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Influences

The following is a list of papers and books that have influenced Two Rivers’ approach to investing

Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers

Joseph D. Piotroski, Stanford University, Graduate School of Business

This paper examines whether an accounting-based fundamental analysis strategy, when combined with valuation, can produce substantial alpha for equity investors. A positive relationship exists between historical accounting information and both future firm performance and subsequent quarterly earnings announcement. The paper suggests that the market initially underreacts to historical information and does not fully incorporate historical financial information into prices in a timely manner.

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.

Howard Schilit, Ph.D., CPA and Jeremy Perler, CFA, CPA; From the founder of the Center for Financial Research and Analysis (CFRA), a very useful practicioners guide to identifying accounting anomalies and potential earnings manipulation. The book is an intelligently organized survey of common earnings padding techniques and red flags in financial statements.

Earnings Quality and Future Returns: The Relation between Accruals and the Probability of Earnings Manipulation
M. D. Beneish and D.C. Nichols
Indiana University

The paper examines the relation between the probability of manipulation, accruals, and future returns. The authors show that firms that have a high likelihood of earnings manipulation (as measured by the Beneish (1999)s M-Score) experience lower future earnings, but that investors expect these firms to have higher future earnings. They also show that the probability of manipulation is an omitted variable for the earnings forecasting models used in prior research on accrual mispricing and that including the probability of manipulation greatly attenuates the mispricing of accrual persistence. Finally, the probability of earnings manipulation predicts economically significant abnormal returns after controlling for accruals and various controls for risk factors, including a factor compensating for earnings quality differences. Accrual mispricing arises because investors are misled by managers opportunistic management of earnings.

The Long and Short of the Accrual Anomaly
Messod Daniel Beneish
Indiana University Bloomington – Department of Accounting

D. Craig Nichols
Cornell University – Samuel Curtis Johnson Graduate School of Management
June 2006
The paper provides evidence that the relation between accruals and future returns is not symmetric. Accrual hedge returns are driven by firms with large positive accruals and firms with high probabilities of earnings overstatement. This asymmetry is consistent with the view that upwards rather than downwards earnings management is an important contributor to accrual mispricing.

Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach
Joseph D. Piotroski
Stanford University – Graduate School of Business

Eric C. So
Stanford University – Graduate School of Business
June 2011
This paper identifies expectation errors regarding future firm performance embedded in the prices of value and glamour firms by contrasting performance expectations implied by firms’ value/glamour classification against a simple, financial statement analysis-based metric that differentiates improving versus deteriorating fundamentals. The authors find that returns to value/glamour strategies, expectation errors, and expectation revisions are concentrated among firms whose financial performance conflicts with implied market expectations. The results suggest that the value/glamour effect is an artifact of erroneous performance expectations that are predictable from fundamental analysis.

Margin of Safety, Seth Klarman
Perhaps the best book on value investing ever written. Klarman focuses on special situations and finding pockets of irrational investment behavior. The book provides useful, applicable advice on following a value-investment process: where to find investment opportunities, how to invest in these opportunities, and various aspects of overall portfolio management.
Out of Print

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

Joel Greenblatt

Greenblatt looks for returns in areas not usually considered by the average investor: spin-offs, mergers, risk arbitrage, restructurings, rights offerings, bankruptcies, liquidations, and asset sales. Greenblatt argues that because these areas are not overstudied by the analysts, possible market inefficiencies can be exploited. He explains each area with case studies from his own experience.

Short Selling: Strategies, Risks, and Rewards

Frank Fabozzi

Frank Fabozzi has collected a group of market experts who share their knowledge on short selling, including:

  • The mechanics of short selling
  • Empirical evidence on short selling
  • The implications of restrictions on short selling for investment strategies
  • Short selling strategies pursued by institutional investors
  • Identifying short selling candidates

Bubble Logic Or, How to Learn to Stop Worrying and Love the Bull
Clifford Asness
AQR Capital Management, LLC

A thoughtful paper on the origins and fallacies surrounding investment expectations. Provides useful long term perspectives on asset prices and behavior. Asness’ Summary: A bull market, and the incentives of those who make their living from bull markets, can create its own form of logic. This book explores some of the stories that encourage the purchase or retention of stocks or mutual funds and the logic behind these stories. Some of these stories are honest attempts to explain new phenomenon, and may or may not prove true going forward. Some seem to be unintended falsehoods that come from an incomplete or lazy application of economic reasoning. Finally, some seem less wellintended. The stories, and the logical analyses behind them, generally originate with Wall Street (both sell side and buy side), sometimes riding the coattails of academia, and are often readily absorbed by investors engaged in wishful thinking. Such wishful thinking has led to a stock market, and the growth/tech sector of the market in particular, that is priced so expensively that even very long-term investors will probably end up disappointed. (Written in 1999.)

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