International Research Journal of Finance and Economics ISSN 1450-2887 Issue 30 (2009) EuroJournals Publishing, Inc. 2009 http://www.eurojournals.com/finance.

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Fundamental Analysis Strategy and the Prediction of Stock Returns

Jaouida Elleuch* Faculty of Economics and management sciences (FSEG), University of Sfax, Tunisia E-mail: Elleuchj@yahoo.fr Abstract This paper examines whether a simple fundamental analysis strategy based on historical accounting information can predict stock returns. The papers goal is to show that simple screens based on historical financial signals can shift the distribution of returns earned by an investor by separating eventual winners stocks from losers. Results show that historical accounting signals can be used to improve the entire distribution of future returns earned by an investor. In fact, despite the overall down activity of the market over the sample period chosen, results reveal that fundamental accounting signals can be used to discriminate from an overall sample generating future negative returns of -0,116 a winner portfolio that provide positive future return of 0,019 from a loser one generating a negative return of -0,229. The over-performance of the winner portfolio seems to be attributable to the ability of the fundamental signals to predict future earnings. In fact, results show that fundamental signals have a positive and significant correlation with future earnings performance and that the winner portfolio have a future earnings realisation (0,100) that outperforms that of the loser portfolio (-0,012). Keywords: Fundamental Analysis, Market Efficiency, Stock returns. JEL Classification Codes: G11, G14

1. Introduction
One object of financial accounting is to provide information that is relevant to investment decisions. Discovering value-relevant accounting attributes has been the subject of numerous empirical studies. Two main research approaches have been considered to assess value-relevance of accounting figures: association studies and predictive studies. The first approach assumes market efficiency and thus considers share market price as a sufficient measure of firms value. So market value can serve as a benchmark against which to evaluate the value-relevance of accounting data. A statistical association or correlation between accounting data and stock prices or returns means that accounting information summarises efficiently events and informations incorporated in prices and so it is value-relevant because its use might provide a value of the firm that is close to its market value. The second approach relies on fundamental analysis and thus embraces a different perspective. Firms fundamental or intrinsic value is well determined by information reflected in
*

Results of the present paper has been taken from the PHD dissertation entitled Contenu informationnel des tats financiers : Analyse fondamentale et validation empirique, discussed by Mme Jaouida Elleuch and directed par Mr Fathi ABID, professor in finance at the Faculty of Economics and management sciences (FSEG), University of Sfax.

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financial statements. Sometimes, stock prices do not reflect in a timely basis and/ or correctly all this information and thus deviate from fundamental values. The predictive approach relies on discovering accounting data that are not reflected in stock prices and thus predicts future stock price adjustments as market values gravitate later to fundamental values. I use the second approach to measure the value relevance of accounting data published by a sample of firms traded on the Tunisian Stock market. I outline a research method that approximates the fundamental analysiss approach on discovering value relevant attributes. Since firms value reflects according to this approach, firms ability to generate positive future earnings, I select from financial statements, fundamental signals that are purported to inform on the direction of future earnings. The papers goal is to show that simple screens based on a summary value measure extracted from theses fundamental signals, can shift the distribution of returns earned by an investor by separating eventual winners stocks from losers. This discrimination seems to be possible according to results of the fundamental strategy I implement. In fact, these results show that the fundamental summary measure is positively associated to future stock returns. In addition, that an investor could discriminate from an overall sample generating over a 15 month holding period negative returns of -11,6%, a winner portfolio generating positive return of 1,9% from a loser one generating negative return of -22,9% over the same holding period. The success of this fundamental strategy seems to be attributed to the ability of the fundamental signals to predict future earnings performance. In fact, the summary value measure constructed is positively associated to future profitability as measured by the one year-ahead rate of return on assets. Moreover, the winner portfolio has a future earningss realisation (0,100) that outperforms that of the loser portfolio (-0,012). The next section of this paper reviews prior fundamental analysis research. Section 3 presents the research design, particularly the fundamental signals used to discriminate eventual winners stocks from losers and the simple fundamental strategy. Section 4 presents results of the empirical tests. Section 5 concludes the paper.

