[MUSIC] Learning Outcomes. After watching this video you will be able to read and understand an abstract of an academic paper. [MUSIC] Welcome back. Welcome to this section on reading an academic paper. As I've told you in the previous section, I'm going to take you through a paper which is a basis of one of the celebrated trading strategies on value investing. This paper is written by Joseph Piotroski and the paper is published in Journal of Accounting Research. By the way, Journal of Accounting Research is our top journal in accounting. So this paper is about building trading strategy which based on value investing philosophy. You would have heard about Warren Buffett and many other investors who practice value investing. What this paper does, is that it creates a formula for value investing. You look at the bunch of variables in a financial statement of a company. Using these variables, you create a number and this number is called the F-score. And using this F-Score, you will develop a trading strategy. That's the broad idea of this paper. As I've told you, the purpose of any academic paper is to contribute to knowledge so that explains why this strategy works. How does it contribute to or understanding of markets and so on and so forth? But as a trader, we are less interested in that part and more interested in the training strategy part of it. Of course, it doesn't mean that I'm discouraging you from reading the paper. You're most welcome to read an entire paper. You can send us questions if any, if you have. But then, the most important part for us is understanding the strategy itself. As I've told you, a paper has many sections. In the last module I told you, it starts with an abstract goes to introduction then you have institutional background, results, empirical strategies, and so on and so forth. So let me start with this paper and give you an introduction as to what each section contains. Let me start with abstract. As I've told you before, abstract ranges from 100 to 200 words and summarizes the entire paper in brief. Let's see an example using this paper. See the first sentence of this abstract that you can see on your screen. This paper examines whether a simple accounting-based fundamental analysis strategy. Let me stop here. What is this paper examining? Simple accounting based, this is important. This is accounting based. I told you before that you need not have any special proprietary data to implement these strategies. This is simple accounting based information. This is all available in the public domain. You don't need to know anyone. You don't need the management. You don't need to have inside information, none of those. All that you have require is accounting information, that's a big plus as far as this trading strategy is concerned. The next key word is fundamental analysis. Now, what is this fundamental analysis? Fundamental analysis is understanding a company through its publicly disclosed information. The idea here is that, if you analyze company's balance sheet, company's revenue statements, the profit and loss account and disclosures made by the management, you will be able to get insights using which are not yet incorporate it in price. We have this concept of efficient market which a lot of academicians use where the idea is every information is instantly priced in. If that is the case then, fundamental analysis is of no use. But people who believe in fundamental analysis think that if you really understand the nitty-gritties of a company through its accounting statements and the statements made by the management, there is money to be made. You will have insights which are not known, you'll read inside which are not priced in by the market. What do I mean by this? You'll be able to identify whether a company's over priced or under priced. So, that's the meaning of fundamental analysis. We'll talk more about this, when I talk to you about this training strategy, you'll understand it even better. Let's continue with this abstract. What it says? When applied to a broad portfolio of high book-to-market firms, let me pause one second. When applied to a broad portfolio, so broad portfolio is important. All these strategies work on a broad portfolio. It's not about individual stock. Nobody making a claim that on every particular stock on every day you can make money. It's impossible, there are large number of factors that impact the stock price. That's not possible. But if you have a broad portfolio of stocks then this strategy's work. And then, what is the next operative work? High book-to-market force. What are these high book-to-market force? In the previous module, you already learned the concept of book value and market value. So book value is nothing but, the value of a form as recorded in its books. Suppose you buy a property at 100,000 and you depreciate it at the rate of 20% every year. First year the value of the property, the book value of the property's 100,000. Second year is 80,000. So if your company has only that asset then the value of your company and suppose that there is no liabilities will be 100,000 in the first year and 80,000 in the second year, that's the book value. And suppose you have 100,000 shares, book value per share will be one. What about market value? Market value is the price of your shares times number of shares. Suppose, for the same company, the value of, price of per share is two. So, if