[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 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 ever heard about Warren Buffett and many other investors who practice value investing? What these people does is that it creates a formula for value investing. You look at a 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 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 your knowledge so the author explains why this strategy works, how does it contribute to our 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 trading strategy part of it. Of course, it doesn't mean that I'm discouraging you from reading the paper, you are most welcome to read the 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 have 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 risk. This is important, this is accounting risk. 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 to know the management. You don't need to have inside information, none of those. All that you require is accounting information, that's a big plus as far as this trading strategy is concerned. The next keyword is fundamental analysis. What is this fundamental analysis? Fundamental analysis is understanding a company through it's 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 never get insights using which are not in incorporated in price. We have this concept of efficient market which lot of academicians use, where the ideas, every information, is instantly. 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 will get insights which are not priced in by the market. What do I mean by this? You'll be able to identify whether a company is overpriced or underpriced. So that's the meaning of fundamental analysis. We'll talk more about this, when I talk to you about this trading 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 once again. When applied to a broad portfolio. So broad portfolio is important. All these strategies work on a broad portfolio, it's not about a new 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 these strategies work. And then what is our next operate of work? High book-to-market forms. What are these high book-to-market forms? In the previous module you would have, you already learned the concept of book value and market value. For book value is nothing but the value of a firm 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 book value of the property is 100,000, second year, it will be 80,000. So if your company has only data set then the value of your company and suppose there are 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, the price per share is two. So if you multiple two with number of shares, which is 100,000, the market value of the firm becomes 200,000. So book-to-market value in this case, is 1 divided by 2, 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 this strategy. So this ratio half, higher this ratio, So the forms which have high book-to-market ratios are the forms on which this strategy works, that's what the author is trying to say. Now let's move on further. The author says, can shift the distribution of returns earned by an investor. I've told you that a lot of parts in the paper that are not required from a trading point of view. This is for an academic audience, if your purpose is just trading, you can safely ignore this part. Can shift the distribution of returns owned by an investor. Those of you that are interested in understanding this If you read the paper, you will 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 you know 100 to 100 words. Let me move on to the next sentence. Petoskey says I show that mean return on buyer 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 firms. With one having .8, one having .6, one having .4 high book to market. The highest is the one affirmed with .8. In the paper, we'll really explain what these characteristics of this high book to market forms are. It's time you can pause, and think what is this high book to market forms. Essentially these are forms who's assets are not valued as much as other forms. In other words for a particular book value. The market value's low. Remember? The book value is in the numerator and market value is 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 Petoskey says, I show that mean return 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 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. Petoskey says, if you use his formula, if you use his trading strategy, you can increase returns on the buyer value investor who buys all high book to market firms by 7 and a half percent by annum. 7 and a half percent per annum is huge. And the operating word is financially strong high BM firms. Now this is where fundamental analysis comes in. How do you know a particular firm is financially strong? You'll learn about the strength of a firm through its accounting information. You just need accounting information for this strategy. You do not need anything which is not there in the public domain. So using accounting information, you identify financially strong high book to market firms. And then trade using this strategy which Piotroski has outlined in his paper. And your returns are, at least in the past, the data that Piotroski analyzes, your returns are 7 and a half percent per annum higher when compared to a strategy where you buy all high book to market firms. Let's move on. Next he says, while the entire distribution of realized return is shifted to the right, again I say 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 shorts expected losers. So you create a trading strategy where you go long on expected winners and you short expected losers. You're already aware about Longson's\g shorts, Longson's\g buying, shorts is selling without buying. You bought a stock and sell it. A previous module has covered shorting in detail. Those of you forwarded can refer to that module. So, the trading strategy of Piotroski is, look at the accounting statements. First of all, create the nuance of this IBM stocks, look at the accounting statements. From the accounting statements identify potential winners using this formula. Identify potential losers. Go along with the winners. Go short on the losers and hold on for a particular period of time. If you do that, Pitroski says, I'm one, in the next sentence of the abstract, Peri says. Investment strategies that buys expected winners and short expected losers generates a 23% annualized return between 1976 and 96. This is huge. The best of the best investors have won their own 22, 24% annualized Retance g/ throughout their career. You can just take an Excel sheet and see if you start with a dollar hundred and if it compounds at 23-24% for 20 years, how much it's going to be? This is huge. Now, mind you, this 23% is based on the past numbers, it is not that every 20 years you only make 23%. There will be a number of tests that we want to do to test whether this is robust. But this is what Petroski is for. Between the 1976 and 1996, if you had used this strategy, you would've made 23% annualized return. Then he says, and the strategy appears to be robust across time, and to control for alternative investment strategies. Now this is the beauty of a academic paper. Number of times, people just do data mining and come out with some kind of a number. In order to show that this is not a mere data mining exercise? Petrosky 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 firms, 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. Now, this is very important. Now, the question is, if it is so easy why is the 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 where the 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 forms with low share prices. This is also important, it is not that you buy penny stocks, you'll have to buy penny stocks for this strategy. Because penny stocks are risky, we all know that these stocks which are priced very low, one dollar or some cents, they easily lose 90 percent in no time. So this strategy, when we say that these are small stocks, it is not small denomination stocks, they are small firms. These are forms where, which are not covered by analysts as much. So the point is this strategy, the results of this strategy are driven by stocks. Which are not covered by analysts which are small. And also those with low trading turnover but not by penny stocks. Petoskey further says a positive relationship between the sign of the initial historical information and both future firm performance and subsequent quarterly earnings announcement reactions suggest that market initially under-reacts to the historical information. Now this is the reason why fundamental analysis works. He gives second reason why it still works. He shows that a positive relationship between sign of the initial historical information and future firm performance. So it's not just that the stocks which are identified as strong book-to-market firms here, you only have high stock returns. He shows these firms actually perform better. Their profits increase, their sales increase, their investments increase. Their efficiency increases. So this formula is sort of indicator of how good the form is going to be. And the market for some reason, does not recognize it beforehand. The market underreacts to this kind of information. And that is why there is a score for trading strategy. Finally, Piotroski says, in particular one-sixth of the annual return difference between ex ante strong and weak forms is earned over four three-day periods surrounding these quarterly earnings announcements. Again, this is not very critical for us. Basically what it's saying is one-sixth of the annual difference between strong and weak forms. There are two numbers I told you, one is 79% and one is 23%. And what does the 79%? 79% is if you have all high book-to-market forms. Trade all high book to market forms, all trade. By trade I mean going long, only those forms identified by PiotroskiFormula. Your returns are likely to be 79% higher in the Piotroski Subsection when compared to the entire high book-to-market portfolio. The 23% comes from a strategy where you go long, and 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 is saying, 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's going to be, immediately after quarterly earnings are announced. So when you 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 pricing 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, there is use 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 that abstract, one does not get the complete idea about the trading studies. 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 introduction, get into the algorithm part, and also read the main desserts. So in the next part, I'll take you through the introduction