2. Prior Fundamental Analysis Research

Consistent with the efficient market hypothesis, publicly available information cannot be used to predict returns and systematically generate abnormal returns. Numerous studies document, however, significant abnormal returns to portfolio investment strategies defined on various financial performance signals. Their approaches focus on the markets inability to fully process and immediately reflect the implications of particular financial signals into prices. Examples include strategies based especially on earnings news specifically post-earnings announcement drift (Bernard and Thomas 1989 1990, Foster, Olsen & Shevlin 1984), and accruals persistence (Sloan 1996, Bradshaw, Richardson & Sloan 1999, Collins & Hribar 2000). Other examples include seasoned equity offering (Loughran & Ritter 1995, Spiess & Affleck-Graves 1995), share repurchases (Ikenberry, Lakonishok & Vermaelen 1995) and dividend omissions /decreases (Michaely, Thaler & Womack 1995). More significant investment strategies involve the practice of fundamental analysis. Consistent with this valuation approach, financial statements data inform on firms fundamental (intrinsic) values. Stock prices might deviate at times from these values but slowly converge to theses fundamental values. Analysis of publicly available accounting information can discover values that are not reflected or unbiasedly reflected in stock prices and so identify mispriced stocks. According to fundamental analysis, stock price reflects the firms ability to generate positive future earnings. Thus to earn abnormal returns using historical accounting data, researchers suggest that financial statements data should inform on firms future earnings performance. Moreover, the market should temporarily under-uses this information about firms future earnings power. Numerous papers provide significant evidence on these two conditions and the markets ability to earn abnormal returns using historical accounting data. Ou & Penman 1989, the pioneers in this research area, document the existence of significant abnormal returns to a trading strategy that is based on the prediction of the sign of future changes in

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annual earnings per share (EPS). They use an exhaustive list of accounting ratios describing firms leverage, activity and profitability. The future earnings implications of current accounting data are extracted via a Logit model that summarizes the large number of accounting ratios into a single value measure labelled Pr: the probability of a one year-ahead accounting earnings change. They define then an investment strategy by forming a hedge portfolio that takes a long position in high Pr stocks and a short position in low Pr stocks. They document an average significant market-adjusted return of 8,34% for a 12-month holding period and 14,53% for a 24-month holding period. Moreover their tests show that financial statements data predict successfully future earnings performance. Indeed, 66% of the predictions appear to be correct. Ou & Penman 1989 conclude that fundamental analysis works in the sense that identifies equity values not currently reflected in stock prices and thus produces abnormal returns. Greig 1992 and Stober 1992 studies re-examine the Ou & Penman 1989 methodology and reach a different conclusion. While significant abnormal returns are earned by the hedge portfolio, no significant incremental predictive ability is attributable to Pr after controlling for cross-sectional differences in CAPM beta and firm size. They conclude that this value measure predicts future returns because it proxies for expected returns not because it captures abnormal returns associated with stock price deviations from fundamental values. The Ou & Penman 1989 approach had been also criticised for the large number of accounting ratios used to make the necessary predictions and the lack of a conceptual arguments for choosing the financial signals assumed to be related to future earnings (Abarbanell & Bushee 1998). To overcome these anomalies, Lev & Thiagarajan (LT) 1993 introduce 12 financial signals claimed by analysts to be useful in security valuation and that reflect traditional rules of fundamental analysis. These signals include information about changes in inventories, account receivables, capital and research and development expenditures, gross margins, selling and administrative expenses, provision for doubtful receivables, effective tax rates, order backlog, labour force productivity, inventory methods and audit qualifications. They show the value relevance of these fundamental signals with respect to their significant correlation in the direction predicted with contemporaneous returns after controlling for current earnings innovations, firm size and macroeconomic conditions. In a later study, Abarbanell & Bushee (AB) 1997 present evidence on the two underlying premises of fundamental analysis by showing, first that many of the fundamental signals introduced by LT 1993 are significantly associated with subsequent earnings changes. Second, that financial analysts under-react to these signals when forming their earnings prediction and conclude that this finding raises the possibility that stock price adjustments to accounting signals disclosure may not be complete. In a subsequent paper published in 1998, the same authors perform the next step in their analysis. They define an investment strategy based upon the ability of the LT fundamental signals to generate abnormal returns as future earnings are realised and if both, these signals predict future earnings changes and stock prices fail to reflect fully the information contained in these signals about future earnings. They show that an average 12 month cumulative size-adjusted abnormal return of 13,2% is earned on hedge portfolio formed on the basis of the decile ranks of the fundamental signals. They also provide evidence consistent with the underlying focus of fundamental analysis on the prediction of earnings by showing that the abnormal return to the strategy is highly associated with the realization of one year-ahead earnings changes. Moreover, a significant portion of the abnormal return is generated around subsequent quarterly earnings announcements. Other evidences by AB 1998 show that abnormal return to the fundamental strategy level off after one year of the signals disclosure and that it does not appear to be closely related to abnormal returns associated with book-to-market or firm size variables. These results argue against risk as a complete explanation for this abnormal return and enhance the conclusion of the preceding findings relating to mispricing as an alternative explanation for this abnormal return. Piotroski 2000 provides evidence supporting the predictive ability of historical accounting signals with respect to future stock price adjustments for a sample of value stocks characterised by high Book-to-Market value (BM). They remark that less than 44% of all high BM firms earn positive

