Earnings Drift Research Articles

Optimal restrictiveness of a financing covenant

This paper identifies the optimal restrictiveness of a financing covenant in a debt contract. We examine the decision of a debt-issuing company that has current operations as well as a future growth opportunity. The optimal financing covenant can substantially reduce the cost of debt financing, and generally allows the issuance of some debt for financing the expansion. Comparative static analysis indicates that the covenant is less likely to be included when growth opportunities, earnings volatility, earnings drift rate, interest rate and tax rate are higher; and when bankruptcy cost is lower. Also, the financing covenant is more likely when the leverage ratio is higher (bankruptcy risk is greater) but becomes less likely for very high leverage ratio (when the firm is in or close to financial distress). These results are generally consistent with existing empirical results in the literature.

Momentum, Reversals, and Investor Clientele

AbstractDifferent share classes on the same firms provide a natural experiment to explore how investor clienteles affect momentum and short-term reversals. Domestic retail investors have a greater presence in Chinese A shares and foreign institutions are relatively more prevalent in B shares. These differences result from currency conversion restrictions and mandated investment quotas. We find that only B shares exhibit momentum and earnings drift and only A shares exhibit monthly reversals. Institutional ownership strengthens momentum in B shares. These patterns accord with a setting where short-term reversals (which represent inventory risk premia) prevail in a market dominated by noise traders and momentum prevails in markets where noise traders are less prevalent relative to informed investors who underreact to fundamental signals. Overall, our findings confirm that clienteles matter in generating stock return predictability from past returns.

Postfundamentals Price Drift in Capital Markets: A Regression Regularization Perspective

Regression regularization techniques show that deviations of accounting fundamentals from their preceding moving averages forecast drifts in equity market prices. Deviations-based predictability survives a comprehensive set of prominent anomalies. The profitability applies strongly to the long leg and survives value weighting and excluding microcaps. We provide evidence that the predictability arises because investors anchor to recent means of fundamentals. A factor based on our fundamentals-based index yields economically significant intercepts after controlling for a comprehensive set of other factors, including those based on profit margins and earnings drift. This paper was accepted by Gustavo Manso, finance.

Trading and market efficiency in summer

The fall in stock-market trading during summer has real effects on stock-market efficiency. I examine the market efficiency of momentum, post-announcement earnings drift, and idiosyncratic volatility (IVOL). The profitability of a momentum winner-loser strategy is significantly enhanced in summer, thus accentuating momentum-related inefficiency. For positive unexpected earnings in summer, market inefficiency is attenuated, but for negative unexpected earnings market inefficiency is accentuated. The IVOL inefficiency is an exclusively summer effect. Once this effect is controlled for, a positive relation emerges between IVOL quintiles and alphas. Overall, market inefficiency appears to be accentuated in summer due to the fall in trading.

Market reaction to trading statements released by Johannesburg Stock Exchange listed companies

Using the event study methodology, this study investigated the market reaction to trading statements released by a sample of the Top 100 Johannesburg Stock Exchange (JSE) listed companies since the inception of the trading statement regulatory requirements in 2010. There appears to be significant information leakages before the release of trading statements. The share prices on the JSE shows a tendency to incorporate more timely sources of information before the release of trading statements. The results show a differential market reaction in the pre-announcement period. For profit warnings, the market seems to have largely impounded the expected poor earnings before the announcement. In the case of profit upgrades, the market appears to be more cautious and requires confirmatory information for a further positive reaction. A post-announcement earnings drift occurs for a period of thirty days after the announcement. This is contrary to the Efficient Market Hypothesis (EMH) which asserts that new information is reflected in share prices almost immediately. This allows investors and portfolio managers with a trading strategy to outperform the market by investing in companies announcing profit upgrades and profit warnings. The observed market inefficiency can be mitigated by managers disseminating the earnings surprise information to a wide range of stakeholders and market participants rather than relying only on the mandatory regulatory announcement.

Momentum, Reversals, and Investor Clientele

The identical cash flow and control rights of Chinese A and B shares provide a natural experiment to explore how investor clienteles affect stock returns. Currency conversion restrictions discourage domestic retail investors from investing in B shares, whereas quotas constrain foreign institutions' investment in A shares. We find that only B shares exhibit momentum and earnings drift, and only A shares exhibit short-term reversals. Institutional ownership strengthens momentum in B shares. These return patterns are consistent with a model that includes institutions, who underreact due to skepticism about outside information sources, and retail investors, who trade on noise.

