Cash Flow Is King? Cognitive Errors by Investors

When investors fixate on current earnings, they commit a cognitive error and fail to fully value the information contained in accruals and cash flows. Extending the accrual anomaly documented by Sloan [1996], we identify significant excess returns from a cash flow-based trading strategy. The market consistently underestimates the transitory nature of accruals and the long-term persistence of cash flows. We find that the accrual anomaly derives from the poor performance of high accrual firms, which are more likely to manage earnings. Combining the accrual and cash flow information also reveals that investors misvalue the quality of earnings. Contrary to Fama [1998], these anomalies are robust to the three-factor model with equally or value-weighted portfolio returns.