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market-adjusted returns in two years following portfolio formation and suggest that investors could benefit by discriminating ex-ante between the eventual strong and weak companies. Using nine fundamental signals relating to three areas of the firms financial condition: profitability, financial leverage, liquidity and operating efficiency, they classify firms in ten portfolios depending on the signals implication for future prices and profitability. Their results show that the mean returns earned by a high book to market investor can be increased by at least 7,5% annually through the selection of financially strong high BM firms. Moreover, an investment strategy that buys expected winners and shorts expected losers generates a 23% annual return. Like AB 1997, 1998, their results support the ability of historical accounting information to predict future firm performance and the markets inability to recognize these predictable patterns. In fact, firms classified weak according to their current accounting signals have lower future earnings realizations and are five times more likely to encounter business failure, as measured by performance-related delisting, than strong firms. Furthermore, historical accounting signals seem to surprise the market around subsequent quarterly earnings announcement in the direction predicted by these signals. Indeed, announcement period returns for predicted winners are 0,041 higher than similar returns for predicted losers. Moreover, approximately 1/6 of total annual return difference between ex-ante strong and weak firms is earned over just 12 trading days of quarterly earnings announcement. These evidences suggest that the market fails to efficiently incorporate past accounting information into stock prices as it is likely to discriminate ex-ante between future successful and unsuccessful firms and profit from the strategy.

3. Research Design
3.1. The Fundamental Signals Twelve fundamental signals have been chosen from previous fundamental research 1. The selection criteria of these signals have been relied, first to their predictive ability with respect to future earnings performance and returns. A criterion that has been much demonstrated by previous research. Second, to their accommodation with Tunisian firms context. These signals are described in table 1. Each firms signal realization is classified as either good or bad according to its expected implication for future earnings and then prices. A binary variable is created for each signal that is equal to one if the signals realization is good and zero if it is bad. 1. Inventory (INV): this ratio measures the percentage change in sales relative to the percentage change in inventory. Inventory increases faster than sales is considered a negative signal because it suggests difficulties in generating sales or the existence of slow-moving or obsolete items that will be written of in the future. All these factors affect negatively future earnings. I use finished goods to measure this signal when this component is available and total inventories if not. A positive value for this ratio represents so good signal. I attribute the value of one (zero) to the binary variable if the signals realisation is positive (negative). 2. Accounts Receivable (AR): this signal represents the percentage change in sales less an analogous measure of accounts receivable. A disproportionate increase in accounts receivable relative to sales suggests cash collection difficulties and problems in selling the firms products. Also, it may likely provoke future earnings decreases as provisions of future receivables experience an eventual increase. These arguments imply future earnings decreases. So a positive value to this signal is considered good news. It is attributed one (zero) to this ratio when it is positive (negative). 3. Investments (INVES): this signal measures the percentage change in capital expenditures relative to the percentage change in sales 2. A negative value of this ratio is considered bad
1 2

Particularly Pitroski 2000 and Lev & Thiagarajan 1993. The measure proposed by Lev & Thiagarajan 1993 compare capital expenditures of a firm to an industry benchmark defining it as the annual percentage change in total two digit industry capital expenditures. A questionnaire conducted by

