Post Earnings Anouncement Drift

The following observation was prepared by The Rivkin Report

1. It exists

PEAD has been observed by academics and finance professionals since the 1960s, but it was Bernard and Thomas’ paper in 1989 that really brought the issue to the fore. They observed that, on average, companies that announced the greatest positive earnings surprise tended to outperform the general market by 2% in the following 60 days. On the flip side, companies with the largest negative earnings surprise tended to under perform the market by 2% in the following 60 days.

2. The cockroach theory

Bernard and Thomas did more work and found that earnings upgrades / downgrades tended to come in bunches. Just like the theory of cockroaches, an earnings downgrade (negative earnings surprise) by a company is often an indicator that there are three or four more lurking in the cupboard. It often takes around 12 months for a company to “sweep out the cobwebs” and get its act together. Interestingly, there tends to be a slight reversal after those 12 months. Once a company gets back to a clean slate, it tends to surprise on the upside.

From a business cycle perspective, the theory makes sense. A company’s results simply don’t switch from one quarter to another. Good and bad trading results tend to flow on for several quarters. Furthermore, analysts who are surprised two or three times by a company’s downgrade announcements learn to factor it into their estimates, to the point where they tend to over-compensate in their estimates. After several quarters of downgrades, most executives tend to be fiercely focused on cutting costs and chasing revenue. Their jobs are often on the line, and it’s at this point in time that a company starts to surprise on the upside.

3. Market reaction is important

Most of the papers on PEAD focused on how companies exceed their previous EPS figures or the earnings estimates produced by industry analysts. The problem is that earnings announcements contain much more than pure earnings figures. Sales, margins, balance sheet items, cash flows and management commentary almost always accompany the earnings announcements.

Instead of looking at earnings numbers, Brandt et al (2008) analysed the share price movement of companies during the period one day prior to the earnings announcement until one day after the earnings announcement, as the price action incorporates not just the earnings figure, but all information. It was found that companies that produced the greatest positive share price movement tended to outperform over the next 60 days and vice-versa for companies with negative share price movement. In short, a stock that acts like a donkey around the earnings date tends to perform like a donkey for the remaining quarter!

4. The PEAD is more pronounced among small caps that miss estimates

It is possible to profit from buying companies that are announcing earnings upgrades (around 6% abnormal return around 60 days after the announcement -this figure applies for the Australian stock market). However, what is most noticeable is that companies that come out with negative earnings surprises tend to produce poor share price returns (-10% after 60 days and the price continues to slide from there). The effect is most noticeable in companies with a smaller market capitalisation.

5. Pay attention to the current market mood

One persistent trend we observe that doesn’t appear to have been captured in the various studies is that during bull markets, bad news can be easily swept aside and stock prices keep rising (and good news can be completely ignored in bear markets and prices keep dropping). It really is as simple as that. We witnessed many times in 2008 companies being sold off even after delivering solid earnings results.

Not only does one need to consider the position in the earnings cycle, but the general mood of the market.

6. Rivkin’s conclusions:

  • Don’t try and catch falling knives. Stocks that tend to drop after an earnings downgrade typically experience further declines.
  • The first earnings downgrade is rarely the last.
  • Be careful of stocks that are “priced for perfection”. Analysts will eventually over-compensate and place their estimates too high. The stock will eventually disappoint and when it does, it will be hammered severely.
  • Buy companies that perform well around the earnings announcement and sell companies that perform poorly, especially if it’s the first downgrade.
  • Don’t fight the overall mood of the market. Try and buy good news companies in good markets and sell bad news companies in bad markets.

CATALYSTS

 

Stock prices are moved by catalysts. There are four major types of catalysts.

1)      Liquidity: low cost of borrowing makes the investment in most asset classes quite alluring. An inflow of money makes price to go up. Rising prices bring joy and confidence to the soul of the masses. Higher confidence leads to higher risk appetite, which usually brings even more money into the stock market. This is a catalyst based on greed and vanity.

2)      Earnings’ related catalysts. If it is not about current earnings (beating estimates), then it is about future earnings (raising outlook above street’s expectations) or potential for future earnings (FDA approval, collaboration with another company, takeover rumors, announcement of new product, regulatory changes that could affect the whole industry). This is a catalyst based on momentum. The key here is market reaction. Reaction no news is more important than news itself.

