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.