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International Research Journal of Finance and Economics - Issue 30 (2009) news by analysts. In fact, capital expenditures are largely discretionary. So an unusual decrease is generally suspect. This decrease may indicate managers concerns with the adequacy of current and future cash flows to sustain the previous investment level. Moreover, analysts associate this decrease with a short-term managerial orientation. The binary variable associated to this signal takes the value of one (zero) if this signals realization is positive (negative). Gross Margin (GM): this signal is defined as the percentage change in gross margin less an analogous measure for sales. A decrease in gross margin relative to sales is considered bad news. In fact, it indicates a deterioration of the firms terms of trade or lack of costs production control. According to Lev & Thiagarajan 1993, variations in this fundamental signal affect long-term performance of the firm and it is therefore informative with respect to earnings persistence and firm values. Since financial statements published by some Tunisian firms do not reveal the information about gross margin, I propose to use earnings from operations as a proxy to this measure of operation performance. The binary variable associated to this signal takes the value of one (zero) if the signals realization is positive (negative). Labour Force (LF): this ratio is defined as the change in sales per employee. It is used by analysts to appreciate the effects of restructuring decisions. In fact, decisions of labour force reductions are generally associated with increases in wage related expenses that affect negatively current earnings but bode well for future earnings. Thats why a similar signal is generally used to better assess future earnings. So it is attributed one (zero) to this ratio when the signals realization is positive (negative). Return on assets (ROA) and variation in return on assets (ROA): ROA is defined as net income before extraordinary items scaled by beginning of the year total assets and ROA is defined as the current years ROA less the prior years ROA. Cash flow (CF): this ratio is defined as cash flow scaled by beginning of the year total assets. Where cash flow = Earnings before extraordinary items Accruals, And Accruals are defined as is common in the earnings management literature (Dechow, Sloan & Sweeney 1995, Sloan 1996): Accruals = (CA - Cash) - CL Dep Where: CA: change in current assets Cash: change in cash/cash equivalents CL: change in current liabilities Dep: depreciation and amortization expense According to Piotroski 2000, the three preceding signals provide information about the firms ability to generate funds. Firm that realises positive earnings or cash flow is demonstrating a capacity to generate some funds through operating activities. Similarly, a positive earnings trend is suggestive of an improvement in the firms underlying ability to generate positive future cash flows. So, the binary variable associated to each signal equals one if the signals realisation is positive and zero otherwise. Accruals (ACC): this signal is defined as accruals scaled by beginning of the year total assets. This signal measures earnings persistence. Authors like Sloan [1996], Bradshaw, Richardson & Sloan [1999] and Collins & Hribar [2000] show that persistence of current earnings is decreasing in the magnitude of the accruals component of earnings. That is firms with high accruals are more likely to experience declines in subsequent earnings performance and others with low accruals are more likely to experience subsequent earnings increase. Consistent with the negative relation between accruals and future earnings, I attribute the value of one to the binary variable if the accruals signal is negative and zero if it is positive.

4.

5.

6,7. 8.

9.

Lev & Thiagarajan 1991 reveals that financial analysts use the percentage change in sales to appreciate this signal. While the industry capital expenditures is not available for some firms, we use so the percentage change in sales as a benchmark to appreciate this signal.

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10. Leverage: LEV: This signal represents change in the ratio of total long-term debt to average total assets. Literature review interested on financial leverages impact on firm value has been controversial. Theoretical studies leaded for example by Harris & Raviv [1990], Stulz [1990] and Hirshleifer & Thakor [1992] show that leverage is positively related to firm value. However, Myers & Majluf [1984] and Miller & Rock [1985] consider that leverage increases can negatively impact firm value. According to this controversy, I suppose that an increase in financial leverage is a good signal and I attribute one to the binary variable if this signals realization is positive and zero otherwise. 11. Liquidity (LIQUID): this signal measures the change in the firms current ratio between the current and prior year. I define current ratio as the ratio of current assets to current liabilities at the fiscal year end. Liquidity increases signals the firms ability to service current debt obligations. So the binary variable attributed to this signal equals one if LIQUID is positive and zero if it is negative. 12. Assets Turnover (TURN): this signal is defined as the firms current year asset turnover ratio less the prior years asset turnover ratio. I define the asset turnover ratio as total sales scaled by beginning of the year total assets. A positive ratio may imply improvement in assets use, that is less assets generating the same levels of sales, or an increase in firms sale. I attribute one to the binary variable if the signals realisation is positive and zero otherwise.

