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Management Forecasts, Disclosure Quality, and Market Efficiency

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... Quality, and Market Efficiency. Jeffrey Ng, Irem Tuna, and Rodrigo Verdi ... We examine short-term and long-term market reaction to management forecasts ... – PowerPoint PPT presentation

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Title: Management Forecasts, Disclosure Quality, and Market Efficiency


1
Management Forecasts, Disclosure Quality, and
Market Efficiency
  • Jeffrey Ng, Irem Tuna, and Rodrigo Verdi

2
What do we do?
  • We examine short-term and long-term market
    reaction to management forecasts
  • We test the effect of disclosure quality on the
    long-term market reaction

3
Motivation
  • There is substantial evidence of market
    underreaction to news events e.g.,
  • PEAD (Bernard and Thomas, 1989, 1990)
  • Conservatism theory (Barberis et al., 1998)
  • Rational structural uncertainty (Brav and Heaton,
    2002)
  • Is there a post-management-forecast drift?
  • Is underreaction to earnings news a function of
    perceived credibility of the news (e.g., stronger
    underreaction to good news)?

4
Motivation
  • Management forecasts constitute an interesting
    setting to study reaction to news because of
    credibility concerns (voluntary disclosure)
  • Stronger short-term market reaction for bad news
    forecasts despite no difference in bias (Rogers
    and Stocken, 2005)
  • Management forecasts allow us to examine whether
    disclosure quality affects the market reaction to
    news

5
Overview of Results
Figure 1a Annual earnings forecasts
6
Anilowski, Feng, and Skinner (JAE 2007)
7
Kato, Skinner, and Kunimura (WP 2007)
8
Hypothesis I
  • PEAD literature provides evidence of
    underreaction to earnings surprises
  • Both conservatism and rational structural
    uncertainty can explain an underreaction
    phenomenon
  • We hypothesize that credibility concerns related
    to management forecasts can exacerbate
    underreaction to earnings news
  • H1 Future stock returns are positively
    associated with management forecast news

9
Hypothesis II
  • Larger stock price reaction to bad news forecasts
    than to good news forecasts (e.g., Hutton et al.,
    2003)
  • Typical explanation is that bad news forecasts
    are more credible than good news forecasts
  • No difference in the forecast bias between bad
    news and good news forecasts (Rogers and Stocken,
    2005)
  • H2 The magnitude of the future returns is larger
    for firms forecasting good news

10
Hypothesis III
  • Better disclosure may help investors understand
    the future cash flow implications of an
    information signal
  • Prior literature provides evidence that better
    disclosure mitigates the magnitude of market
    inefficiency
  • PEAD (Francis et al., 2005 Kimbrough, 2005)
  • Accruals anomaly (Richardson et al., 2005 Levi,
    2007)
  • H3 The magnitude of the hedge portfolio returns
    from the PMFD trading strategy is lower for firms
    whose forecasts are of higher quality.

11
Sample Description
  • Follow Anilowski et al. (2007)
  • 17,184 (14,890) forecasts of annual (quarterly)
    EPS
  • 6,369 (5,859) annual (quarterly) forecasts that
    do not overlap with earnings announcements
  • Ordinary shares listed on NYSE / AMEX / NASDAQ
    from 1996 to 2005

12
Key Variables
  • Surprise (Manag. Forec Analyst Forec) / Price
  • Abnormal returns
  • Size-adjusted buy-hold returns
  • Size-BM adjusted buy-hold returns
  • Factor alphas (3-factor, 4-factor, 5-factor)
  • Short-term 3-day around the forecast
  • Long-term 12-month subsequent to the forecast
    month

13
Short- and long-term reaction
  • Return ß0 ß1 Good News ß2 Surprise
  • ß3 Surprise x Good News
  • ? ßj Surprise x Controls ? ßm Controls e
  • Return is either
  • - AbRet3d (3-day return around forecast)
  • - AbRet (future 12-month return)
  • Fama-MacBeth regressions with Newey-West
    corrected standard errors

14
Table 3 FRC Regressions

15
Hedge Portfolio Analyses
  • We sort the observations into quintiles based on
    the previous years distribution of forecast
    surprises
  • Hedge portfolio strategy
  • Buy shares of firms in Q5 (extreme good news)
  • Short shares of firms in Q1 (extreme bad news)
  • Abnormal returns
  • Size-adjusted and size-BM-adjusted buy-hold
    returns
  • 3-factor, 4-factor, and 5-factor alphas

16
Hedge Portfolio Annual Forecasts

17
Short- and Long-term returns
18
Mean Returns by Quarter

19
Median Returns by Quarter

20
Factor Alphas Annual Forecasts
21
Conservatism vs. Structural Uncertainty
  • Analyst forecast dispersion
  • Proxy for precision of pre-forecast signals
  • Lower dispersion, greater conservatism
  • Intraday return volatility
  • Proxy for the degree of uncertainty generated by
    the disclosure signal
  • Higher volatility, more structural uncertainty

22
Research Design
  • AbRet ß0 ß1 QSurprise
  • ß2 QSurprise Dispersion
  • ß3 QSurprise Intraday Vol
  • ß4 Dispersion ß5 Intraday Vol ? ßj Risk
    Controls
  • Prediction ß2 lt 0 and ß3 gt 0
  • AbRet (future 12-month size-adjusted return)
  • Fama-MacBeth regressions with Newey-West
    corrected standard errors
  • QSurprise is a quintile variable re-scaled from 0
    to 1.
  • Dispersion and Intraday Vol are dummy variables
    based on median.

23
Table 6 Theories

24
Disclosure Quality (H3)
  • Accuracy -1Earnt-1 Man Forecastt-1 /
    Price
  • Precision Point versus range forecasts
  • Horizon of days between forecast and
    Fiscal-year end

25
Research Design
  • AbRet ß0 ß1 QSurprise
  • ? ßi QSurprise Disclosure Quality
  • ? ßj Disclosure Quality ? ßm Risk Controls
  • Prediction
  • ßj lt 0 for Accuracy
  • ßj lt 0 for Precision
  • ßj gt 0 for Horizon
  • QSurprise is a quintile variable re-scaled from 0
    to 1.
  • Disclosure Quality are dummy variables based on
    median.

26
Table 7 Disclosure Quality

27
PMFD vs. PEAD

28
Summary of Findings
  • The short-term reaction larger for bad news
  • The future long-term reaction is larger for good
    news
  • A hedge portfolio earns annual abnormal returns
    above 25
  • Both analyst forecast dispersion and intraday
    volatility explain the cross-sectional variation
    in the PMFD
  • Hedge returns smaller for firms with higher prior
    forecast accuracy

29
Implications
  • Significant underreaction to management
    forecasts.
  • Results consistent with behavioral theories of
    conservatism (Barberis et al., 1998) and rational
    structural uncertainty (Brav and Heaton, 2002)
  • Disclosure quality appears to reduce the market
    underreaction to management forecasts
  • An unresolved question is why the effect is not
    arbitraged away
  • As Merton (1987) states
  • an anomaly must uncovered and learned before
    one can arbitrageeven when learned, there are
    limits to arbitrage
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