Earnings Disappointments Research Articles

Does accounting information identify bubbles for Fama? Evidence from accruals

Economists have long observed that stock price bubbles are associated with corporate overinvestment. We study the ex-ante identification of bubbles (i.e. stock price booms followed by busts) by examining industry-level investments in net operating asset (NOA) accruals and stock returns for 49 countries around the world. Consistent with overinvestment in operating assets being key to bubble formation, we document five findings: (1) NOA accruals positively forecast the eventual crash of an industry price run-up; (2) NOA accruals negatively forecast stock returns following a run-up; (3) NOA accruals are positively associated with investor sentiment; (4) higher NOA accruals forecast more disappointing earnings relative to analysts’ expectations for run-up industries; and (5) NOA accruals are sharply stronger predictors of crashes, returns and analyst forecast errors following run-ups compared to other periods. Our results provide the first evidence that accounting information identifies stock price bubbles and suggest that financial statements are important for detecting and anticipating industry- and market-level inefficiencies.

Mutual funds' capital gains lock-in and earnings management

Capital gains taxation creates a lock-in effect, increasing investors' incentives to monitor and decreasing portfolio firms' incentives to cater to short-term investors. We show a negative relation between lock-in and portfolio firms' earnings management, and this relation is stronger for capital gains held by tax-sensitive investors. Further, the relation between lock-in and earnings management is stronger when the capital gains tax rate is higher. We show that locked-in funds vote against management and against audit committee members' reappointment following earnings management. Locked-in funds are less likely to exit a position following disappointing earnings announcements, reducing firms' incentive to manage earnings.

Why Do Predicted Stock Issuers Earn Low Returns?

Abstract Predicted stock issuers (PSIs) are firms with expected high-investment and low-profit profiles that earn extremely low returns. We evaluate alternative explanations for this empirical phenomenon. Our results show top-PSI firms are cash-strapped, have lottery-like payoffs, high volatility, high beta, low liquidity, and high shorting costs. Over the next 2 years, top-PSI firms earn return on assets of −30% per year, report disappointing earnings, and experience strongly negative forecast revisions. They perform poorly in down markets and are six times more likely to delist for performance-related reasons. Overall, we find substantial support for mispricing, some support for nonstandard preferences, and virtually no support for the risk explanation. (JEL G12, G14, G32, G40, G41) Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Insiders’ Foreknowledge of Earnings Results and Rule 10b5-1 Sales Trades

This article investigates the source of 10b5-1 plan insiders’ superior trade performance. Specifically, this article examines whether insiders trade on their private information about the firm’s future earnings performance through 10b5-1 sell trades and the features of 10b5-1 plan trades that are exploited to achieve superior trade performance. I find strong evidence that insiders use 10b5-1 plans to sell stock before disappointing earnings results. However, there is no evidence of earnings management around 10b5-1 sales, consistent with insiders’ good trade timing deriving from their foreknowledge about unfavorable earnings news rather than their ability to influence the timing and recognition of earnings performance. Restricting the sample to insiders who trade both before and after the implementation of Rule 10b5-1, I find that these insiders traded aggressively on earnings information even in the pre-10b5-1 era, but then shifted aggressive trading into 10b5-1 plans after the availability of planned trading, implying an unintended consequence of Rule 10b5-1. Finally, I document that strategic 10b5-1 trades tend to be infrequent, irregularly timed, close to the plan initiation date, and executed during traditional earnings blackout periods, revealing problematic features within 10b5-1 plans.

High-frequency factor models and regressions

We consider a nonparametric time series regression model. Our framework allows precise estimation of betas without the usual assumption of betas being piecewise constant. This property makes our framework particularly suitable to study individual stocks. We provide an inference framework for all components of the model, including idiosyncratic volatility and idiosyncratic jumps. Our empirical analysis investigates the largest dataset in the high-frequency literature. First, we use all traded stocks from NYSE, AMEX, and NASDAQ stock markets for 1996–2017 to construct the five Fama–French factors and the momentum factor at the 5-minute frequency. Second, we document the key empirical properties across all the stocks and the new factors, and apply the nonparametric time series regression model with the new high-frequency Fama–French factors. We find that this factor model is effective in explaining the systematic component of the risk of individual stocks. In addition, we provide evidence that idiosyncratic jumps are related to idiosyncratic events such as earnings disappointments.

