Newswise — Companies that report large positive earnings surprises continue to outperform the market and beat analysts' expectations up to three years later, according to a University of Michigan business school study.
On the contrary, firms that disappoint Wall Street by delivering extremely bad news perform poorly afterward, producing negative stock returns over the subsequent three-year period---although there are no clear differences between companies reporting large versus small earnings disappointments.
"Our results are surprisingly simple," said Russell Lundholm, professor of accounting at Michigan's Stephen M. Ross School of Business. "Firms that report a large positive earnings surprise do much better than expected in the future and firms that report a large negative earnings surprise do somewhat worse than expected.
"In subsequent years, firms with extremely good news tend to have persistent earnings surprises in the same direction, strong growth in cash flows and earnings, and large increases in analyst coverage relative to firms with extreme negative earnings surprises."
Lundholm and colleagues Jeffrey Doyle of the University of Utah and Mark Soliman of Stanford University examined 159,789 firm-quarters between 1988 and 2000 and reported average future returns for each of 10 portfolios of earnings surprises, ranked from the top 10 percent of firms with the largest positive earnings surprises down to the bottom decile.
To qualify for the "extreme" positive earnings label, a company must beat the consensus-forecasted quarterly earnings per share by about one-half percent of the price per share at the end of the fiscal quarter.
The study found that after controlling for risk and other market-related effects, the estimated return associated with a positive earnings surprise is about 10 percent after one year, 16 percent after two years and nearly 20 percent three years later. Beyond this time, there is little additional return.
A hedge portfolio that takes a long position in the top decile of earnings surprises and a short position in the bottom decile returns 14 percent in the year following the earnings announcement, 20 percent two years later and 24 percent after three years.
Holding a long position in the portfolio of firms with the largest positive earnings surprises proved to be a good investment strategy, generating two-thirds of the hedge return, according to Lundholm.
Exactly why the market seems "asleep at the switch" and takes up to three years to correct the earnings-surprise mispricing is somewhat perplexing, he says.
However, Lundholm says this may happen because firms in the extreme earnings surprise portfolios are classic "neglected stocks." These companies are generally smaller, with higher book-to-market ratios and less analyst coverage than firms in the other surprise portfolios, and there is more disagreement in analysts' forecasts about their earnings performance.
"It appears extreme positive earnings news is less transitory than the market anticipates, and as firms with large positive surprises continue to outperform financially, they attract more analyst attention, which eventually eliminates their underpricing," Lundholm said.