2000). Piotroski (2000) documents that the effectiveness of Fhttp://www.stevendeklerck.com/25-years-of-accounting-based-investment-strategies.html
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SCORE is indeed concentrated in slow information-dissemination environments, viz. in the group
of small and medium-sized companies, companies with low share turnover, and firms with no analyst
following. This is shown in the following table. While the difference in returns between high FSCORE firms and low F-SCORE firms is significant for both small and medium firms, the opposite
can be said for large firms.
As opposed to some of the other accounting-based investment strategies, F-SCORE has become a
frequently used fundamental investment strategy among financial analysts and equity investors. FSCOREs popularity definitely originates from the simplicity of the strategy and the use of clear and
well-known fundamental signals. F-SCORE has been integrated into many popular stock screeners.
I would like to conclude the first ten years of research in the accounting literature on fundamentalsbased investment strategies (from Ou and Penman (1989) to Piotroski (2000)) with two important
observations.
First, it has become clear that a massive amount of accounting information is not automatically
translated into robust and/or promising investment strategies. Ou and Penman (1989): 68 ad-hoc
selected accounting variables. Piotroski (2000): 9 accounting variables with a strong businesseconomic rationale.
Secondly, the absence of statistical techniques makes the strategy by Piotroski (2000) much more
user-friendly. In case of Ou and Penman (1989) and Abarbanell and Bushee (1998) but also in the
case of Penman and Zhang (2006) and Dickinson and Summers (2012) as an investor you have to
compute ALL accounting information for ALL companies in order to be able to run the annual
regressions over the past three and more fiscal years. This is not the case for the Piotroski (2000)
strategy. In case of F-SCORE, you as an investor can look for the first 20-30 companies with high
F-SCORE during the publication season, which is a relatively easy task.
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Beneish, Lee and Tarpley, 2001

