“Unexpected changes in corporate earnings reports and its impact on stock prices”

by

David Rascon

MSc Finance Dissertation. 2008

Bradford, United Kingdom, Class of 2008.

STATEMENT OF AUTHENTICITY I have read the University Regulations relating to plagiarism and certify that this dissertation is all my own work and do not contain any unacknowledged work from any other sources.

WORD COUNT: 11,707

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David Rascon. 07024650 “Unexpected changes in corporate earnings reports and its impact on stock prices” Abstract. The goal of this study was to find out if abnormal returns may be gained by using the information released in the quarterly earning reports. In order to determine this, we studied the Efficient Market Hypothesis created by Eugene Fama, that affirms in its strong efficiency form that news are fully and instantaneously priced into stock prices, and its relevant relationship with this study. In addition, we also studied relevant academic information provided by Ball and Brown suggesting prices adjust gradually rather than instantaneously. We were observing stock prices movements around the day of the event, and analyzed these movements using a window event methodology. After carefully observing the direction, duration and magnitude of this movements we were able to establish if the information contained in these reports was priced instantaneously as suggested by Fama’s Efficient Market Hypothesis, or if the information was priced gradually, giving enough time to investors to participate in the short time uptrend. The outcome of the event window methodology gave us solid and strong elements to believe surprises in earning reports were priced gradually over a short period of time, not instantaneously. This gradual movement can be seen as an opportunity for investors to take advantage of this short trend, and gain abnormal returns in this process. Our conclusions suggest a profitable and consistent strategy for short term trading can be achieved using this kind of information, and proving at the same time, the market is efficient but it does not act as fast as the EMH suggests.

Keywords: abnormal returns, earnings reports, window event, trading strategies, EPS.

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Preface. This study analyze the impact of earnings reports on stock prices, by observing how market participants react to positive, negative and neutral earnings related news in the short term. The methodology used to measure these changes in stock prices was the window event methodology. This window is 50 days long, and compiles information of 80 companies traded in the U.S.A. stock exchanges. After watching the behaviour of stock prices around this type of events it was possible to determine that news are absorbed gradually rather than instantaneously. This fact is a contradiction to the strong form of EMH. This gradual change in stock prices takes place in a period of 10 to 20 days, giving investors the chance to gain an abnormal return by buying a portfolio of equities whose reports were positive. Since creating wealth is the main goal of any fund manager, and the performance of their portfolios is often compared against the yield of market indexes, we believe this study is relevant, mainly because it provides a good strategy to outperform the markets using relevant information, a trading strategy that rely on a company’s change of intrinsic value due to the change of earnings, a trade fully based in fundamental analysis.

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TABLE OF CONTENTS

STATEMENT OF AUTHENTICITY…………………………… 2 ABSTRACT………………………………………………………... PREFACE………………………………………………………….. LIST OF TABLES…………………………………………………. LIST OF GRAPHICS……………………………………………… ABBREVIATIONS………………………………………………… 3 4 5 6 7

INTRODUCTION……………………..……………….….……..……… 10

Chapter 1. LITERATURE REVIEW. 1.1 Background……………………………………..…………… 1.2 Efficient Market Hypothesis……………..…………………. 1.3 Market Equilibrium Models…………..…………………….. 1.4 The Ball and Brown study…………….…………………..… 1.5 Random Walk Theory……………………………………….. 12 14 18 20 23

Chapter 2. RESEARCH STRATEGY 2.1 Hypothesis…………………………………………………… 25 2.2 Research Design……….…………..………………………… 2.3 Research Data…………………………………..…………… 25 26

2.4 Sampling……………………………………………………... 27 2.5 Window event methodology………………………..……….
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Chapter 3. ANALYSIS OF DATA 3.1 Window event Analysis and price behaviour……………….. 3.2 Cumulative Average Abnormal Return……………………… 32 33

Chapter 4. CONCLUSIONS 4.1 Introduction…………………………………………………. 4.2 Review of Methodology…………………………………….. 37 37

4.3 Summary of Results………………………………………….. 38 4.4 Final Conclusions…………………………………………….. 39 4.5 Answers to key Questions……………………………………. 39

APPENDIX A. Dissertation Proposal……………………………………. 41 APPENDIX B. Positive surprises, Portfolios 1…….…………………….. 49 APPENDIX C. Positive Surprises, Portfolio 2…………………………... 50 APPENDIX D. Stock Prices, Window Event……………………………. 51 APPENDIX E. Returns per Stock, Window Event……………...………. 58 BIBLIOGRAPHY………………………………………………………. 65

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LIST OF TABLES.

