Abstract
I investigate whether it is possible to profitably trade on predicted earnings surprises, forecasted using the Foster (1977) model. Unlike the extant literature, which documents a strong positive relation between actual earnings surprises and returns, I find that trading on predicted earnings surprises, generated by the Foster (1977) model, has earned a small negative, but statistically indistinguishable from zero, return. This result highlights the difficulty in forecasting earnings surprises.
Highlights
It has been shown in the capital markets literature that stocks of firms announcing earnings surprises experience large returns at the time of the announcement
I test whether an investor can accurately predict earnings surprises, i.e. Standardized Unexpected Earnings (SUE), using the Foster (1977) model and find that a long-short strategy that invests based on these predictions has not been profitable
The strategy that uses actual SUE values is highly profitable during the month of the earnings announcement but this return decreases dramatically afterwards
Summary
It has been shown in the capital markets literature that stocks of firms announcing earnings surprises experience large returns at the time of the announcement. (Ball and Brown, 1968; Bernard and Thomas, 1989) This pattern in the data is referred to as post-earnings announcement drift (PEAD). Post-earnings announcement drift is measured using Standardized Unexpected Earnings (SUE), defined by Bernard and Thomas (1990) as the forecast error from a first-order autoregressive earnings expectations model (in seasonal differences) scaled by its estimation period standard deviation. A strategy that invests in a long-short portfolio formed on predicted SUE 2 months before the announcement and held for nine months yields a cumulative average return of -0.89%. The traditional long-short SUE strategy, formed on actual earnings surprises, yields a cumulative average return 18.77%
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