3)      Valuation: I am simply not smart enough to define the intrinsic value of a stock; therefore I leave that job to the Warren Buffets of the world – people, which pocket is deep enough to survive prolonged periods of market irrationality. Who am I to say that certain stock should be traded at 18 times next year earnings or 28 times next year cash flows? Don’t get me wrong. There are plenty of smart people, who are constantly able to find stocks, trading below their intrinsic value and know how to profit from them. A big bow to them. For me their work is 50% science and 50%s art and gut feeling (experience). This is a catalyst based on common sense, but don’t forget that in trading the obvious rarely happens, the unexpected constantly occurs.

4)      Fear: of missing out on a big move or fear of getting short squeezed; fear of losing more than can afford to lose; fear of accepting that you were wrong.

I often look at the charts of stocks that make big moves in short time frame. How often? Every day, hoping that I will find out as many common patters in the beginning of those moves as I can. In hindsight, everything looks so easy. “I should’ve bought here and sold here and I would’ve made quick 10-15%”, but taking the proper decision in real time is always much harder than expected. Such fast moving stocks often experience violent corrections along their climb higher. Only the few with strong stomachs, enough experience and sound risk management behavior survive. How to overcome the fear of losing and act quickly when an opportunity presents itself? Risk smaller portion of your capital. A portion that wouldn’t hurt your confidence or sound judgment if you actually lose it. If you are risking 1% of your capital and it happens that you lose it, you only need to make 1.01% on the next trade to break-even. Can you do that? Absolutely. Then why you are afraid to take on new trading ideas, produced by your method? If you’re not able to sleep, then you are risking too much. If you are trading too often, then you are not risking enough. And one more thing. No one can buy at the bottom and sell at the top. If it happens, it is due to pure luck, not skill. Gradually build positions in equity that you like and gradually take profits when you exit.

How big moves happen

 

All markets cycle endlessly between contraction and expansion. But congestive phases use up many more price bars than trending moves. This suggests why making money in the markets can be so difficult. A trend may already be over by the time most participants see a sharp rally or sell off. At the least, risk escalates dramatically as advancing price can reverse or enter new congestion at any time.

Alan Farley

Case #1: ASTC

astc

On September 29th, ASTC gained 176% after 5 months of boring sideways action. The traded volume that day was an all-time high for ASTC. The company reported Q4/09 net income of $2.6 million or 0.15 per diluted share on revenue of 10.4 million compared with Q4/08 net loss of 1.5m or (0.11) per diluted share on revenue of 6.1m. Astrotech announced that it has engaged investment banking firm Lazard Ltd to advise the Company in exploring strategic alternatives.

A gigantic, earnings’ related one day move. What to do if you did not catch it intra day? Often such enormous one day moves tend to consolidate time-wise and price-wise before they continue.

A time-wise consolidation will look like a bullish flag. The big range day is followed by several small ranged days, located in the upper one third of the first day range. A break-out above the high of the big range day is then buyable.

In a price-wise consolidation, the stock often retraces big part (if not the whole) of the big range day move. It is not unusual to see the stock to come back to the bottom of the big range day candle. This is not the place to buy. You don’t buy blindly on weakness, because you don’t know how far the decline could actually continue. Instead you are looking at the bottom of the big range candle day only as a potential support. If it is, you are likely to see a sideways action, which gives time to the rising 10 DMA (this is the one I use) to catch up with the price. Several days of sideways, low volume action will form a tight range, which could be looked as a sign of accumulation as buyers are defending the opening range of the gap. Then you buy on the break-out from that range or on 5%+ move on at least 2 times the average volume. Actually here volume has secondary importance as in such moves, volume often tends to follow price.

Another recent example of Case #1 that I recently played was LEE:

lee

Case #2: TLB

tlbWent from 9 to 12 during the last 6 trading days as actually only 2 days accounted for the bulk of the move. What was interesting for me was that the stock was already up 156% in the 6 months preceding this 9 to 12 one week move. TLB had a quick run from 6 to 9 in September, followed by 3 weeks of sideways consolidation. The buy was on the day of the 5%+ move above rising 10 DMA. I am constantly looking intraday for 5%+ moves among the stocks that at least doubled during the last 6 months. Most of my trading ideas come from this screen.