Table 1.4.1 Beaver et Al Study. Residual changes in EPS and Stock prices. Table 2.4.1 Sampling, list of companies taken for the window event study. Table 3.1.1 CAAR. Information taken from day zero to day 25.

LIST OF GRAPHICS.

Graphic 3.1.1 CAAR, per group. Graphic 3.1.2 Portfolio of companies taken from group #1, positive surprises.
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ABBREVIATIONS CAAR EMH EPS NASDAQ NYSE S&P 500 USA Cumulative average abnormal returns. Efficient market hypothesis. Earnings per share. National Association of Securities Dealers Automated Quotation New York Stock Exchange Standard and Poor’s, 500 companies, Market Index United States of America.

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INTRODUCTION. Traditional academic literature embraces the study of financial statements as an important part of the investment decision making process. Investors use considerable amount of resources analyzing information and historical data of public listed companies. Many finance professionals agree that sometimes the release of new information affect the intrinsic value of a given company and causes an intermediate change in stock price trend. Allegedly, this price trend changes because market participants are discounting this new information gradually over time. When discounting this information, some investors use fundamental analysis, this type of analysis attempt to find value on stock prices trough the study of internal and external factors, such as earnings, growth, and company performance over time, ratios, business cycles, monetary policy and global economic trends. There are a large variety of events that might change investor’s expectations; these events may be related to interest rates changes determined by central bankers, inflation, GDP, government regulations, mergers, acquisitions and earnings reports among others. We are particularly interested on analyzing the changes on stock prices due to positive, neutral or negative surprises (changes) in quarterly earnings corporate reports. We believe this type of report is one of the most important pieces of information because they convey valuable data concerning firm’s activities, cash flows, returns, expenses, financial performance.
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We will analyze return and abnormal return data in the days around corporate quarterly earnings announcements. We will be observing the direction, speed and magnitude of changes due to positive, neutral and negative surprises. The intention of this study is to determine if a trading strategy may be built by trading stocks that are affected by earning surprises on the day of the announcement, analyze and quantify the possible returns of this strategy. Event window methodology will be employed in this study in order to determine returns and abnormal returns around the announcement day. The sample will be taken out of public companies traded in the NYSE, Nasdaq and Amex. Taking into consideration comments made by well known financial market professionals and practitioners on the financial press, we have reasons to believe the market is not efficient, and many opportunities to gain abnormal returns are available when these announcements are made. Hopefully we will be able to determine if the release of new information has some value, or it has already been discounted by the markets by the time this information is known.

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1. LITERATURE REVIEW. 1.1 Background. At the end of every quarter, companies listed in the organized markets have the obligation to report their performance to the public (investors). Included in earning reports are items such as, gross and net income, sales, earnings per share among some other key metrics. The majority of the companies file this report on the months of January, April, July and October. These reports are widely observed by all market participants. These reports contain relevant information of the company’s performance within that period, Financial statements are provided to investors so they can observe the ability of the company to gain sustainable profits and growth. The balance sheet, the income statement and the cash flow statement can provide valuable information that help investors to take educated guesses about the company future. Some of the most followed parameters used to measure performance are the gross profit margin ratio, net profit margin ratio and EPS. EPS is calculated as follows.

Investors watch for these results and they usually compare them against the expectations set by the consensus of professional analysts. If the reports of the company surprise the investment community by providing better than expected results, the price of the stock will usually go higher. In the other hand, if this information reflects poor performance of the company and the results are disappointing and behind analyst’s expectations the most likely scenario is that the price of the stock will go down. These positive and negative surprises are powerful triggers for short term stock price movements.

