The negative earnings effect

Abstract

T his is a simple story. On average, stocks of :ompanies reporting negative earnings in one year in his study generated positive, abnormal (riskand narket-adjusted) returns in the subsequent year. Our research is motivated by several factors. ;irst, Jaffe, Keim, and Westerfield (JKW) in studying he small-firm effect and the low PE effect found ‘consistently high returns for firms of all sizes with iegative earnings” [1989, p. 1351. Almost as an .side, JKW report that ”surprisingly, stocks with neg.tive earnings outperform many of the positiveZarnings portfolios” (p. 138). Their reference is to raw” returns, as opposed to abnormal (riskand .iarket-adjusted) returns, but we thought this was a hding worth exploring further. In addition, De Bondt and Thaler [1985, 19871 .ave argued that investors overreact to earnings an.ouncements. This drives the stock prices of compaies reporting unusually poor earnings (”losers”) too )w, and the prices of those reporting unusually ood earnings (“winners”) too high. The subsequent mection of the overreaction generates positive (negtive) abnormal returns for investments in the loser vinner) stocks. De Bondt and Thaler argue that this an exploitable market inefficiency. Howe [1986] .id Brown and Harlow [1988] report results that merally support those of De Bondt and Thaler. Not surprisingly, the hypothesis that the mar2t overreacts to earnings announcements is contromial. Zarowin [ 19891 reports that the overreaction is just another manifestation of the well-documented size effect. That is, when he controls for firm size using a matching procedure, he finds no evidence that investors overreact to earnings announcements. Zarowin, however, does not specifically examine market reaction to announcements of negative earnings, as we do in this paper. Even after controlling for size, we do find a “negative earnings effect.” Stocks of firms reporting negative earnings outperform other stocks over the next twelve months on a risk-adjusted basis. Finally, Brown, Harlow, and Tinic [1988] develop what they call the Uncertain Information Hypothesis (UIH). The UIH argues that when the full implication of new information concerning a stock is uncertain, investors revise their perception of the stock’s risk upward. This results in an increase in the expected or required rate of return for the stock. Even when an event clearly conveys good or bad news about a firm’s prospects, the full extent of its eventual impact on stock prices may be uncertain. As the uncertainty is resolved, the perceived risk diminishes, and price changes subsequent to the event tend to be positive on average, even if the event was clearly bad news. Furthermore, if investors’ preferences exhibit decreasing absolute risk aversion (which is a typical assumption in economic risk-return models), the UIH predicts that the average price change subsequent to the event will be larger following bad news than following good news.

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