Name of investment strategy: /
Number of variables used: 21
Before starting with a brief discussion of the Beneish, Lee and Tarpley (2011) paper, it is important to
mention that the paper does not report realizable portfolio returns; this fact is noted in a single line on
p. 179 of the paper:
The disadvantage of this approach is that, strictly speaking, we cannot implement a trading strategy
based on this model. (Beneish, Lee and Tarpley, 2001, p. 179)
Beneish, Lee and Tarpley (2001) start from the observation that US stocks in the top two percent
realize an average +69% size-adjusted return per quarter over the 1976-1997 period; stocks in the
bottom two percent realize an average -28% per quarter. Starting from this observation, it would be
quite lucrative when we as investors should be capable to forecast ex ante the stocks with extreme
(positive) returns. To that end Beneish, Lee and Tarpley (2001) apply a two-stage approach, first using
market-based signals to identify likely extreme performers (both winners and losers), and then
applying fundamental signals to differentiate between extreme winners and extreme losers among the
firms identified as likely extreme performers in the first stage. Beneish, Lee and Tarpley (2001)
consider their two-stage procedure an application of a contextual financial statement analysis.
They find that extreme performers, i.e. stocks with extreme positive and negative quarterly returns,
have the profile of young growth firms engaged in more speculative ventures as reflected in the
variables AGE, SIZE, AVGVOL, SGI, STDRET, R&D and S/P. All the variables used by Beneish,
Lee and Tarpley (2001) are shown in the following table.
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Within the group of extreme performers, Beneish, Lee and Tarpley (2001) find that extreme losers are
confronted with lower sales growth (SGI), decreasing margins (GMG), lower R&D expenditures
(R&D), more negative earnings surprises (CHGEPS), negative momentum (FRTN6), more aggressive
accruals (ACCRUAL) and higher capital expenditures (CAPX). They conclude that extreme losers
have the profile of over-extended growth stocks. As a consequence, these variables might be useful to
growth investors who want to avoid growth torpedoes in their portfolio.
The paper is discussed by Sloan (2001). Sloan (2001) argues that the selection of the context (i.e.
extreme performers) is characterized by a poor business-economic rationale on the one hand and that
the market and accounting variables are mechanically selected from the past literature on the other
(i.e. the variables are not tailored to the specific context).
Overall, the in-sample methodology used by Beneish, Lee and Tarpley (2001) and the corresponding
absence of realizable portfolio returns lead to a disappointing reading.
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Mohanram, 2005
Name of investment strategy: G-SCORE
Mohanram (2005) follows in the footsteps of Piotroski (2000). Mohanram (2005) applies a financial
statement analysis to a broad sample of low book-to-market or glamour firms. The financial statement
analysis consists of eight signals: signals related to earnings and cash flow profitability, signals related
to nave extrapolation and signals related to accounting conservatism. The following table provides an
overview of the three categories.
The first three signals of G-SCORE are part of the Earnings and Cash Flow Profitability category. It
is assumed that relatively highly profitable firms are more likely to maintain their relative high
profitability. Consequently, companies with net income to total assets and cash flow from operations
to total assets larger (smaller) than the industry median are rewarded with a score of +1 (0). The third
signal in this category incorporates the findings by Sloan (1996).
As part of the Nave Extrapolation category, two accounting signals relative earnings variability
and relative sales growth variability are added to the list. Mohanram (2005) reasons that the odds
that current strong performance is sustainable, is significantly lower for firms with relatively high
variability in earnings and sales growth. Consequently, firms with below (above) industry median
variability in earnings and sales growth get a score of +1 (0).
The three signals under the heading of Accounting Conservatism reward companies with above
median levels of investments in R&D, capital expenditures and advertising. These investments
depress current earnings and book values the two drivers underlying the residual earnings model
but may boost future earnings growth rates when the investments start to pay off. R&D and
advertising expenditures are often expensed based on traditional accounting rules. Mohanram (2005)
fails to explain why the Capital Expenditure to Total Assets ratio belongs to the Accounting
Conservatism category.
The eight signals are again assembled in an index: G-SCORE. Mohanram (2005) shows that GSCORE is able to identify future winners and future losers among low book-to-market firms. In line
with Piotroski (2000), Mohanram (2005) finds that firms with the strongest business fundamentals
as measured by G-SCORE realize the highest returns. Finally, Mohanram (2005) shows that the GSCORE strategy is less successful in high book-to-market firms compared to low book-to-market
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firms. Analogously, the F-SCORE strategy introduced by Piotroski (2000) is less effective for growth
stocks compared to value stocks.
Piotroski (2005) provides a critical discussion of the G-SCORE strategy in general and gives an indepth comparison between the F-SCORE and G-SCORE strategies in particular. Piotroski (2005)
remarks that the implementation costs associated with G-SCORE are significantly higher compared to
F-SCORE. F-SCORE uses an absolute performance benchmark and does not require an investor to
gather any accounting data outside of the most recent annual report. G-SCORE, on the other hand, is
implemented using industry benchmarks. The use of industry benchmarks results in at least two
additional costs: (a) investors must collect the annual reports of all firms in the industry and (b) if all
firms in the industry do not have the same fiscal year end, the investor must synchronize the industry
data
through
the
use
of
quarterly
accounting
statements.
In regard to the documented results, Piotroski (2005) notes that the real strength of G-SCORE resides
on the short-side. Low G-SCORE firms earn annual size-adjusted returns of -17.5 percent whereas
high G-SCORE firms earn average annual size-adjusted returns of only 3.1 percent. This is shown in
the following table.
F-SCORE, on the other hand, is able to identify both successful long and short positions. High FSCORE firms generate a mean annual market-adjusted return of 13.4 percent; for low F-SCORE firms
Piotroski (2000) documents a mean annual market-adjusted return of -9.6 percent. Piotroski (2005)
also notes that in contrast to F-SCORE the effectiveness of G-SCORE increases as the
information
environment
and/or
information
dissemination
mechanisms
improve.
I believe that the Beneish, Lee and Tarpley (2001) and Mohanram (2005) variables can be used
mainly by growth investors trying to avoid so-called torpedo growth stocks, i.e. growth firms with
the highest probability of negative changes in their development curve. As a consequence and also
noted by Piotroski (2005) in his discussion on G-SCORE, these two investment strategies are closer to
informed speculation than informed investment as outlined in Graham and Dodd (1934) and Graham
(1949).
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Penman and Zhang, 2006

