Abstract
We document a market failure to fully respond to loss/profit quarterly announcements. The annualized post portfolio formation return spread between two portfolios formed on extreme losses and extreme profits is approximately 21 percent. This loss/profit anomaly is incremental to previously documented accounting-related anomalies, and is robust to alternative risk adjustments, distress risk, firm size, short sales constraints, transaction costs, and sample periods. In an effort to explain this finding, we show that this mispricing is related to differences between conditional and unconditional probabilities of losses/profits, as if stock prices do not fully reflect conditional probabilities in a timely fashion.
Highlights
Market observers, academics, and regulators seem to agree that investors consider earnings releases important corporate events
A hedge portfolio that takes a long position in the extreme profit firms and a short position in the extreme loss firms generates approximately 10 percent abnormal return, which translates into an annualized return of approximately 21 percent
To test whether the loss/profit strategy is incremental to the post-earnings-announcement drift, we examine the loss/ profit strategy after controlling for the post-earnings-announcement drift (SUE) effect
Summary
Academics, and regulators seem to agree that investors consider earnings releases important corporate events. Notwithstanding the attention investors seem to pay to earnings releases, academic studies have found that investors fail to fully incorporate the implications of earnings news into stock prices in a timely fashion One strand of this literature (e.g., Foster et al, 1984; Bernard and Thomas, 1990; Ball and Bartov, 1996) documents predictable stock price changes around future earnings announcements (up to four quarters ahead), and attributed this finding to investors’ misperception of the time-series process underlying standardized unexpected earnings (SUE). The idea that humans, who are endowed with limited processing capacity, rely on simplified models, or imperfect decision-making procedures (i.e., heuristics), to solve complex problems is rooted in the field of social cognition
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