Anchoring on Past Fundamentals

Regression regularization techniques show that deviations of accounting fundamentals from their preceding moving averages forecast drifts in equity market prices. The deviations-based predictability survives a comprehensive set of prominent anomalies. The profitability applies strongly to the long-leg and survives value-weighting and excluding microcaps. We provide evidence that the predictability arises because investors anchor to recent means of fundamentals. A factor based on our fundamentals-based index yields economically significant intercepts after controlling for a comprehensive set of other factors, including those based on profit margins and earnings drift.

NETWORK ATTENTION AND EARNINGS DRIFT

For the first time, this article uses the search volume index (SVI) of Google Trends to measure investor attention and observe stock market. Empirical results show that the higher the attention to individual stocks, the lower the cumulative abnormal returns. If stocks had positive (negative) abnormal returns, the cumulative abnormal returns would decline, thereby weakening (strengthening) earnings drift. Only the stocks with earnings that weren't as good as expected encountered an increase in cumulative abnormal returns. Regarding stocks that attract investor attention, having a positive (negative) earnings surprise brings more positive (negative) cumulative abnormal returns and strengthens (weakens) earnings drift.Keywords: Earnings drift; search volume index; investor attentionJEL Classifications: G1, J3DOI: https://doi.org/10.32479/ijefi.7975

Risk management in student-managed funds

PurposeStudent-managed investment funds typically pursue “plain vanilla” objectives. The purpose of this paper is to demonstrate the value of adding option strategies to reduce the risk of equity positions around earnings announcements. The collar strategy is one such technique with the advantages of a low net cost and limited potential losses.Design/methodology/approachThe authors provide recommendations for utilizing the collar strategy around earnings announcements. The authors also discuss how the value of this strategy is related to the literature on option pricing and earnings announcement returns.FindingsRisk management strategies can enhance the pedagogical value of student-managed investment funds. The authors document how students have successfully utilized the collar strategy to immunize risk.Originality/valueThe collar strategy can enhance the pedagogical value of student-managed investment classes in several ways. First, students learn how to implement risk reduction strategies. Second, the proper implementation of these strategies requires students to learn the complex mechanisms associated with corporate earnings dissemination and analyst coverage. This also provides an opportunity to study earnings drift, which is a persistent and economically significant financial anomaly.

Risk Management in Student-Managed Funds: Earnings Announcements and the Collar Strategy

Student-managed investment funds typically pursue “plain vanilla” objectives that satisfy risk-adverse university administrators. We demonstrate the value of adding option strategies to reduce the risk of equity positions around earnings announcements. Such trading strategies enhance the pedagogical value of these classes in several ways. First, students learn how to implement risk reduction strategies. Second, the proper implementation of these strategies requires students to learn the complex mechanisms associated with corporate earnings dissemination and analyst coverage. This also provides an opportunity to study earnings drift, which is a persistent and economically significant financial anomaly. We document how students have successfully utilized collar strategies to immunize risk in the fund at the University of Denver.

Voluntary profit forecast disclosures, IPO pricing revisions and after-market earnings drift

Prospectus profit forecasts (PPF) constitute one of the most important discretionary disclosure items in an IPO. I examine such disclosures in the Hong Kong market, where both IPO activity and PPF disclosure rates are at high levels. The median forecast typically ‘underestimates’ future earnings by around 6%. More importantly, PPF disclosure exhibits a strong inverse association with pre-listing owners' retained equity levels (Hughes, 1986; and Li and McConomy, 2004). PPF disclosure is thus more likely in IPOs raising more capital and generating larger floats. I also demonstrate a strong link between PPF disclosure and post-IPO earnings drift.Ensuing forecast errors also bear strong connection with IPO coordinators' initial price determinations as well as with subsequent investor returns. This area usefully extends the related literature (Cheng and Firth, 2000; Chen, Firth and Krishnan, 2001; Jog and McConomy, 2003; Chong and Ho, 2007; and Gounopoulos, 2011), which stresses an association between forecast errors and initial investor returns but ignores the preceding price ‘determination’ process. It also suggests that forecast errors serve as a valuable ex-post proxy for the amount of ex-ante uncertainty surrounding issuer value (Beatty and Ritter, 1986; Falconieri, Murphy and Weaver, 2009). This study also demonstrates a connection between final offer price ‘determinations’ and the information content and “superiority” of PPFs (Brown, Richardson and Schwager, 1987). Finally, and in contrast to final offer price ‘determinations’, initial investor returns strongly anticipate post-IPO earnings drift.