This paper yields a summary number (S-SCORE) that informs about the sustainability of earnings.
(Penman and Zhang, 2006, p. 1)
Name of investment strategy: S-SCORE
Before taking a look at the S-SCORE strategy by Penman and Zhang (2006), I would like to attract
the readers attention to a remark made by Nissim and Penman (2001) in their research paper Ratio
Analysis and Equity Valuation: From Research to Practice:
But it is fair to say that the research [since 1962] has been conducted without much structure. Nor
has it produced many innovations for practice. (Nissim and Penman, 2001, p. 110)
Nissim and Penman (2001) argue that the preceding literature on financial statement analysis (e.g. Ou
and Penman, 1989; Lev and Thiagarajan, 1993; Abarbanell and Bushee, 1997) is characterized by a
lack of structure in the selection of relevant accounting ratios. By introducing a structured,
fundamental analytical approach, the authors try to address this shortcoming. In this approach, they
start from the most aggregated value drivers underlying a valuation model (e.g. the residual earnings
model). The aggregated components are then, step by step, split up in the underlying financial ratios
(e.g. profit margin and asset turnover). It is assumed that the current values of the ratios are the value
drivers underlying the future values of the aggregated components. In addition to this, the structured
approach takes into account key interrelations between accounting data; an understanding of these
interrelations contributes to building a cohesive earnings forecasting framework.
This renewed view on financial statement analysis is operationalized by Penman and Zhang (2002,
2004, 2006). Their working paper is one of the first attempts to provide structure to the earnings
forecasting exercise. Richardson, Tuna and Wysocki (2010) a extensive literature overview on
fundamental analysis refer to the Penman and Zhang (2006) approach as a promising avenue for
future research.
The objective of Penman and Zhang (2006) is similar to the one of Ou and Penman (1989). Penman
and Zhang (2006) develop a summary measure for the sustainability of earnings as reflected in a
forecast of the change in operating profitability one year ahead (deltaRNOAt+1). deltaRNOAt+1 is
one of the components underlying the residual operating income valuation model.
In Table 4 of their research paper, the change in the return on net operating assets one year ahead
(deltaRNOAt+1) is considered to be driven and forecasted by six accounting variables: the return on
net operating assets (RNOAt), the change in the return on net operating assets (deltaRNOAt), its
underlying Du Pont components deltaPMt and deltaATOt, the growth rate in net operating assets
(GNOAt) and the operating accruals (OpAccrt). This is shown in the following table.
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The parameters in the above multivariate linear regression model are estimated annually. Out-ofsample predictions for deltaRNOAt+1 are made by combining the average regression coefficients
estimated over the prior three years (from year t-3 to year t-1) in combination with the accounting
variables from year t. The forecasts are truly ex ante because future values of the independent
variables are not used. The sample is then recursively rolled forward to forecast deltaRNOAt+1 for
each of the twenty-four out-of-sample years over the 1976-1999 period. Based on the forecasts made,
the companies are ranked from small to large.
Penman and Zhang (2006) document that a stock portfolio consisting of a long position in the ten
percent stocks with the highest predicted change in operating profitability on the one hand and a short
position in the ten percent stocks with the lowest predicted change in operating profitability on the
other, leads to returns that are markedly positive over 20 of the 21 years analysed. This is shown in the
following graph.
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Penman and Zhang (2006) document a mean size-adjusted return difference between decile 10 and
decile 1 of 13.1 percent with a t-statistic of 5.03. This return difference is realized when portfolios are
established three months after fiscal-year end. Delaying portfolio formation by one month results
however in a substantial drop in mean size-adjusted return difference between decile 10 and decile 1
of 34.5% and 31.6%, a finding mentioned in footnote 13 (Penman and Zhang, 2002, 2004) and
footnote 19 (Penman and Zhang, 2006) of their working paper respectively.
The study shows no results about the distribution of returns over the long and short position. For
investors it would be interesting to dispose of these results. The question can also be raised whether
the above hedge returns can be realized. When shorting stocks you should take into account possible
short selling constraints, insufficient liquidity and the costs associated with holding short positions
among others. The effectiveness of the model should also be assessed on international data, among
many other robustness analyses.
Again, and consistent with many of the already discussed accounting papers, critical and important
results remain hidden for the fundamental investor. Based on the reported results I believe further indepth research on S-SCORE is needed.
The empirical results by Penman and Zhang (2006) are used as an input in the development of PEISCORE by Wahlen and Wieland (2010), which stands for Predicted Earnings Increase-SCORE or
PEI-SCORE.
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Wahlen and Wieland, 2010

