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Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

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22 Financial Statement Analysis

By Paul A. Griffin

Companies release financial statements on quarterly and annual timetables. Securities analysis, popularized by Graham and Dodd (1940), is the in-depth study of these statements on a per-company basis to deduce the potential for excess returns based on the underlying quality of that company. This analysis is used by “fundamental value” investors and hedge funds famously represented by Warren Buffet and Berkshire Hathaway. It contrasts with studying movements and order flow of stock prices, as discussed by Lefevre (1923), or other technical analysis approaches such as momentum-based strategies that make bets based on an expectation that price trends will continue into the future (see Chan et al. (1996) and references therein).

Financial statement analysis attempts to systematically measure the effect of factors taken from the earning statements and determine their ability to predict future returns; subsequently, it ranks, sorts, and filters companies to create a portfolio with improved financial strength. (Note that, in this context, the preliminary quarterly announcements and the subsequently filed statements can differ; audited yearly financials are generally considered to be most authoritative.)

The fact that financial statement analysis produces alpha was initially controversial because, in an efficient market, all accessible information is reflected in the market price. However, subsequent works on multiple factors constructed ...

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