Earnings Announcements As Wake-Up Calls

Tong Wang

Virginia Polytechnic Institute & State University – Department of Finance, Insurance, and Business Law

February 1, 2016


Scholars have argued that entrants into markets promoted by collective activists will be largely homogenous, sharing similar identity attributes and practices that align with market category expectations. Yet, a review of empirical studies shows that diverse firms, such as those characterized by category-spanning features often do enter these markets. We seek to resolve the inconsistency between prior theory and findings by outlining conditions that influence entry of category-conforming (focused) and category-spanning (hybrid) firms into an activist-mediated market. Using in-depth qualitative and quantitative data on all ventures founded in the U.S. biodiesel industry from 1990 to 2008, we develop and test theory to explain how the evolving influence of market proponents and opponents affect entrepreneurs’ perceptions of market attractiveness and thus differentially affect entry of focused and hybrid firms. The findings contribute to research on social movements, entrepreneurship and market categories.

Earnings Announcements As Wake-Up Calls – Introduction

Asset pricing theories based on a friction-less market predict that, Ceteris paribus, changing the stock price per share of a company by changing the number of shares outstanding should have no real impact on its investors and, therefore, should not change the properties of its stock returns. Contradicting this prediction, a number of empirical works have shown that share prices play a non-trivial role in determining expected asset returns, return correlations, and investor composition.

Two recent works focus on the abnormal returns associated with share prices. Birru and Wang (2015) find that returns of the zero-investment strategy that buys OTM calls and writes OTM puts are positively correlated with the share prices of the underlying stocks. Their result holds for both delta-hedged and unhedged option returns. Singal and Tayal (2015) study stock returns and provide evidence that low-price stocks tend to underperform high-price stocks.

Both papers attribute the under-performance associated with low share prices to the so-called nominal price illusion, which we refer to as the Nominal Price Illusion Hypothesis throughout this paper. According to their argument, investors tend to mistake low share prices for cheapness, and believe that low-price stocks have high upside potential and limited downside potential, more than the objective distributions of returns can justify. This cognitive bias leads to overpricing and low expected returns of low-price stocks. Another potential explanation of the previous findings is the preference for lottery-like investments. Specifically, investors with such a preference derive higher utility from investments that provide more positively skewed returns. Because the returns of low-price stocks tend to be more positively skewed, as shown by Birru and Wang (2015), lottery-seeking investors might require lower expected returns to hold these stocks. This explanation relies on the form of utility functions rather than the biased subjective distribution held by investors.

Both arguments essentially suggest that low-price stocks are like lotteries, and therefore tend to be overpriced. This follows a large literature on lottery-like investments (see, e.g., Mitton and Vorkink (2007), Barberis and Huang (2008), Kumar (2009), Boyer, Mitton, and Vorkink (2010), Bali, Cakici, and Whitelaw (2011), Doran, Jiang, and Peterson (2011), Boyer and Vorkink (2014), and Eraker and Ready (2015).).

Earnings Announcements As Wake-Up Calls

Our paper contribute to this literature by providing a clear picture regarding the impact of share prices on investor psychology. Specifically, we show that all the underperformance of low-price stocks concentrates in earnings announcement periods. Buying high-price stocks and shorting low-price stocks over the five trading days centered at their earnings announcement dates generates an average abnormal five-day return of 40 basis points (bps). In contrast, there is no evidence that low-price stocks underperform high-price stocks outside announcement windows. Reexamining the findings in Birru and Wang (2015), we find that the abnormal option returns are also more pronounced surrounding earnings announcements.

In our view, the concentration of the underperformance of low-price stocks in announcement periods is sensible in light of the Nominal Price Illusion Hypothesis. After all, no matter how \delusional” investors might be, they are ultimately confronted with facts and are forced to reconcile their beliefs with hard evidence such as corporate earnings results. In contrast, if investors’ utility function is the main reason behind the underperformance of low-price stocks, then such underperformance should be more evenly distributed across time. Based on this argument, the rest of this paper mainly focuses on testing the Nominal Price Illusion Hypothesis.

Earnings Announcements As Wake-Up Calls

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