Richard G. Sloan had written a paper in 1996 for a trading strategy. This paper had shown that using this strategy profits were made for 28 out of 30 continuous years. This strategy may no longer be applicable in the US markets. However, this strategy is very useful for trading in the Indian markets today.
The strategy is based on the fact that we need to consider the amount of accruals in a company and not just the total revenue. The strategy states that companies with more amount of earnings from accruals will eventually generate lower profits for traders of the stock compared to companies which have higher cash equivalents and lower accruals.
The rationale of the strategy is that accruals may or may not convert into cash. This can happen because of accidents where the company fails to collect its dues from the services and products rendered. Also, it can be due to the company’s internal strategies to reflect better numbers to the traders.
One example of how accruals can be manufactured is from the automobile industry. The deliver managers generally push finished inventory to the distributors without firm orders. This immediately inflates the current receivables and thus increases the assets of the company. However, these are accruals and may not actually convert into cash. There is every likelihood that the Distributors may not be able to sell the inventory and return it to the manufacturer.
So, Sloan’s method is to find out the actual cash equivalent of a company and make decisions to buy or sell stocks based on that.
Sloan’s formula is calculated as follows:
Step 1: Calculate the Accruals (Let us call this “A”)
To calculate the accruals, the below formula needs using.
- Delta(Current Assets) = Current Assets of Current Year – Current Assets of Previous Year
- Delta(Cash) = Cash of Current Year – Current Cash of Previous Year
- Delta(Current Liabilities) = Current Liabilities of Current Year – Current Liabilities of Previous Year
- Delta(Total Short Term Debts) = Total Short Term Debts of Current Year – Total Short Term Debts of Previous Year
- Delta(Tax Payable) = Tax Payable of Current Year – Tax Payable of Previous Year
- Depreciation is taken for the Current Year.
Step 2: Determine the Total Income from Continuous Operations (Let us call this “I”)
This can be determined from the Income Statement of the Company. Some companies also call this “Statement of Profit and Loss”.
Step 3: Calculate Sloan Score = (I – A)/(Average Assets of Current Year and Previous Year)
The higher the Sloan Score, the Stock should be bought (or go long on the Stock). The lower the Sloan Score, the stock should be sold (or short it).
We first take the case of Tata Consultancy Services (TCS). I have the Annual Statement from TCS for the Financial Year 2016-17 as on date.
|Account Head||(All figures are in crores of Rs.)|
|Non-current assets including property, plant and equipment||21,139||24,040|
|Cash and bank balances||1,316||4,806|
|Short-term loans and advances||2,704||2,523|
|Other current assets||2,986||2,348|
|TOTAL CURRENT ASSETS||68,619||53,377|
|Secured loans: overdraft from banks||0||112|
|Unsecured loans: overdraft from banks||200||1|
|TOTAL SHORT TERM DEBTS||200||113|
|Revenue from Operations||117,966||108,646|
|Depreciation and amortisation expense||1,575||1,459|
Based on these figures, we can calculate the Sloan Score.
- Delta(Current Assets) = 68,619 – 53,377 = 15,242
- Delta(Cash) = 1,316 – 4,806 = -3,490
- Delta(Current Liabilities) = 10,701 – 11,309 = -608
- Delta(Total Short Term Debts) = 200 – 113 = 87
- Delta(Tax Payable) = 6,413 – 6,264 = 149
Accruals (A) = (15,242 – (-3,490)) – ((-608) – 87 – 149) – 1,575 = 18,001
Total Revenue from Continuous Operations (I) = 117,966
A Normalised = A / (Average Assets of Last 2 Year) = 18,001 / 83,587.50 = 0.215
I Normalised = I / (Average Assets of Last 2 Year) = 117,966 / 83,587.50 = 1.411
Sloan Score = 1.411 – 0.215 = 1.196
Sloan Score for a few more Companies chosen at random
|Infosys||ITC||Kar Bank||RIL||LIC HFL||NALCO||Siemens|
Expansion of Acronyms used
- CA – Current Assets
- C – Cash
- TA – Total Assets
- L – Liabilities
- TSTD – Total Short Term Debt
- TP – Tax Payable
- IfCO – Income from Continuous Operation
- ITC – Indian Tobacco Company
- Kar Bank – Karnataka Bank
- RIL – Reliance Industries Ltd
- LIC HFL – Life Insurance Corporation Housing Finance Ltd
- NALCO – National Aluminium Company Ltd
How to make decision to buy and sell?
Before we can make decision to buy or sell, we need to order the stocks in the portfolio in the order of the Sloan Score in the descending order. For the stocks we have discussed above, the order would be as follows.
|Tata Consultancy Services Ltd||1.196||100|
|Relaince Industries Ltd||0.489||38|
|LIC Housing Finance Ltd||0.036||13|
Now, as your strategy, you need to decide whether you will buy the top 25 percentile and sell the bottom 25 percentile OR you will buy the top 10 percentile and sell the rest.