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Table 1:
Signal Inventory (INV)

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Definitions of Fundamental Signals
Measurement % of sales - % of inventory

Sales t Sales t 1 Inventory t Inventory t 1 Sales t 1 Inventoryt 1

Sales t Sales t 1 Accounts receivable t Accounts receivable t 1 Sales t 1 Accounts receivable t 1

% of sales - % of accounts receivable Accounts Receivable (AR)

% of firm investments - % of sales Investments (INVES)

Investmentst - Investmentst -1 Salest Salest 1 Investmentst-1 Salest 1

% of Gross margin - % of sales

Gross Margin (GM)

Gross margin t - Gross margin t -1 Sales t Sales t 1 Sales t 1 Gross margin t -1

Earnings from operations is used as a proxy of gross margin. % of sales per employee

Labour Force (LF) Return on assets (ROA) Variation in Return on assets (ROA) Cash flow (CF)

Sales t sales t 1 Sales t 1 )/ Employees number t Employees number t -1 Employees number t -1

Accruals (ACC)

Net income before extraordinary itemst / Total assetst-1 ROAt ROAt-1 Cash flowt / Total assetst-1 Cash flow = Earnings before extraordinary items Accruals Accrualst / Total assetst-1 Accruals = (CA - Cash) - CL Dep Where: CA: change in current assets Cash: change in cash/cash equivalents CL: change in current liabilities Dep: depreciation and amortization expense

Leverage (LEV) Liquidity (LIQUID) Assets Turnover (TURN)

Long term debtt Long term debtt-1 (Total assetst + Total assetst-1 ) / 2 (Total assetst-1 + Total assetst-2 ) / 2

Current assets t Current assets t 1 Current liabilitie st Current liabilitie st 1 Salest Salest 1 Total assetst 1 Total assetst 2

3.2. The Fundamental Strategy and the Empirical Tests The fundamental strategy implemented relies on the construction of zero-investment portfolios that buys expected winners stocks and sells expected losers. This strategy is defined as follows: First, for each stock, a fundamental score labelled F_Score is defined. It represents the sum of the individual binary variables defined for the twelve underlying fundamental signals. This fundamental score is calculated for each stock and for each year from financial statements published for fiscal years 1995-2001. Second, at each fiscal year-end of the sample period 1995-2001, stocks are assigned given their fundamental scores in two portfolios: A low F_Score portfolio and a high F_Score portfolio. These portfolios are defined according to the following procedure: Given the twelve fundamental signals, F_Score can vary from 0 to 12. I rank each year the stocks according to their F_Score. I eliminate those that have an F-Score placed in the middle because I consider that these values dont indicate well the direction of future earnings and returns. That is, I eliminate stocks with F_Score equal to 6 and 7.

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Stocks with F_Score 5 are classified in the low F_Score portfolio and those with F_Score 8 are classified in the high F_Score portfolio. The empirical tests consist to compare future returns and future earnings performance between low F_Score and high F_Score portfolios. Since high F_Score firm represents firm with predominantly good signals and low F_Score firm, firm with very few good signals, I anticipate that the high portfolio F_Score outperforms the low portfolio F_Score in subsequent returns and earnings realizations. The first test I implement compares the mean return earned by the high F_Score portfolio against the mean return earned by the low F_Score portfolio. Where firm-specific return is defined as the buy-and-hold return earned over the holding period commencing at the beginning of the fifth month after fiscal year end through 15 month after this date. This return is calculated as follows:

BHRit = (1 + Rit ) 1
t =1

Where Rit is the rate-of-return for stock i in week t. m is the number of weeks over the 15 months holding period. I choose the fifth month because I assume that financial statements of Tunisian firms and therefore the financial information necessary to calculate the accounting signals and the F_Score are available to investors at this time. A 15-month-holding period is chosen to ensure that this period covers future stock price adjustments to subsequent earnings announcement. In fact, previous studies show that the market under-react to financial accounting information and that the positive return to fundamental strategies is essentially earned over subsequent earnings announcements. I consider that an event window of 3 months subsequent to one year-ahead earnings announcements, supposed to be available at the fourth month after year-end, is sufficient to take account of stock price adjustments to this announcement. This analysis justifies the choice of a 15-month-holding period. The first test consists to show that: Mean BHR of the high F_Score portfolio > Mean BHR of the low F_Score portfolio. Thus, the return generated by the fundamental strategy that is equal to the mean return difference between the high and the low F_Score portfolios is positive: High low BHR portfolio > 0. Traditional student-test is used to implement this test. The second test compares future firm performance between the low F_Score and the high F_Score portfolios. I test whether the aggregate fundamental Score (F_Score) successfully predicts future earnings performance as measured by the level of the one year-ahead return on assets ratio (ROAt+1). Where ROA equals income before extraordinary items scaled by beginning of the year total assets. So the test consists to show that: mean ROAt+1 of the high F_Score portfolio > Mean ROAt+1 of the low F_Score portfolio. The difference between the mean ROA of the high and the low F-Score portfolios is tested using the traditional student-test.
3.3. Data and Sample Selection

