Stocks That Are Cheaper Than They Look

Company earnings have always been prone to sudden spikes and swoons. That's why it's a bad idea for stock investors to rely too heavily on value signals the price-to-earnings ratios.Some changes to earnings, however, are less surprising than others. In the mid-1990s, an accounting professor named Richard Sloan uncovered something called the accrual anomaly. "Anomaly" is a word researchers have long used to describe clues that predict stock returns, on the belief that in an efficient market, such clues aren't supposed to exist. "Accrual" is an accounting term that's central to how earnings are calculated.

In theory, earnings should match cash profits over time, as positive accruals (when earnings exceed cash profits) in some quarters are offset by negative accruals in others. In reality, as Sloan's research showed, accruals are often subjective, so the accrual component of earnings tends to be less persistent than the cash component. Accordingly, stocks with earnings that far exceed cash profits tend to underperform. Those with the opposite condition, however, tend to produce rising earnings and handsome returns. The accrual anomaly isn't an accurate predictor in every case, but it's a good place to begin a search for bargain shares.

Source: SmartMoney

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