Now, I must make a confession. My analytic prowess has never extended to the financial industry, so I have only a very basic understanding of the workings of the stock market. (Think: Buy low, sell high.) However, I found Moulton’s paper accessible, easy to understand, and, most importantly, interesting -- especially after she walked me through some background on the motivation for her research.
Obviously, any research into the behavior of the market that provides the ability to better predict stock prices can be valuable to companies and investors. The particular behavior covered by this paper is the phenomenon known as post-earnings-announcement drift (PEAD), which is the finding that after a firm announces its quarterly earnings, stock prices adjust up or down depending on the news, and then continue to drift in that direction for a period of time before reaching their eventual “fair price.” Moulton was interested to know how hospitality companies’ stocks reacted to earnings announcements, and whether their behavior was the same or different as the market in general.
I’ll start at the beginning (which is where Moulton started with me). For those of you who are already familiar with this area, skip right to her paper. For the rest of us, here’s the background.
Most of us know that publicly traded companies are responsible for reporting performance to the market on a quarterly basis through an earnings call. During this call, key company executives (usually the CEO and CFO) summarize performance, list key factors that are contributing to that performance, and talk about their expectations for the future. At times, there are “surprises,” either good or bad, that result in the stock's value being worth dramatically more or less than it was believed to be worth prior to the new earnings information.
In a perfectly efficient market, the stock price would immediately adjust to the new fair price based on the updated company information. However, this doesn't always happen. Instead, stock prices react to some degree, and then drift in the same direction eventually stabilizing at that fair price. The timespan for this drift in the market in general can be up to 60 trading days after an earnings announcement.
The complication in the process of communicating results is in the manner by which the information is disseminated. To advise clients on the broad range and large quantity of publicly traded stocks, brokerages (which execute trades for their clients) typically employ analysts. The analyst's job is to be an expert in a particular area of the market (usually industry-based). The analyst must follow the performance of specific companies within the industry and any other factors that might impact the financial prospects of that industry (in hospitality, for example, gas prices or global tourism trends). The analyst's function is to make broad recommendations about the prospects for the industry as a whole and specific recommendations about what to do a with company’s stock (buy, sell, hold). Analysts listen carefully to quarterly earnings calls and quickly publish reports that detail their interpretations and recommendations. These reports are purchased immediately by institutional investors who want to react quickly to news, and the contents eventually make their way into publicly consumed resources like the Wall Street Journal.
In order for the market to be perfectly efficient (react that day to triggers that impact the value of the stock), company managers need to do an effective job of communicating information, analysts need to interpret the information correctly, and investors need to consume that information and take action quickly. The volume and direction of the actions will then move that stock price to the fair price.
Why is this important? Obviously, the timing of a stock purchase or sale is a key determinant in whether you’ll make money from that purchase. When a company makes an announcement that is likely to trigger a change in the stock price, you have one of those “buy low, sell high” opportunities that results in financial gain (or prevention of loss, I guess). If the price drifts, it means that the ideal timing of the action you might want to take is somewhat more flexible.
Moulton gave me an example: Say a stock is currently priced at $20 and company management makes a positive surprise announcement -- earnings are higher than expected. The announcement may mean that the new fair market value of the stock is $25. If the stock exhibits post-earnings announcement drift, the stock price might go up to only $22 on that first day, then a few days later to $23, and so on until it eventually reaches $25, the new fair price. So, if you were a potential investor, and didn’t get the news for a couple of days, you still have an opportunity to make some money on the stock because it will continue to drift in a positive direction for a while. You may not make as much as if you had bought that first day, but the opportunity is still there. Of course, the reverse is true in the case of a negative earnings surprise -- post-earnings announcement drift means you won’t lose as much if you don’t sell right away.
I asked her if PEAD was an advantage or a disadvantage. Of course she told me that the answer depended on the perspective and the direction. For investors, regardless of the announcement, PEAD could be an advantage (as described above), and there’s more time to make a decision that is financially advantageous. However, if you are a “high speed” trader with a positive surprise announcement, there’s maybe a disadvantage in that you might have to hold a stock longer than you want to get the full value from a positive announcement. From a company perspective, with the thought that you want to attract and retain investors by keeping that stock price up, you may wish to have positive surprises reflect instantly in the stock price to attract investment but to have negative surprises take their time so you can avoid the negative press coverage that a sudden big drop in stock price can attract.
Clearly there are some complex interactions that are driving stock prices (I mean, I knew that, but still, interesting to understand it in more detail), and the better we understand them (through analytics, of course) the better we will be able to take advantage of information in stock prices -- whether personally, for our own portfolios, or professionally, on behalf of our companies.
Moulton will present the results of her research in our upcoming webcast (and you can read her paper as well). You will probably be surprised to find the similarities and differences in how hospitality stocks behave (she was!). Hopefully, this discussion will provide some good background for those that needed a bit more context to appreciate her work!
This post first appeared on the SAS blog, The Analytic Hospitality Executive.