30 Years Of Accounting Lessons: Penman, Piotroski, Beneish, And More

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Eight Principal Fundamental Investment Strategies in the Accounting Literature Over the Past Three Decades: Lessons Learned – Part I of IX by Steven De Klerck 

1. Introduction

In the past years my attention has focused amongst other things on investigating virtually all fundamental investment strategies published. This study resulted in the identification of only (!) eight principal publications with respect to fundamental investment strategies in the accounting literature.

The eight studies are – in chronological order:

1. Ou and Penman, “Financial Statement Analysis and The Prediction of Stock Returns” published in the Journal of Accounting Research in 1989.

2.  Abarbanell and Bushee, “Abnormal Returns to a Fundamental Analysis Strategy” published in The Accounting Review in 1998.

3. Piotroski, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” published in the Journal of Accounting Research in 2000.

4. Beneish, Lee, and Tarpley, “Contextual Fundamental Analysis Through the Prediction of Extreme Returns” published in the Review of Accounting Studies in 2001.

5. Mohanram, “Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis” published in the Review of Accounting Studies in 2005.

6. Penman and Zhang, “Modeling Sustainable Earnings and P/E Ratios Using Financial Statement Information” published as Working Paper in 2006.

7. Wahlen and Wieland, “Can financial statement analysis beat consensus analysts’ recommendations?” published in the Review of Accounting Studies in 2010.

8. Dickinson and Sommers, “Which Competitive Efforts Lead to Future Abnormal Economic Rents? Using Accounting Ratios to Assess Competitive Advantage” published in the Journal of Business, Finance & Accounting in 2012.

In the following sections I will successively discuss these studies. Particularly I focus on the methodology, the documented results in the afore-mentioned and more recent studies and I will already advance some short conclusions with respect to the effectiveness of each of these strategies.

During the past years I have also applied the strategies (3), (5), (6), (7) and (8) on US and international data. For US data the analyses refer to the period 1971-2013; for international data such as Japan and Europe the analyses relate to the period 1987-2013. For many strategies mentioned above it was the first time that these strategies were applied internationally also. The results of these empirical analyses will be handled in a second discussion. For the time being we will concentrate on the already existing knowledge. Based on this discussion we will already gather quite some knowledge with respect to the characteristics of successful and less successful fundamental investment strategies.

2. Ou and Penman, 1989

Name of investment strategy: Pr
Number of accounting variables used: 68
Use of statistical techniques: YES

Ou and Penman (1989) concerns the first important study trying to establish an investment strategy based on fundamental accounting information.

“This paper performs a financial statement analysis that combines a large set of financial statement items into one summary measure which indicates the direction of one-year-ahead earnings changes.” (Ou and Penman, 1989, p. 295)

The researchers try to forecast whether a company will realize an increase / a decrease of profits over the next fiscal year. For that purpose Ou and Penman (1989) select more than 60 (!) accounting variables. The accounting variables used are shown in Table I. We already notice that the calculation of these 68 accounting variables for many individual investors is quite an insurmountable obstacle. Through various statistical analyses (i.e. univariate analyses and stepwise logistic regression) Ou and Penman (1989) model the relationship between these accounting variables in year t on the one hand and the increase of profits realized (indicated by a 1) or the decrease of profits realized (indicated by a 0) on the other in year t+1. Afterwards this modelled statistical relationship is used in order to predict the probability of an increase of profits regarding a new fiscal year (e.g. year t+2) for each company; Ou and Penman (1989) denote this probability by “Pr”.

Table I: Accounting variables used by Ou and Penman (1989) (click to enlarge)


In a next step the companies are sorted based on their predicted probability. It is understood that as an investor, you are mainly interested in buying the companies with the highest probability of an increase of profits and selling the companies having the highest probability of a decrease of profits. Consequently Ou and Penman (1989) establish stock portfolios based on this principle; they go long on stocks with the highest probability of an increase of profits and short on companies with the lowest probability of an increase of profits.

Technical note: Ou and Penman (1989) establish stock portfolios three months after fiscal year end. This choice might introduce a look-ahead bias if not all companies have published their annual accounting statements within three months after fiscal year end.

Ou and Penman (1989) document a buy-and-hold hedge return of 16.8 percent over a 24-months period for their investment strategy over the (limited) period 1973-1983. The biggest part of the hedge return originates from the short position. Long portfolios are characterized by a significantly higher debt ratio and consequently they are more risky compared to short portfolios.

Later studies identify various shortcomings related to the Ou and Penman (1989) fundamental investment strategy.  A brief overview:

1. Holthausen and Larcker (1992) document that the Pr measure does not predict stock returns very well after 1983, which is due to an overfitting of the data in Ou and Penman (1989).

2. Greig (1992) finds that the positive association between the Pr measure and subsequent stock returns becomes insignificant and even negative when size is controlled. Greig (1992) concludes that the Ou and Penman (1989) results are another manifestation of the size effect rather than new evidence of market inefficiency. Similar findings have been documented by Bernard, Thomas and Wahlen (1997). They also find considerable volatility in returns through time and a high risk of loss.

3. Abarbanell and Bushee (1998) identify three important disadvantages of the Ou and Penman (1989) approach. First, Ou and Penman (1989) do not attempt to identify a priori conceptual arguments for studying any of their 68 accounting variables. Secondly, the Ou and Penman (1989) approach retains a large number of explanatory accounting variables, many of which fail to inspire any obvious business-economic logic as to why the retained variables would be good predictors of the change in one-year-ahead earnings. Finally, the set of accounting predictors changes from one short estimation period to the next, making it both difficult to identify the business-economic forces reflected in these variables and to exploit a consistent fundamentals-based investment strategy across time.

4. Piotroski (2000) considers the use of complex methodologies and a vast amount of historical accounting information to make the necessary predictions to be serious shortcomings of the Pr measure.

Otherwise said, based on the Ou and Penman (1989) study, in general we don’t learn much about the relationship between critical accounting items and future stock returns.

To conclude it is important to indicate that Ou and Penman (1989) see significant research opportunities with respect to the improvement of their fundamental investment strategy. One of these improvements is the contextual analysis of the financial statements. A contextual analysis of the financial statements implies that the financial analyst also takes into account characteristics such as the type of industry in which the company operates as well as the life-cycle phase of the company. Dickinson and Sommers (2012) is the first study that actually strictly responds to this research opportunity in a comprehensive manner.

“Further, [our analysis] was based on a pooling of all firms and one suspects that industry-specific or firm-specific models would produce improvements.” (Ou and Penman, 1989, p. 328)

It lasted about ten years – following Ou and Penman (1989) – for a new fundamental investment strategy to be introduced in the accounting literature. The next attempt was made by Abarbanell and Bushee in 1998. In order to have a really successful method we had to wait on Piotroski in 2000. These studies will be dealt with in the second part.

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