Information in Balance Sheets for Future Stock Returns: Evidence from Net Operating Assets

In this paper, we extend the work of Hirshleifer, Hou, Teoh and Zhang (2004) on the "sustainability effect" by directly linking the implications of NOA (net operating assets) and NOA components for the sustainability of current earnings performance with future stock returns. After controlling for current profitability, we find a strong negative relation of NOA with future stock returns. Moreover, the results indicate that this relation is associated with the sustainability implications of the underlying components of NOA. We also find that the hedge strategies on NOA and those NOA components that indicate low sustainability of current profitability generate positive abnormal returns and constitute statistical arbitrage opportunities. The findings on the sources of the NOA anomaly indicate a significant role for earnings management but no significant role for growth. However, it is found that the interaction of earnings management and growth is an important contributing factor in the anomaly. Overall, our evidence suggests that the interpretation of the NOA anomaly requires investor's limited attention on accounting distortions arising from earnings management.