Name of investment strategy: PEI-SCORE
Wahlen and Wieland (2010) develop the Predicted Earnings Increase (PEI) score. This score
summarises the likelihood of an increase in one-year-ahead earnings. In this regard, Wahlen and
Wieland (2010) follow in the footsteps of, for example, Ou and Penman (1989) and Penman and
Zhang (2006).
PEI-SCORE consists of six financial signals; each company is granted a score of -1, 0 or +1 for every
signal. The signals are chosen based on findings from previous studies (e.g. Penman and Zhang, 2006;
Wieland, 2006). Hence, Wahlen and Wieland (2010) explicitly state that their results should be
interpreted with caution. Their study furthermore concerns a relatively limited time period (i.e. 19942005). It is unclear why Wahlen and Wieland (2010) do not implement their investment strategy over
a longer time period.
The six financial statement ratios are shown in the following table. They concern the return on net
operating assets (RNOA), the operating accruals (OpAccr), the growth rate in net operating assets
(GNOA), the change in gross profit margin relative to the change in sales (deltaGM), the change in
selling, general and administrative expenses (deltaSGA) and the change in asset turnover (deltaATO).
First, I want to highlight a major difference between F-SCORE on the one hand and PEI-SCORE on
the other. Under F-SCORE, a company receives a score of +1 if the return on assets and the cash flow
from operations are positive. Under PEI-SCORE, strongly loss-making companies receive a score of
+1. Consequently, it might be expected that the best companies according to PEI-SCORE are more
risky, from a fundamental point of view, compared to companies with the highest F-SCOREs.
Secondly, the scoring model of Wahlen and Wieland (2010) is also more detailed and complex
compared to that of Piotroski (2000), as can be seen in the following explanation.
As far as the signals RNOA, deltaGM and deltaATO are concerned, companies are annually sorted
from large to small.
Economic theory suggests that the earnings generated by a firm on its net operating assets, RNOA,
will converge to a firm-specific mean over time (Stigler, 1963). A firm with extremely high RNOA is
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likely to encounter new competition and reduced future returns; a firm with an extremely low RNOA
is likely to take steps to increase future returns or to cease operations. Companies in the top (bottom)
quintile get a score of -1 (+1) for signal RNOA.
Prior work (e.g. Graham, Dodd and Cottle, 1962; Lev and Thiagarajan, 1993; Abarbanell and Bushee,
1997) asserts that when the gross margin ratio increases at a rate faster than the rate of growth in
sales, this signals potentially sustainable improvement in the firms relative pricing power. When the
gross margin decreases at a rate faster than the rate of growth in sales, it signals potentially persistent
deterioration in the relationship between a firms input and output prices.
The asset turnover ratio measures the efficiency of how the firm utilizes its assets to generate sales.
An increase in the asset turnover ratio occurs when sales increase faster than net operating assets. If
the increase is the result of increased operating efficiency and continues into the future, one should
observe a positive relation between the asset turnover ratio and the future change in RNOA.
Companies in the top quintile get a score of +1 for signals deltaGM and deltaATO; companies in the
bottom quintile get a score of -1 for deltaGM and deltaATO. The companies in the remaining quintiles
get a score of 0.
As far as the other accounting variables are concerned, the score depends on the value that the
company assumes for another variable. For the accrual signal (OpAccr), companies first are
subdivided in quintiles based on RNOA. Within each RNOA quintile, companies are subsequently
sorted from small to large based on their operating accruals (OpAccr) and again subdivided in
