Domestic and Foreign Earnings, Stock Return Variability, and the Impact of Investor Sophistication

Abstract

We examine whether domestic or foreign earnings contribute more to the variability of unexpected stock returns for a sample of U.S. multinationals and consider the role of investor sophistication. We use a variance decomposition methodology that measures the contribution of each earnings component (and expected future discount rates) to the variance of unexpected returns. We show that the contribution of each earnings component to the variance of unexpected returns depends both on the variance of the earnings component and on its persistence. We document that domestic earnings contribute significantly more to the variability of unexpected returns than do foreign earnings. We further find that the relative variance contribution of foreign earnings is an increasing function of the degree of investor sophistication. Finally, when we classify institutional investors as short-term and long-term following Bushee (1998), we find that the relative variance contribution of foreign earnings increases with the level of investment by long-term investors. In contrast, there is no significant relation between the degree of ownership by short-term (or transient) investors and the relative variance contribution of domestic and foreign earnings. Overall, our results are consistent with Thomas' (1999) finding that investors on average underestimate the persistence of foreign earnings due to lack of understanding of firms' foreign operations caused in part by poor disclosure.