Pre – Earnings Announcements Over-Extrapolation
Aytekin Ertan
London Business School
Stephen A. Karolyi
Carnegie Mellon University – Tepper School of Business
Peter Kelly
University of Notre Dame
Robert C. Stoumbos
Yale School of Management
January 22, 2016
Abstract:
Using earnings announcements as our experimental setting, we uncover evidence that individual investors over-extrapolate from past earnings announcement returns. Investors become overly optimistic about future earnings and are more likely to purchase a firm’s stock immediately before the upcoming earnings announcement if recent earnings announcement returns are high. This purchasing behavior leads to predictable patterns in returns before and after earnings announcements: A value-weighted portfolio based on pre-earnings announcement purchases earns over 17 basis points a day and a value-weighted portfolio based on a post-earnings reversal earns about 13 basis points per day.
Pre – Earnings Announcements Over-Extrapolation – Introduction
In their seminal paper, Kahneman and Tversky (1974) highlight that experimental subjects tend to ignore the laws of probability—instead, they assess likelihoods by the degree to which an event reflects the salient characteristics of a specific class. The authors refer to this tendency as the representativeness heuristic. A number of authors (e.g., Barberis et al., 1998) have suggested that investors, guided by the representativeness heuristic, over-extrapolate, or draw strong conclusions from small samples of data. In this paper, we explore this argument by studying investor behavior around earnings announcements.
An investor using the representativeness heuristic may misclassify a stock that has recently had great earnings announcement returns as one that is a great investment during earnings announcements. Consistent with this, we find that investor forecasts are more likely to be overly optimistic about a firm’s future prospects when the firm has a history of good past performance.1 Specifically, when a firm is in the top decile of the extropolated return measure, an additional 5.5 to 8.6 percent of investors have forecasts that are higher than the consensus sell-side analyst forecast. The increased optimism that a firm will beat the consensus forecast is consistent with investors misclassifying these good past-performers as firms that will likely perform well.
Building on these observations, we predict that individual investors will “bet” on this classification. Namely, if a firm has recently had great earnings announcement returns, the investor will bet on, or purchase, the firm’s stock shortly before the next earnings announcement. To test this, we first look at how individual investor behavior responds to our extrapolated return measure. We analyze household trading data from a large discount brokerage and find that past earnings announcement returns are a strong determinant of individual investor purchasing decisions in the period leading up to the next earnings announcement. Specifically, if a firm is in the top decile of our extrapolated return measure, we predict that the total value of purchases in the 5-day pre-earnings announcement period will be ten percent higher than for a firm that is not in the top decile.2 Additionally, we predict that the total value of sales in the 5-day pre-earnings announcement period will decrease by about four percent.
We next examine whether this buying behavior leads to predictable patterns in asset prices. The prediction is that over-extrapolation of previous positive earnings announcement returns will motivate investors to purchase shares of the stock before the next earnings announcement. This would lead to a rise in the stock price, and overpricing, before the next earnings announcement. We argue that this “mispricing” will not be corrected by appealing to the limits to arbitrage literature.3 Importantly, there is significant fundamental risk immediately before the earnings announcement. After the earnings announcement, fundamental risk decreases, and we expect the stock price to start reverting back to its “fundamental value”. To summarize, we expect to see predictable patterns in returns both before and after such earnings announcements—specifically, a high value for our extrapolated return measure should predict excess positive returns before the earnings announcement, and a reversal after.
We confirm this prediction in the data where we find that the return in the 5 trading days before the earnings announcement period is strongly positively associated with the earnings announcement returns of previous quarters. If a firm is in the top decile of our extrapolated return measure and is in the pre-earnings announcement period, we expect to see a daily return about 11 basis points higher than all other days in its quarter. We also find evidence that this is an overreaction. If a firm is in the top decile of our extrapolated return measure and is in the post-earnings announcement period, we expect to see a daily return about 12 basis points lower.
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