quintiles. Wahlen and Wieland assign a score of -1 (+1) to firms in the top (bottom) accrual quintile
within each RNOA quintile. The companies in the remaining quintiles get a score of 0. An identical
methodology is applied to the GNOA signal. Wahlen and Wieland (2010) argue that if the current
period growth rate in net operating assets is low relative to current RNOA, this trend implies
increasing operating efficiency, which leads to further earnings increases. Conversely, if the current
growth rate in net operating assets is high relative to RNOA, it implies the inefficient usage of (net)
operating assets.
The deltaSGA variable measures the firms overhead expenses growth relative to sales growth.
Anderson, Banker and Janakiraman (2003) argue that the interpretation of this signal must be
conditioned on the direction of sales growth. Consequently, as part of PEI-SCORE, a distinction is
made between the companies with an increase or decrease in sales in the previous fiscal year.
Anderson, Banker and Janakiraman (2003) predict and find that when sales increase and SGA
expenses increase as a percentage of sales, it implies weak overhead cost control, which does not bode
well for future earnings growth. Likewise, if SGA expenses decline as a percentage of sales, it implies
strong overhead cost control, which portends future earnings increases. Companies having had a sales
increase get a score of +1 (-1) in case they are based on the deltaSGA signal in the bottom (top)
quintile. Conversely, when firms experience sales declines, Anderson, Banker and Janakiraman (2003)
predict and find that when SGA expenses grow as a percentage of sales, it signals managers optimism
about future growth in sales and earnings. Similarly, when firms experience sales declines and
managers simultaneously cut SGA expenses as a percentage of sales, it signals their pessimism about
future. Companies with a sales decrease get a score of -1 (+1) in case they are based on the
deltaSGA signal in the bottom (top) quintile. All remaining companies get a score of 0.
In the final step Wahlen and Wieland (2010) compute the sum of the scores on the six financial
signals; they obtain the so-called Predicted Earnings Increase (PEI) score.
From the above discussion, it becomes clear that PEI-SCORE computations are much more complex
compared to F-SCORE.
The study demonstrates that over the 1994-2005 time period a long position in the companies with the
20 percent highest PEI-SCORE results in an average annual size-adjusted return of 6.5 percent. This
is shown in the following table. In line with Penman and Zhang (2006), Wahlen and Wieland (2010)
19
provide no information on the performance of PEI-SCORE for smaller stock portfolios. These results
would give us more insight into the returns of stocks with the highest (between 4 and 6) and lowest
(between -6 and -4) PEI-SCOREs.
AmorTapia and Tascn (2012) find that PEI-SCORE is not effective in European stock markets, as
shown in the following table. High PEI-SCORE firms underperform low PEI-SCORE firms over the
1981-2011 period, contrary to previous evidence in the US stock market.
20
In the light of these findings, among many other critical observations, investors are advised to put the
results of the study by Wahlen and Wieland (2010) through additional (international) empirical
analyses.
In the next part on fundamentals-based investment strategies in the accounting literature, I discuss the
paper by Dickinson and Sommers (2012): Which Competitive Efforts Lead to Future Abnormal
Economic Rents? Using Accounting Ratios to Assess Competitive Advantage. In this paper, the
researchers quantify competitive advantages using accounting-based ratios. Based on my limited
knowledge of Warren Buffetts investment strategies (I am more a follower of Grahamite value
investing) and his focus on moat, this paper might be interesting to Buffetts followers.
21
Dickinson and Sommers, 2012