Earnings Shortfalls and Strategic Profit Allocations in Segment Reporting

SYNOPSIS I examine whether firms strategically classify earnings components when reporting bad earnings news. Specifically, I examine whether firms reporting small earnings shortfalls allocate profits across their business segments in a manner that understates the future implications and within-firm drivers of disappointing earnings performance. I find that firms reporting small earnings shortfalls transfer profits toward segments in which profit rates are more informative for firm value and away from segments that operate in industries with higher frequencies of bad earnings news. In addition, I find that shortfall shifting initially tempers negative market responses to shortfall news, but pricing effects reverse in the months following shortfall announcements. My findings suggest that firms strategically classify earnings components when reporting small earnings shortfalls and that strategic classifications temporarily affect the pricing of shortfall news. Data Availability: Data are available from public sources identified in this paper.

Insider Trading: What Really Protects U.S. Investors?

I examine the ability of the U.S. investor protection regime to limit insider trading returns, absent Section 16(b) of the Securities Exchange Act of 1934 (the short-swing rule). I find that in this setting, U.S. insiders execute short-swing trades that i) beat the market by approximately 15 basis points per day and ii) systematically divest ahead of disappointing earnings announcements. These results indicate that the bright-line rule restricting short-horizon round-trip insider trading plays a substantial role in protecting outside investors from privately informed insiders in the United States.

Insider Trading: What Really Protects U.S. Investors?

I examine the ability of the U.S. investor protection regime to limit insider trading returns, absent Section 16(b) of the Securities Exchange Act of 1934 (the short-swing rule). I find that, in this setting, U.S. insiders execute short-swing trades that (i) beat the market by about 15 basis points per day and (ii) systematically divest ahead of disappointing earnings announcements. These results indicate that the bright-line rule restricting short-horizon roundtrip insider trading plays a substantial role in protecting outside investors from privately informed insiders in the United States.

High-Frequency Factor Models and Regressions

We consider a nonparametric time series regression model. Our framework allows precise estimation of betas without the usual assumption of betas being piecewise constant. This property makes our framework particularly suitable to study individual stocks. We provide an inference framework for all components of the model, including idiosyncratic volatility and idiosyncratic jumps. Our empirical analysis investigates the largest data set in the high-frequency literature. First, we use all traded stocks from NYSE, AMEX, and NASDAQ stock markets for 1996-2017 to construct the five Fama-French factors and the momentum factor at the 5-minute frequency. Second, we document the key empirical properties across all the stocks and the new factors, and apply the nonparametric time series regression model with the new high-frequency Fama-French factors. We find that this factor model is effective in explaining the systematic component of the risk of individual stocks. In addition, we provide evidence that idiosyncratic jumps are related to idiosyncratic events such as earnings disappointments.

Intra-industry information transfer effects of leading firms’ earnings narratives

We investigate whether there are information transfers related to the narratives accompanying earnings announcements in the same way there are for bottom-line earnings numbers. Our study is motivated by the conjecture that the narratives accompanying earnings press releases may contain industry-relevant information beyond that conveyed by the earnings number. If so, we expect earnings narratives to trigger distinct information transfer to industry-related peers. Our empirical tests confirm that, after controlling for the earnings information transfer, when industry leaders report positive earnings news and cite external causes, industry peers experience share price increases. Conversely, when industry leaders experience earnings disappointments and cite external causes, industry peers experience share price declines. We also find that the level of industry concentration plays a significant role in these relationships. These findings add to our understanding of the dynamics underlying co-movement of share prices within an industry. Additionally, these findings provide insights into another (previously undiscovered) means by which earnings narratives have relevance for investors.