you multiply two with number of shares which is 100,000, the value of the form becomes 200, market value of the form becomes 200,000. So, book-to-market value, in this case, is one divided by two which is half. So this strategy applies to a broad portfolio of forms which are high book-to-market value. This high book-to-market is very, very crucial in the strategy. So, this ratio half is higher this ratio, So that the forms where which have high book-to-market ratios are the forms in which this strategy works. That's what the other is trying to say. Now, let;s move on further. The author says, can shift to the distribution of returns earned by an investor. I've told you that a lot of parts in the paper which are not required from our training point of view. Now, this for academic audience. If your purpose is just training, you can safely ignore this part, can shift the distribution of returns on one investor. Those of you who are interested in understanding this If you read the paper you'll get an idea you can write to us, but from a purely trading point of view you can ignore this part. Now this is the first sentence. The sentences in abstract let me warn you tend to be very long. The reason is they want to club a lot of information in this 100 to 100 words. Let me walk more to the next sentence. Petroski says, I show that mean return earned by a high book-to-market investor. So, I already told you what high book-to-market is. You know, if there are let's say three forms with one having 0.8, one having 0.6, one having 0.4. High book to market. The highest is one of 1.8. In the people will really explain what are the characteristics of these high book to market forms are. But it's time you can pause and think, what are these high book to market firms? Essentially, these are firms, who's assets are not valued as much as other firms. In other words, for a particular book value, the market value's low. Remember, the book value is in the numerator and market value in the denominator. So these are our value stocks. So, the strategy focuses on value stocks. We are going to give you more examples as we proceed. So Petroski says, I show that mean return earned by a high book to marketing restaurant can be increased by at least 7.5% annually through the selection of financially strong high BM forms. This is important. Number of people have shown that the strategy of buying high book to market stocks makes money. Value stocks make money. People ignore these stocks but if you buy all these value stocks and hold on for five, ten years, people have shown that they make money. Petroski says, if you use his formula. If you use the trading strategy. You can increase your chance on buying a value stocks. All high book to market forms by 7.5% per annum, 7.5% per annum is huge. An the operating word is financially strong high BM forms. Now this is where fundamental analysis comes in. How do you know a particular form is financially strong? You learn about the strength of a firm through it's accounting information. You just need accounting information for this strategy. You do not need anything which is not there in the public domain. So use your accounting information, you identify financially strong high book to market forms. And then trade using this strategy, which Petroski has outlined in this paper and your returns are, at least in the past. The data that Petrosky analyses your returns are 7.5% per annum higher when compared to a strategy where you buy all high book to market forms. Let's move on. Next he says while the entire distribution of realize return has shifted to the right. Again I said we will not bother about distribution of returns here. Next sentence. In addition, an investment strategy that buys expected winners. Now how do you know which firms are expected winners? Again, fundamental analysis, going back to accounting statements, identifying strong high book to market firms. If you do that, you will come out with expected winners and charge expected losers. So you create a trading strategy that will go long on expected winners. And you short expected loser. You're already aware about longs and shorts. Longs is buying, shorts is selling without buying. You bought all stock and sell it. A previous module has covered shorting and detailed. Those of you who forgotten can refer to that module. So, creating study your Petroski is, look at the accounting statements. First of all create the newest of these IBM stocks, look at the accounting statements. From the context statements identify potential winners using his formula. Identify potential losers. Go long on the winners. Go short on the losers. And hold on for a particular period of time. If you do that Petroski says, I'm on in the next sentence of the abstract where he says Investment strategy that buys expected winners and shorts expected losers generates a 33% annualized return, between 1976 and 96. This is huge. The best of the best investors have around 20 to 24% annualized Returns through order period. You can just take an Excel sheet and see if you start with a $100 and if it compounds at 23, 24% for 20 years, how much it's going to be? This is huge, now please, mind do, this 23% is based on The parse numbers. It is not that every 20 years you want to make 23%. There have been number of tests that we want to do, to test whether this is robust. But this is what Petroski has found. Between 1976 