Name of investment strategy: Competitive S-SCORE
Accounting signals used: 26
In this part, I discuss the paper by Dickinson and Sommers (2012): Which Competitive Efforts Lead
to Future Abnormal Economic Rents? Using Accounting Ratios to Assess Competitive Advantage.
Following Penman and Zhang (2006), Dickinson and Sommers (2012) predict the change in operating
profitability one year ahead (deltaRNOAt+1) (more correctly, they predict the change in industry- and
risk-adjusted operating profitability). They start out from a base model; this base model incorporates
the following accounting variables: the return on net operating assets (RNOAt), the change in the
return on net operating assets (deltaRNOAt) and the growth rate in net operating assets (GtNOA).
This is shown in the following table under the column Base. Consequently, there is a strong overlap
between the base model by Dickinson and Sommers (2012) and the Penman and Zhang (2006) model
in their Table 4.
Subsequently, Dickinson and Sommers (2012) introduce accounting variables to assess competitive
22
advantages. By selecting the proper strategy and establishing competitive efforts, companies can
delay the well-known phenomenon of mean reversion in (operating) profitability.
For this reason, competitive efforts directly impact firm profitability and, according to Dickinson and
Sommers (2012), they should be incorporated into investment strategies.
Their most extensive model adds twenty additional accounting variables to capture competitive
advantages. These variables are shown in the above table under the column Diminishing Returns.
Cost of Sales (CoS) is defined as the cost of goods sold divided by net sales and is used to capture
economies of scale. Product differentiation is measured using the advertising intensity ratio; this ratio
is measured as advertising expense divided by net sales (AdvInt). Innovation intensity (Inv) is
assessed using research and development expense divided by net sales. Similarly, capital intensity
(CapInt) is measured using depreciation expense divided by net sales. Power over suppliers is
captured by a firms operating liability leverage (OLLev); this accounting ratio is computed as
operating liabilities divided by net operating assets. Power over customers is assessed using two
variables: receivables turnover (ARTurn) and market share (MktShr). Finally, credible threat of
expected retaliation is measured using financial leverage (FLev) and the availability of excess cash
(ExFunds).
When all twenty accounting variables are included in the regression model, Dickinson and Sommers
(2012) document an increase of 32.53% in explanatory power of the regression model over the base
model. For many of the accounting variables, the sign of the regression coefficients is contrary to
expectations. As a consequence, I leave it up to the reader to find the (ex ante) explanations given by
Dickinson and Sommers (2012) for the obtained results credible or not.
Next, Dickinson and Sommers (2012) use the extended models in Table 3 to generate out-of-sample
forecasts for the change in operating profitability one year ahead (deltaRNOAt+1). The researchers
restrict their out-of-sample forecasts to the 2001-2003 period, which is quite disappointing because
after all their entire sample period covers the 1972-2003 period.
As opposed to Penman and Zhang (2006), Dickinson and Sommers (2012) do not use the generated
forecasts for the change in operating profitability one year ahead (deltaRNOAt+1) to set up an
investment strategy. Consequently, this finding (again) largely keeps the reader in a state of
uncertainty regarding the actual relevance of the paper and the assessment of competitive advantages
through accounting ratios in particular for fundamentals-based investors. In addition, it would be
interesting to quantify the added value in terms of (risk-adjusted) returns of the very cumbersome
risk- and industry-adjustment procedure used by Dickinson and Sommers (2012). Here also, the
added value of these computations remains a mystery to the reader. Despite the promising title, the
paper ends quite disappointingly for the fundamental investor.

25 Years of Fundamental Analysis

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1

Ou and Penman, 1989

Abarbanell and Bushee, 1998

Beneish, Lee and Tarpley, 2001

Penman and Zhang, 2006

Wahlen and Wieland, 2010

Dickinson and Sommers, 2012

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