Financial statements of the period 1995-2001 are used to test the predictive ability of financial accounting signals with respect to future returns and future earnings performance. A sample of 22 non financial firms, whose stocks are traded on the Tunisian Stock market (BVMT) are chosen. Because calculation of certain accounting signals necessitate accounting data for two previous years, financial statements for the period 1993-2001 are used to estimate the financial accounting signals. Since portfolios are held for a period of 15 months that follow the fourth month after fiscal year end, weekly stock returns are calculated for the period beginning the 01/05/1996 and ending the 31/07/2003. A definitive number of 108 observations meet these selection criteria over the period 1993-2003.

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4. Analysis and Interpretation of Statistical Results

4.1. Returns to the Fundamental Analysis Strategy

Table 2 presents Spearman correlations between the twelve fundamental signals transformed into binary variables, the aggregate fundamental score (F_Score) and future buy-and-hold returns (BHR). As expected, the F_Score has a positive correlation with future returns (0,111). Although it is not statistically significant, the positive correlation implies that firms future returns realizations are well as firms historical aggregate financial position has been well. In addition, this positive correlation denotes that historical accounting data inform on future returns performance. Contrary to expectation, this table shows that not all individual signals have positive correlation with future returns. Particularly, the fundamental signals represented by INVES, LEV and ACC have negative correlation with these returns. On the other hand, some fundamental signals like AR (0,163), LF (0,12) and ROA (0,159) contribute with a level of correlation superior to that given by the F_Score (0,111). Given the negative correlation presented by some fundamental signals, it seems better to use an aggregate measure of financial position to define the fundamental strategy than one or two financial signals. However, for variables presenting correlation outperforming that of the F_Score, it appears interesting to test their individual predictive ability with respect to future returns and fundamental strategies definition.
Table 2: Spearman Correlation between Future Returns, the twelve Fundamental Signals and the Fundamental Score (F_Score)
INV 1,000 _ _ _ _ _ _ _ _ _ _ _ _ _ AR -0,042 (0,668) 1,000 _ _ _ _ _ _ _ _ _ _ _ _ INVES -0,298** (0,002) 0,019 (0,848) 1,000 _ _ _ _ _ _ _ _ _ _ _ GM 0,083 (0,393) -0,028 (0,770) -0,111 (0,251) 1,000 _ _ _ _ _ _ _ _ _ _ LF 0,352** (0,000) -0,035 (0,720) -0,315** (0,001) 0,131 (0,175) 1,000 _ _ _ _ _ _ _ _ _ ROA -0,050 (0,607) 0,142 (0,143) -0,248** (0,010) 0,017 (0,865) 0,108 (0,267) 1,000 _ _ _ _ _ _ _ _ DROA 0,228* (0,018) 0,014 (0,887) -0,296** (0,002) 0,295** (0,002) 0,353** (0,000) 0,182 (0,059) 1,000 _ _ _ _ _ _ _ DLEV 0,096 0,323 -0,004 (0,967) 0,371** (0,000) 0,034 (0,726) -0,150 (0,121) -0,358** (0,000) -0,266** (0,005) 1,000 _ _ _ _ _ _ DLIQUID 0,054 (0,580) 0,114 (0,238) -0,352** (0,000) -0,091 (0,346) -0,037 (0,701) 0,306** (0,001) 0,019 (0,843) -0,072 (0,460) 1,000 _ _ _ _ _ DTURN 0,244* (0,011) 0,035 (0,720) -0,352** (0,000) 0,054 (0,576) 0,408** (0,000) 0,091 (0,348) 0,426** (0,000) -0,123 (0,204) -0,037 (0,706) 1,000 _ _ _ _ CF -0,050 (0,607) 0,042 (0,668) -0,099 (0,306) -0,133 (0,170) 0,108 (0,267) 0,200* (0,038) 0,083 (0,394) -0,462** (0,000) -0,191* (0,048) 0,091 (0,348) 1,000 _ _ _ ACC 0,005 (0,962) 0,068 (0,483) 0,063 (0,519) -0,066 (0,498) 0,116 (0,233) -0,103 (0,290) 0,082 (0,398) -0,091 (0,349) -0,260** (0,006) 0,177 (0,067) 0,570** (0,000) 1,000 _ _ F_Score 0,453** (0,000) 0,361** (0,000) -0,172 (0,076) 0,347** (0,000) 0,552** (0,000) 0,299** (0,002) 0,577** (0,000) 0,030 (0,761) 0,149 (0,124) 0,545** (0,000) 0,221* (0,021) 0,361** (0,000) 1,000 _ BHR 0,092 (0,343) 0,163 (0,093) -0,129 (0,182) 0,039 (0,686) 0,120 (0,215) 0,159 (0,099) 0,055 (0,570) -0,146 (0,131) 0,022 (0,819) 0,001 (0,993) 0,110 (0,257) -0,063 (0,515) 0,111 (0,254) 1,000