Earnings Management, Earnings Surprises, and Distressed Firms

We examine the propensity of distressed firms to manage earnings and the impact of their earnings management on investor response to earnings. We find that distressed firms manage earnings upward and downward more than other firms. Distressed firms manage earnings upward significantly more than non-distressed firms after negative earnings surprises. Investor response to earnings surprises is smaller in magnitude for distressed firms. Investor response to positive earnings surprises of distressed firms is larger in magnitude than the response to negative earnings surprises. The change in bankruptcy probability after a negative earnings surprise is greater for distressed firms. Distressed firms have less post-announcement earnings drift. The results suggest that earnings management by distressed firms lowers earnings quality and weakens investor response. Our evidence has implications for investors, analysts, and compensation and audit committees.

Market Frictions, Price Delay, and the Cross-Section of Expected Returns

We parsimoniously characterize the severity of market frictions affecting a stock using the delay with which its price responds to information. The most delayed firms command a large return premium not explained by size, liquidity, or microstructure effects. Moreover, delay captures part of the size effect, idiosyncratic risk is priced only among the most delayed firms, and earnings drift is monotonically increasing in delay. Frictions associated with investor recognition appear most responsible for the delay effect. The very small segment of delayed firms, comprising only 0.02% of the market, generates substantial variation in average returns, highlighting the importance of frictions. Predictability in the cross-section of returns fuels much of the market efficiency debate. Whether this predictability is due to mismeasurement of risk or constitutes an efficient market anomaly remains unresolved. Complicating this debate is the fact that traditional asset pricing theory assumes markets are frictionless and complete and assumes investors are well diversified. However, ample empirical evidence demonstrates the existence of sizeable market frictions and large groups of poorly diversified investors.

Post-Earnings-Announcement Drift: The Role of Revenue Surprises and Earnings Persistence

This study explores an additional factor that is associated with differential levels of the post-earnings-announcement drift (henceforth drift) the contemporaneous surprise in revenues. Consistent with prior evidence about greater persistence of revenues and greater noise caused by heterogeneity of expenses, this study shows that the earnings drift is stronger when the revenue surprise is in the same direction as the earnings surprise. Moreover, the study provides direct evidence that the drift is stronger when the earnings persistence is greater. The results are robust to various controls, including the proportions of stock held by institutional investors, trading liquidity, and arbitrage risk.

On the rationality of the post-announcement drift

This paper demonstrates that a post-announcement earnings drift, which is often advanced as an example of market irrationality, can arise even if traders act rationally on their information. Specifically, we show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes. Such a correlation arises from the fact that while prices reveal private information that cannot be found in public signals, non-information based trading distorts the information content of prices relative to the implications of both private and public information. Under these circumstances, markets may appear semi-strong inefficient and slow to respond to earnings announcements even though information is processed in a timely and efficient manner. Our findings correspond well with previously documented empirical evidence and suggest that the robustness of earnings-based "anomalies" may be rational outcomes of varying uncertain share supply.

The incremental information content of bond rating revisions: The Australian evidence

The objective of this study is to provide evidence on the information content of bond revisions by controlling for the information content of concurrent annual accounting income numbers and testing the incremental information content of bond rating revision. The reasons for this approach is threefold. First, the information content of annual accounting income numbers is well documented in the literature. Second, bond rating agencies in their revisions extensively utilise accounting information, hence it could be argued that bond rating revisions only confirm what is already known by equity investors. Third, recent evidence indicates an ‘earnings drift’ effect surrounding earnings announcements which could drive abnormal returns associated with bond revisions. However, by controlling for the information content of annual accounting income numbers, evidence can be provided on the value added by rating agencies. The results of the study indicate that only the announcement of bond downgrades has incremental information content.

Worker Participation and Wage-bargaining in Denmark

Union wage-bargaining power in Denmark is analysed for the 1970s using earnings drift between centrally bargained and firm-level earnings as the basis for a measure of bargaining power. This measure is given a justification in terms of bargaining theory. During the 1970s various forms of worker participation, which are described and analysed in the paper, were introduced in Denmark. The paper attempts to relate changes in bargaining power to these developments.

Earnings Drift in Australian Secondary Industry

Economic RecordVolume 47, Issue 3 p. 410-417 Earnings Drift in Australian Secondary Industry N. F. Dufty, N. F. Dufty University of Alberta, and Western Australian Institute of TechnologySearch for more papers by this author N. F. Dufty, N. F. Dufty University of Alberta, and Western Australian Institute of TechnologySearch for more papers by this author First published: September 1971 https://doi.org/10.1111/j.1475-4932.1971.tb02649.xCitations: 1AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinked InRedditWechat Citing Literature Volume47, Issue3September 1971Pages 410-417 RelatedInformation