SEC Rule 10b5-1 Plans and Strategic Trade around Earnings Announcements

We examine how corporate insiders profit from private information about future earnings performance through SEC Rule 10b5-1 trading plans. We first provide evidence consistent with insiders using 10b5-1 plans to sell stock in advance of disappointing earnings results. We then examine insiders who not only currently use 10b5-1 plans, but also actively traded their own company’s stock prior to the availability of such plans. We find that this group traded aggressively on earnings information prior to 10b5-1, but then shifted their aggressive trading into 10b5-1 plans after the availability of planned trading. We also document several questionable patterns associated with their trading behavior. Namely, their trades tend to be irregularly timed, close to the plan initiation date, infrequent in nature, and executed during traditional earnings blackout periods. In terms of firm characteristics, these insiders are more likely to be employed at firms with weaker firm governance and lower institutional ownership.

Sexy or Safe: Why Do Predicted Stock Issuers (PSIs) Earn Low Returns?

Predicted stock issuers (PSIs) are firms with expected “high-investment and low-profit” (HILP) profiles that earn unusually low returns. Over a 36-year period (1978-2013), average returns to top-decile PSIs are indistinguishable from Treasury yields. We show these firms have lottery-like payoffs, high volatility, and high Beta. They are cash-strapped and most will need additional financing. Top-PSIs generate future average return-on-assets of -30% per year, report disappointing earnings, and experience strongly-negative analyst forecast revisions. They earn especially low returns in down markets, and are nine times more likely to delist for performance reasons than bottom-PSIs. We conclude that top-PSIs, and HILP firms in general, earn low returns because they are more salient (i.e., sexier) to investors and thus overpriced, not because they are safer.

Strategic silence, insider selling and litigation risk

Prior work finds that managers beneficially time their purchases, but not sales, prior to forecasts. Focusing on if (as opposed to when) a forecast is given, we link insider selling to silence in advance of earnings disappointments. This raises the question of whether the absence of incriminating trading drives reductions in litigation risk potentially attributed to warnings. We find that the absence of a warning combined with the presence of selling exacerbates the consequences associated with the individual behaviors. Yet, selling prior to a warning typically does not offset all of the warning׳s benefit. In so doing, we supply the first robust evidence of a litigation benefit associated with warning.

The book-to-market ratio, optimism and valuation

There is no agreement as to why the book-to-market (BTM) ratio is positively related to future stock return. Behavioural finance maintains that low BTM stocks have optimistic expectations embedded in their prices and the prices of high BTM stocks are less optimistic. An alternative view is that risk is increasing in the BTM ratio. This paper confirms that the BTM effect is related to earnings disappointments. However, it is posited that the association of the BTM ratio with subsequent return stems from its ability to predict the price reaction to an earnings disappointment rather than its predictive ability for earnings disappointments per se. Specifically, accounting valuation models suggest that the price of low BTM stocks is sensitive to earnings disappointments while that of high BTM stocks is not. Evidence consistent with this prediction is provided. Fundamental valuation reasons and not differential optimism underlie the BTM ratio’s ability to predict return.

The acquisition puzzle and mispricing: evidence of over-optimism

Purpose– Researchers suspect that the overvaluation of equity issuing acquirers is a major cause of their subsequent post-event underperformance. Definitive conclusions regarding this overpricing hypothesis have not been possible since indicators of overpricing such as the book-to-market ratio and subsequent underperformance are open to alternative interpretations. The purpose of this paper is to corroborate or refute overvaluation as a driver of equity issuing acquirers’ subsequent underperformance.Design/methodology/approach– The literature has linked overvaluation of acquirers to over-optimistic expectations. The authors use analysts’ earnings forecasts to reflect the market's expectations. Over-optimism is indicated by subsequent earnings disappointments. The authors examine the relation between acquirers’ choice of payment method and their tendency to report disappointing earnings. The authors also examine the effect of including a more direct measure of over-optimism in a model to explain the long-run post-event buy-and-hold-abnormal returns of acquirers.Findings– The post-acquisition earnings of equity issuing acquirers disappoint more often than those of acquirers employing alternative financing methods. This relationship is confined to glamour acquirers. The ability of financing method to predict long-run post-acquisition performance is subsumed when direct measures of optimism are included in a model explaining long-run post-acquisition performance. This result is robust to controls for overpayment and other potential explanations of post-acquisition underperformance.Research limitations/implications– Acquirers’ management exploit their information advantage to exchange overvalued equity for the assets of the target company in accordance with Loughran and Ritter's (2000) behavioural timing hypothesis.Originality/value– The study provides new and unambiguous evidence that equity-issuing acquirers are optimistically priced at the time of acquisition.