INV AR INVES GM LF ROA DROA DLEV DLIQUID DTURN CF ACC F_Score BHR

** (*) denote values of Spearman correlations significant at the 1% (5%) level; values between parenthesis denote p-value. The twelve fundamental signals presented in this table represent the values of an individual binary variable that is equal to one (zero) if the underlying signal was a good (bad) signal about future performance. F_Score represents the sum by firm of the individual binaries variables associated to the twelve fundamental signals. BHR is the buy-and-hold return earned over the holding period commencing at the beginning of the fifth month after fiscal year end through 15 month after this date. The sample represents 108 firm-year observations between 1995 and 2001.

Table 3 presents buy-and-hold future return to the fundamental investment strategy defined using the aggregate fundamental score (F_Score). Results in this table show that the high F_Score firms outperform low F_Score firms in subsequent future return. This result corroborates the previous evidence justifying the positive correlation between the fundamental score and future stock returns performance. The most striking result in this table is the negative sign of future returns generated by all firms constituting the sample observations of this study. Since the sample represents nearly all non-

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financial firms traded on the market, this result could be justified by an overall down activity of the market. Despite this worst performance, results show that we could specify from an overall sample firms generating negative returns of -0,116, a winner portfolio providing positive future return of 0,019 from a loser portfolio generating negative future return of -0,229. The mean return difference of 0,248 between the winner portfolio and the loser one, suggest that an investor could constitute a hedge portfolio that generate positive return when selling short expected losers stocks and buying expected winners ones.
Table 3: Buy-and-Hold Returns to Investment Strategy based on Fundamental Signals

BHR 1995a 1996 1997 1998 1999 2000 2001 Meanb Return Low F_Score portfolio -0,573 -0,056 -0,375 -0,242 0,119 -0,286 -0,193 -0,229 High F_Score portfolio -0,143 -0,097 0,004 0,816 -0,116 -0,240 -0,095 0,019 Hedge Portfolio (High Low) 0,248 (t-stat) (1,542) (P-value) (0,174) All Firms -0,347 -0,155 -0,014 0,240 -0,047 -0,306 -0,185 -0,116 Low F_Score portfolio consists of firms with an aggregate F_Score 5; High F_Score portfolio consists of firms with an aggregate F_Score 8, where F_Score represents the sum by firm of the individual binary variables associated to the twelve fundamental signals; the binary variable is equal to one (zero) if the signals realization was a good (bad) signal about firms future performance. a, these values represent mean returns to portfolios constructed annually on the basis of the fundamental signals associated to every fiscal year. b, these values represent mean returns to annual portfolios over the seven years from 1995 to 2001. BHR is the buy-and-hold return earned over the holding period commencing at the beginning of the fifth month after fiscal year end through 15 month after this date. Hedge portfolio consists to take short position on low F_Score stocks and long position on high F_Score stocks. Mean returns to this portfolio is the mean returns differences between the high and the low F_score stocks.