and 1996, if you had used this strategy, you'd have made 23% annualized return. Then he says, and the strategy appears to be robust across time and to control for all tried to investment strategies. Now this is the beauty of a academic paper. Number of things we process through data mining and come out with some kind of a number. In order to show that this is not a mere data mining exercise, Petroski shows that these results hold even when you change the time period, even when you control for other kinds of explanations as well. Then he says, within the portfolio of high BM forms the benefits to financial statement analysis are concentrated in small and medium sized firms, companies with low share turnover and firms with no analyst following. This is very important. Another question is if it is so easy why is this strategy working? Why are others not implementing these strategies? The next sentence gives a partial answer to this. Most of the money to be made here comes from small stocks, stocks which are not covered by analysts, stocks which where their trading is very thin. In other words, these are stocks where smart institutional investors cannot enter that easily. That's one of the reasons why this works. Yet the superior performance is not dependent on purchasing firms with low share prices. This is also important. It is not that you buy penny stocks. You're allowed to buy penny stocks for this study because penny stocks are risky. We all know that the stocks which are priced really low, one dollar or some cents, they easily lose 90% in no time. So when we say that these are small stocks, it is not small denomination stocks. These are small firms. These are forms which are not covered by analysts that much. So, the point is the results of this strategy are driven by stocks Which are not covered [INAUDIBLE] which are small and also those with low training turnover but not by penny stocks. [INAUDIBLE] further says a positive relationship between the sign of the initial historical information. And both future before performance and subsequent quarterly earnings announcement reaction suggests that market initially underreacts to the historical information. Now this is the reason why fundamental analysis works. [INAUDIBLE] Second reason why it still works. He chose that a positive relationship between sign of the initial historical information and future form performance. So it's not just that the stocks which are identified as high, strong book to market firms here, give only high stock returns. He shows these firms actually perform better. Their profits increase, their sales increase, their investments increase. Their efficiency increases. So, this formalized sort of and at once indicator of how good the firm is going to be. And the market for some reason does not recognize it before hand. The market underreacts to this kind of information. And that is why there is a school for alternative studies. Finally, Piotroski says, in particular, 1/6 of the annual return difference between ex ante strong and weak firms. Is earned over the four three-day periods surrounding these quarterly earnings announcements. Again, this is not very critical for us. Basically what he's saying is one-sixth of the annual return difference between strong and weak firms. Mind you now, we have moved on. There are two numbers I told you. One is 79%. One is 23%. Now, what is this 7.5%? 7.5% is if you have all high book to market firms. Trade all high book to market firm, all trade. By trade, I mean going long. Only those forms identified by Piotroski formula. Your returns are likely to be 7.5% higher in the Piotroski sub-section when compared to the entire hybrid to market portfolio. The 23% comes from a strategy where you go long on have strong high book to market firms. You go short on weak high book to market firms and the difference between the two works out to be 23%. Now, what Piotroski's saying is one-sixth of this difference comes in a short interval of few days immediately after quarterly earnings announcement. So if you want to know where the maximum impact of this strategy is going to be, is immediately after quarterly earnings are announced. So one should be really quick to utilize this strategy, to implement this strategy. Otherwise, you would have lost one-sixth of your return. Overall, finally, Piotroski says overall, the evidence suggests that the market does not fully incorporate historical financial information into prices in a timely manner. Now this is the important contribution Piotroski makes to the literature. He says markets are not super efficient, they do not instantaneously present every possible information. There is call for fundamental analysis. There is call to understand accounting information in detail. You can make money by such an exercise that is used to such an exercise and that's the purpose of this paper. So if you see the abstract, the entire paper has been summarized in about eight to ten sentences. When one reads the abstract, one does not get the complete idea about the trading strategy. But you understand the background, you understand the contribution of this paper. And you also understand roughly what the trading strategy is going to be. So it's important that we continue reading further and read the introduction, get into the algorithm part and also read the main results. So in the next part, I'll take you through the introduction.
