Lemons or Lemonade?

This past Sunday it was 71 degrees and dry in Chicago. If you've ever lived here in November, you know that's an anomaly. At this time of year, it's usually 44 and wet. I felt so warm, I decided to have a glass of lemonade, which is usually reserved mostly as a summer treat. As I sat on my porch enjoying the day with my beverage, it reminded me of the tale of two lemonade entrepreneurs.

The story itself is a little long, but here's the summary. There are two businessmen (Bill & Ted) that decide to setup lemonade stands. Bill does everything with a 'just-in-time' approach: buying only the amount of supplies and inventory he needs for each day. Ted decides to buy everything for 100 days of lemonade sales up front, including a brand new stand. Total Day 1 costs for Bill are $120 and for Ted they are $2100. Since the quality of product and price are the same, they both earn $200 the first day.

It's pretty clear Ted needs an accountant to handle the expensing of his equipment with the accrual method. The accountant determines that Ted could expense $120 that first day. So Bill's and Ted's net income is the same: $80. However, interesting enough, Ted has a cash flow of -$1900 the first day while Bill has a +$80 cash flow. The effect you see here is that Bill has a low or zero level of accruals and Ted has a very high level of accruals. It could also be said that even though both had income of $80, that Bill's income was of a higher quality than Ted's.

So which person do you think is taking more risk? What if customers start putting their lemonade purchases on account and then don't pay? What if there are some rainy or cold days that dampen sales? It's pretty clear Ted might even have some days when he loses money because he still has to expense those assets.

Now let's move out of our hypothetical lemonade stands and into the reality of the stock market. The Accrual Anomaly, first discovered by Dr. Richard Sloan, provides evidence that stocks of companies with low accruals significantly outperform stocks of companies with high accruals. That's the key: the market rewards cash inflows and higher-quality earnings as opposed to cash outflows and low-quality earnings.

Let's take a look at those rewards. In Sloan's research, he finds creating a hedged portfolio of buying low-accrual companies and shorting high-accrual companies created an average return of 11% per year from 1970-2007. Using Research Wizard, I continued the study from 2008 thru October 2011 and observed an average annualized return of 15%. Lemonade, indeed!

Here's a method for finding stocks to take advantage of Accrual Anomaly:

• First, start with only US common stocks.
  
• Next, create a liquid (no pun intended!) investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  
• Add another filter by selecting those stocks with a Zacks Rank less than or equal to 3. (Let's be clever and avoid the poorly-rated stocks.)
  
• Select the top 10 stocks with the lowest accruals (net income – cash flows) / total assets

Here are 5 great stocks based on this idea (11/15/11):

TNS – TNS Inc.

TNS is a data communications company that provides networking and connectivity to telecoms, retailers, banks and other financial institutions. Cash flow at this company remains strong and has been increasing in recent years.

(BSX - Analyst Report) – Boston Scientific Corporation

Boston Scientific develops, manufactures, and markets medical devices used in various interventional medical specialties worldwide. BSX's cash flow is decent and its accruals are low.

(ACXM - Analyst Report) – Acxiom Corporation

Acxiom provides marketing technology and services that enable marketers to manage audience, personalize consumer experiences and create customer relationships. Again low accruals for this company.

(RCII - Analyst Report) – Rent-A-Center Inc.

Rent-A-Center engages in leasing durable household goods to customers on a rent-to-own basis. This company has a history of good cash flow.

(MYE - Snapshot Report) – Myers Industries Inc.

Myers manufactures and distributes polymer products for the industrial, agricultural, automotive, commercial and consumer markets. Another company with low accruals.

If you'd like to learn more about Accruals, as well as other anomalies, you're in luck. The Handbook of Equity Market Anomalies has just been released and it details several winning strategies used by investment pros. You can also learn more about various market anomalies by visiting a website dedicated to their explanation and discussion: hema.zacks.com.

But for now, focus your investment choices on high cash flow, higher earnings quality and low accrual companies and you'll be more likely to experience the sweet taste of lemonade.