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What are we looking for?

Cheap stocks that have cash flow from operations that is greater than earnings. This situation is caused by what are known as negative earnings accruals.

Inspiration for our search comes from financial author Jack Hough. In his book, Your Next Great Stock: How to Screen the Market for Tomorrow's Top Performers, Mr. Hough notes that "earnings aren't real" as they include accrual accounting, which reflects non-cash items. "Income is counted as it's accrued (but not necessarily collected) and expenses are subtracted as they are incurred (but not necessarily paid)."

The accrual anomaly was identified in 1996 by Richard Sloan. Mr. Sloan is professor of accounting at Haas School of Business at the University of California Berkeley. In his research paper "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?" Mr. Sloan found that stocks with small or negative accruals tend to produce far better stock returns than those with large ones. Investors should be cautious of companies that report strong earnings growth that have high accruals as Mr. Sloan found that strong earnings growth driven by high accruals doesn't last.

More about today's screen

In creating today's offering, I filtered the Morningstar CPMS database of Canadian companies for medium sized and larger companies using Mr. Hough's criteria (I used five-year earnings growth versus his three-year suggestion).

To qualify for the list, firms had to have:

-A market cap above $250-million;

-Trailing 12 months free cash flow minus trailing net income greater than zero;

-Five-year annualized earnings growth greater than 10 per cent;

-One year earnings growth greater than the five-year earnings growth rate;

-A price/earnings multiple (based on current year forecast) below the industry median.

What did we find?

Back testing based on up to 15 stocks from September, 2004, to July, 2012, using the Morningstar CPMS database, showed the portfolio based on Mr. Hough's criteria significantly outperformed the S&P/TSX composite index (19.1 per cent versus 6.6 per cent for the S&P/TSX).

The median forecast P/E for 2013 for the portfolio is 30 per cent below the median P/E for the S&P/TSX, 8.7 times versus 12.4 times. The median 2013 earnings growth forecast of 15 per cent is about equal to the 16 per cent forecast for the S&P/TSX. The earnings estimate revision in the past 90 days for 2013 of 4 per cent was 12 per cent higher than the minus 8 per cent revision for the S&P/TSX.

With an attractive list of cheap stocks with good free cash flow yields, strong forecast earnings growth and rising earnings estimates, it appears that investors should continue to take advantage of the accrual anomaly.

Robert McWhirter is president of Selective Asset Management Inc.