30 YEARS OF ACCOUNTING LESSONS: PENMAN, PIOTROSKI, BENEISH, AND MORE – PART VI by Steven De Klerck – Also follow him on Twitter here
8. Dickinson and Sommers, 2012
Name of investment strategy: Competitive S-SCORE
Accounting signals used: 26
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Use of statistical techniques: YES
In this part on fundamentals-based investment strategies in the accounting literature over the past 30 years – the last part but one – I discuss the paper by Dickinson and Sommers (2012): “Which Competitive Efforts Lead to Future Abnormal Economic Rents? Using Accounting Ratios to Assess Competitive Advantage”.
Following Penman and Zhang (2006), Dickinson and Sommers (2012) predict the change in operating profitability one year ahead (deltaRNOAt+1) (more correctly, they predict the change in industry- and risk-adjusted operating profitability). They start out from a base model; this base model incorporates the following accounting variables: the return on net operating assets (RNOAt), the change in the return on net operating assets (deltaRNOAt) and the growth rate in net operating assets (GtNOA). This is shown in the following table under the column “Base”. Consequently, there is a strong overlap between the base model by Dickinson and Sommers (2012) and the Penman and Zhang (2006) model in their Table 4.
Subsequently, Dickinson and Sommers (2012) introduce accounting variables to assess competitive advantages. By selecting the proper strategy and establishing competitive efforts, companies can delay the well-known phenomenon of mean reversion in (operating) profitability. For this reason, competitive efforts directly impact firm profitability and, according to Dickinson and Sommers (2012), they should be incorporated into investment strategies.
Their most extensive model adds twenty additional accounting variables to capture competitive advantages. These variables are shown in the above table under the column “Diminishing Returns”. Cost of Sales (CoS) is defined as the cost of goods sold divided by net sales and is used to capture economies of scale. Product differentiation is measured using the advertising intensity ratio; this ratio is measured as advertising expense divided by net sales (AdvInt). Innovation intensity (Inv) is assessed using research and development expense divided by net sales. Similarly, capital intensity (CapInt) is measured using depreciation expense divided by net sales. Power over suppliers is captured by a firm’s operating liability leverage (OLLev); this accounting ratio is computed as operating liabilities divided by net operating assets. Power over customers is assessed using two variables: receivables turnover (ARTurn) and market share (MktShr). Finally, credible threat of expected retaliation is measured using financial leverage (FLev) and the availability of excess cash (ExFunds).
When all twenty accounting variables are included in the regression model, Dickinson and Sommers (2012) document an increase of 32.53% in explanatory power of the regression model over the base model. For many of the accounting variables, the sign of the regression coefficients is contrary to expectations. As a consequence, I leave it up to the reader to find the (ex ante) explanations given by Dickinson and Sommers (2012) for the obtained results credible or not.
Next, Dickinson and Sommers (2012) use the extended models in Table 3 to generate out-of-sample forecasts for the change in operating profitability one year ahead (deltaRNOAt+1). The researchers restrict their out-of-sample forecasts to the 2001-2003 period, which is quite disappointing because after all their entire sample period covers the 1972-2003 period.
As opposed to Penman and Zhang (2006), Dickinson and Sommers (2012) do not use the generated forecasts for the change in operating profitability one year ahead (deltaRNOAt+1) to set up an investment strategy. Consequently, this finding (again) largely keeps the reader in a state of uncertainty regarding the actual relevance of the paper and the assessment of competitive advantages through accounting ratios in particular for fundamentals-based investors. In addition, it would be interesting to quantify the added value – in terms of (risk-adjusted) returns – of the very cumbersome risk- and industry-adjustment procedure used by Dickinson and Sommers (2012). Here also the added value of these computations remains a mystery to the reader. Despite the promising title, the paper ends quite disappointingly for the fundamental investor.
In the final part of this series I will draw some major conclusions regarding accounting-based investment strategies. By now it already has become quite obvious that the development of successful fine-grained and/or forecast-oriented and/or contextual fundamentals-based investment strategies is easier said than done. I will elaborate on this view in the final part.