4.2. Future Firm Performance Conditional on the Fundamental Signals

Table 4 presents Spearman correlations between future firms profitability as measured by the rate of return on assets for the year following portfolio formation, the twelve fundamental signals and the aggregate fundamental score (F_Score). As expected, results show that the F_Score is positively associated to future firms profitability. The spearman coefficient correlation of 0,275 is statistically significant at the 1% level. In addition, this table shows that except the signals represented by INVES, GM and LEV, all other nine fundamental signals have positive correlation with future profitability. Overall, these results suggest that firms with bad current accounting signals have lower future earnings realization and contrary, firms with good signals have higher future earnings realization. Results in table 5 corroborate the last suggestion by showing that the low F_Score portfolio realise a negative mean ROAt+1 of -0,012 against a positive ratio of 0,100 by the high F_Score portfolio. The mean differences of profitability between these two portfolios is positive (0,112) and statistically significant at the 5% level. The higher return being earned by the high F_Score firms over the low F_Score firms could be explained by the higher profitability of these firms. Moreover, results in this table show that the high F_Score portfolios profitability outperforms the overall samples profitability (0,046) by a mean of 0,054 where the low F_Score portfolio underperforms the sample by a mean of -0,058%. This provides evidence on the success of the fundamental strategy on discriminating between more profitable and less profitable firms.

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Table 4:

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Spearman Correlations between Future Earnings, the twelve Fundamental Signals and the Fundamental Score (F_Score)

ROAit+1 0,275** F_Scoreit (0,004) 0,075 INVit (0,442) 0,054 ARit (0,583) -0,347** INVESit (0,000) -0,077 GMit (0,432) 0,208* LFit (0,033) 0,572** ROAit (0,000) 0,284** DROAit (0,003) -0,484** DLEVit (0,000) 0,262** DLIQUIDit (0,007) 0,232* DTURNit (0,017) 0,318** CFit (0,001) 0,008 ACCit (0,936) ** (*) denote values of Spearman correlations significant at the 1% (5%) level; values between parenthesis denote p-value. The twelve fundamental signals presented in this table represent individual binary variable that is equal to one (zero) if the underlying signal was a good (bad) signal about future firms performance. F_Score represents the sum by firm of the individual binary variables associated to the twelve fundamental signals. ROAt+1 is return on assets for one year-ahead. The sample represents 108 firm-year observations between 1995 and 2001.

Table 5:

Performance based on Fundamental Signals

1995a 1996 1997 1998 1999 2000 2001 Meanb

ROAt+1 Low F_Score portfolio 0,035 0,035 -0,289 0,038 0,073 -0,026 0,047 -0,012 High F_Score portfolio 0,093 0,156 0,061 0,076 0,078 0,142 0,094 0,100 Hedge Portfolio (High Low) 0,112** (t-stat) (2,515) (P-value) (0,046) All Firms 0,025 0,050 0,039 0,052 0,070 0,064 0,021 0,046 ** denote values significant at the 5% level. Low F_Score portfolio consists of firms with an aggregate F_Score 5; High F_Score portfolio consists of firms with an aggregate F_Score 8, where F_Score represents the sum by firm of the individual binary variables associated to the twelve fundamental signals; the binary variable is equal to one (zero) if the signals realization was a good (bad) signal about firms future performance. a, these values represent mean ROAt+1 to portfolios constructed annually on the basis of the fundamental signals associated to every fiscal year. b, these values represent mean ROAt+1 to annual portfolios over the seven years from 1995 to 2001. Hedge portfolio consists to take short position on low F_Score stocks and long position on high F_Score stocks. Mean ROAt+1 to this portfolio is the mean ROAt+1 differences between the high and the low F_score stocks.

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5. Summary and Conclusion

This paper presents evidence that accounting-based fundamental signals can be used to predict future stock returns. A simple fundamental analysis strategy that consists of simple screens based on accounting signals, shift the distribution of returns earned by an investor by separating winners stocks from losers ones. From a sample generating over a 15-month- holding period, negative future returns of -0,116, the strategy discriminates a winner portfolio that provides positive future returns of 0,019 from a loser one generating negative future returns of -0,229. The finding that nearly all individual accounting signals have a positive correlation with future stock returns and for some signals, a correlation that outperforms that of the aggregate signal constructed, highlights the necessity to identify the individuals signals contributions in defining successful fundamental strategies. The positive correlation between the aggregate fundamental signal and future earnings performance and the finding that the winner portfolio has a future earnings realisation (0,100) that outperforms that of the loser one (-0,012), suggest that the over-performance of the winner portfolio compared to the loser portfolio may be the result of an under-reaction to historical accounting information. That is the market slowly incorporates the predictive ability of public historical accounting information into prices. However, prior studies have suggested the possibility that returns to fundamental strategies could be a risk attribute. Whether returns difference between winners stocks and losers ones documented in this paper, is the result of a systematic market under-reaction to the future earnings signal inherent in current financial statements, or equates to differences in risk, is a subject for future research.

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