Management Forecast Credibility and Under-Reaction to News by Jeffrey Ng, Irem Tuna and Rodrigo Verdi

Electronic copy available at: http://ssrn.com/abstract=930697

Management Forecast Credibility and Underreaction to News

Jeffrey NgMIT Sloan School of Management jeffng@mit.edu

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rem TunaLondon Business Schoolituna@london.eduRodrigo VerdiMIT Sloan School of Managementrverdi@mit.edu

ABSTRACT

This paper investigates two questions: i) whether there is an underreaction to news inmanagement earnings forecasts and ii) whether forecast credibility has a role inexplaining this underreaction. We document evidence of an underreaction to managementforecast news, especially for good news forecasts. In the context of the post-earnings-announcement drift literature, our result suggests that the market also underreacts tovoluntary earnings disclosures in the form of management forecasts. Most importantly,we find evidence that the magnitude of the underreaction is smaller for firms that providemore credible forecasts. This finding contributes to the literature by documenting thatdisclosure credibility is a cross-sectional determinant of market underreaction to news.

JEL Classification

: G12; G14; G30; M41Keywords: Market efficiency; Forecast credibility; Voluntary disclosure Nov 2008(First version: May 2006) _________________

A previous version of this paper was titled “Management Forecast, Disclosure Quality, and MarketEfficiency.” We thank Brian Bushee, Gavin Cassar, Tarun Chordia, Vicki Dickinson, S.P. Kothari, RyanLaFond, Kin Lo, Rick Mendenhall, Ray Pfeiffer, Scott Richardson, Jonathan Rogers, Tjomme Rusticus,Praveen Sinha, Siew Hong Teoh, Joseph Weber, and workshop participants at Barclays Global Investors,Berkeley, London Business School, Minnesota, MIT, 2006 FEA conference, 2007 FARS Midyear Meeting,2007 Maryland Finance Symposium, 2007 WFA conference, and 2007 AAA conference for their helpfulcomments. We appreciate financial support from the Wharton School and the Sloan School of Management. Jeffrey Ng and Rodrigo Verdi are also grateful for financial support from the Deloitte &Touche Foundation.

Electronic copy available at: http://ssrn.com/abstract=930697

1. Introduction

Management earnings forecasts are increasingly common voluntary publicdisclosures through which managers can influence price formation in the equity markets.Many papers have examined the short-run returns around these forecasts to study theinformation content of the forecasts (e.g., Ajinkya and Gift [1984], Waymire [1984],Jennings [1987], Rogers and Stocken [2005]). Although these papers show thatmanagement forecasts are informative (i.e., the market reacts to the forecasts), they donot address the question of whether the market responds completely to the forecast newswithin a short period of time. We address this by examining the future long-termabnormal returns following the forecasts. This question is motivated by the post-earnings-announcement drift (PEAD) literature that provides substantial evidence that investorsunderreact to earnings news in reported earnings, a type of mandatory disclosure (e.g.,Bernard and Thomas [1989, 1990]). A contribution of our paper is to investigate whether the market underreacts to voluntary earnings disclosures such as management forecasts.A unique feature of our paper is our hypothesis that forecast credibility could provide an explanation for the underreaction to news. Specifically, we predict a smaller underreaction to management forecast news when the forecast credibility is higher. Wetest this hypothesis using management forecasts because the literature on managementforecasts has emphasized that the voluntary and non-audited nature of the forecastscreates credibility concerns (e.g., Jennings [1987], Skinner [1994], Hutton, Miller, andSkinner [2003], Rogers and Stocken [2005], Hirst, Koonce, and Venkataraman [2007],Hutton and Stocken [2007]; Lansford, Lev, and Tucker [2007]).1

We first show that there is underreaction to management forecast news.Specifically, using equal-weighted (value-weighted) portfolios and size-adjusted returns,we document 3-month hedge portfolio returns of 3.71% (3.31%) and 12-month hedge portfolio abnormal returns of about 4.66% (6.14%). In addition, the post-forecast returnsseem to be largely driven by good news forecasts. These returns contrast with thestronger short-term market response to bad news forecasts (e.g., Hutton et al. [2003]),suggesting that the market regards good news as being less credible and thereby takes alonger time to respond to them. Our findings are robust to different asset pricingmethodologies, measures of abnormal returns, and sub-samples. These results areconsistent with some evidence of a drift after aggregate management forecast surprises inthe U.S. in Anilowski, Feng, and Skinner [2007] and after management forecast surprisesin Japan in Kato, Skinner, and Kunimura [2006].

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We then conduct analyses to test whether forecast credibility provides anexplanation for the underreaction to management forecast news. Specifically, we examinehow the underreaction varies cross-sectionally with characteristics of the forecasts andfirm’s economic characteristics that have been associated with forecast credibility (wediscuss these predictions in more detail in Section 2.2).With respect to forecast characteristics, we follow the existing managementforecast literature and assume that i) more precise forecasts are more credible than less precise forecasts (e.g., Hassell, Jennings, and Lasser [1988], King, Pownall, andWaymire [1990], and Baginski, Conrad, and Hassell [1993]) and ii) managers develop areputation of issuing credible forecasts when prior forecasts have been more accurate

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Anilowski et al. [2007] and Kato et al. [2006] do not study whether there is underreaction to managementforecasts. The time-series returns graphs in these papers, however, indicate a drift in returns in the daysafter the management forecasts.

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