Aggregate Investment and Investor Sentiment

Using bottom-up information from corporate financial statements, we examine the relation between aggregate investment, future equity returns, and investor sentiment. Consistent with the business cycle literature, corporate investments peak during periods of positive sentiment, yet these periods are followed by lower equity returns. This pattern exists in most developed countries and survives controls for discount rates, equity flows, valuation multiples, operating accruals, and other investor sentiment measures. Higher aggregate investments also precede greater earnings disappointments, lower short-window earnings announcement returns, and lower macroeconomic growth. We conclude aggregate corporate investment is an alternative, and possibly sharper, measure of market-wide investor sentiment.

Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence

ABSTRACTSeemingly self-serving attributions either attribute favorable performance to internal causes (enhancing attributions) or poor performance to external causes (defensive attributions). Managers presumably provide such attributions in earnings press releases to heighten (dampen) investors' perceptions of the persistence of good (bad) earnings news, thereby increasing (decreasing) the market reward (penalty) for good (bad) earnings news. Building on attribution theory and prior research on earnings commonality, this study investigates cross-sectional differences in investors' responses to quarterly earnings press releases that contain seemingly self-serving attributions. Using a random sample of press releases from 1999 to 2005, we find that firms that provide defensive attributions to explain earnings disappointments experience less severe market penalties when: (1) more of the their industry peers also release bad news, and (2) their earnings share higher commonality with industry- and market-level earnings. On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when: (1) more of their industry peers release bad news, and (2) their earnings share lower commonality with industry- and market-level earnings. Collectively, our results demonstrate that investors neither ignore seemingly self-serving attributions nor accept them at face value, but rely on industry- and firm-specific information to assess their plausibility.Data Availability: Data are publicly available from the sources identified in the text.

Does Aggregate Investment Reflect Investor Sentiment?

Using bottom-up information from corporate financial statements, we examine the relation between aggregate investment, future equity returns, and investor sentiment. Consistent with the business cycle literature, corporate investments peak during periods of positive sentiment, yet these periods are followed by lower equity returns. This pattern exists in most developed countries and survives controls for discount rates, equity flows, valuation multiples, operating accruals, and other investor sentiment measures. Higher aggregate investments also precede greater earnings disappointments, lower short-window earnings announcement returns, and lower macroeconomic growth. We conclude aggregate corporate investment is an alternative, and possibly sharper, measure of market-wide investor sentiment.

Once Bitten, Twice Shy: The Relation Between Outcomes of Earnings Guidance and Management Guidance Strategy

We examine how management quarterly guidance strategy is affected by various outcomes from previously issued guidance. We find that managers are less likely to provide quarterly earnings guidance for a given year when past management forecasts have been overly optimistic, when past forecasts have resulted in earnings disappointments, when past forecasts were unsuccessful at influencing analysts' expectations, and when past forecasts were followed by increased levels of stock price volatility. In addition, even firms continuing to guide give less precise guidance and guide for fewer quarters within a year when they have previously experienced adverse outcomes from issuing guidance. Finally, we document that outcomes from previously issued guidance also help explain the recent discontinuation of quarterly earnings guidance by many high-profile U.S. firms.

Analysts' Conflicts of Interest and Biases in Earnings Forecasts

AbstractAnalysts' earnings forecasts are influenced by their desire to win investment banking clients. We hypothesize that the equity bull market of the 1990s, along with the boom in investment banking business, exacerbated analysts' conflicts of interest and their incentives to strategically adjust forecasts to avoid earnings disappointments. We document shifts in the distribution of earnings surprises and related changes in the market's response to surprises and forecast revisions. The evidence for shifts is stronger for growth stocks, where conflicts of interest are more pronounced. However, shifts are less notable for analysts without ties to investment banking and in international markets.