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Even if the results of a company are strong and robust, but lower that the so called “consensus of analysts”, prices of stocks will go down. If the company provides very disappointing results but they are above consensus, the stock will go up. For example Ford Motor in April 2008, analysts were forecasting an EPS of -$.60, and the result was -$0.09. The company loose money, but they loose less money than previously estimated, stock prices went up during the following 20 days. Earnings surprises may occur because of different reasons. First, it is very difficult to make an accurate forecast since all companies are subject of hard to predict forces and economic changes. Sales, costs, exchange rates and other factors and conditions may change abruptly, making this process even harder. Second, most of the analyst set estimations too high at the beginning of the year, and spend the rest of the year making downward adjustments. This is attributed to the fact that most analysts work for big brokerage firms, and brokerage firms need to encourage investors to buy stocks, and in order to push the investor to buy, they try to set high expectations, high rewards. Another factor is the herding effect, most of the analyst will try to make close calls to their peers, because of the fear of being wrong, and the “herd” is not always right. How fast this information will be reflected on stock prices once the “new” information is released is one of the questions of this study. Before we analyze the data we will review the Efficient Market Hypothesis in order to understand how the markets are supposed to work from the academic perspective.

1.2 Efficient Market Hypothesis. The efficient market hypothesis was developed by Professor Eugene Fama at the University of Chicago in the early 60’s. The efficient market hypothesis assumes that
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financial markets are "informationally" efficient, meaning that all known information is already reflected in the prices of stocks, bonds, currencies. This hypothesis states that is not possible to outperform the market by using information the market already knows. In this case information is defined as anything unknowable that may affect prices, information that may appear randomly in the future. We are talking about unpredictable information such as geopolitical events, change in regulations, corporate events, earnings announcements, changes in monetary policy, natural catastrophes, etc. The EMH requires market participants, investors, to have rational expectations. And that the majority of them update their expectations according to news whenever new information is released or publicly known. This hypothesis also states that any of the investors might be wrong, but the market as a whole cannot be wrong. It is important to make the distinction that EMH does not require investors to be rational, but to have rational expectations, when investors are faced with new information some of them may under react and some of them may overreact, these reaction should follow a random walk and follow a normal distribution pattern so that the net effect on the market prices cannot be used in a reliable form to make abnormal profits. The efficient Market Hypothesis, as discussed by Coutts and Sheik (2002) can be formally stated:

Where is the information set available at time , P*is the expected price based upon the information of , sp P* is not correlated with variables in the information set so that:

Assuming a zero constant equilibrium return and risk neutrality. Test for the market efficiency theory are focused on whether or not the forecasted error is uncorrelated with the variables contained within the information set . In an efficient market the time series of stock prices are uncorrelated with the variables in the

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information set . The EMH is subdivided in three forms, strong form efficiency, semistrong form efficiency, weak form efficiency. In the strong form, share prices reflect all public and private news and there is no chance of making abnormal returns or outperform the market using news, it also implies there is no group of investors with access to private information that will allow them to gain abnormal returns. In this kind of efficiency there is no fund manager who can outperform the market during long periods of time in a consistent manner. Out of thousands of investors some of them will earn abnormal returns or outperform the market, but it is because of statistical reasons, not financial decisions. Researchers have tested this form of efficiency by analyzing the performance of four major groups of investors. These four groups are, company insiders, stock exchange specialists, equity analysts, and fund managers. It has been demonstrated in different studies, that corporate insiders consistently enjoyed abnormal return profits, apparently this type of investors , on average, were sell their stock before prior to low return earnings announcements, and hold their investments prior strong announcements. Stock exchange specialists have monopolistic access to important information about unfilled limit orders, and they are able to gain abnormal returns using this information, they have a tendency to outperform the market indexes return. Security analyst’s opinions are useful, they have a tendency to outperform the market, because some of them have the ability to select undervalued stocks, there are studies that prove top 100 ranked companies made by a consensus of analysts have a tendency to outperform the market. Last, Fund managers, studies indicated only 33% of fund managers can outperform the buy and hold strategy, this give us reasons to believe that money managers, in average, often find difficulties to gain abnormal returns, this information supports the EMH and suggests all information is priced instantaneously. The semi-strong form efficiency affirms that all information is digested by the market very rapidly, with no chances of gaining excess returns by using this information. It also states that fundamental analysis and technical analysis are not reliable tools that can help a fund manager to make excess returns. The adjustments of prices because new information is almost instantaneous in this efficiency form and these adjustments have a reasonable and sizeable movement.
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Studies that have tested the semi strong form of EMH can be divided by two, studies that predict future rates of returns using prices and trading volume, these studies can involve either time series analysis of returns and cross section distribution of returns. This type of study advocates the idea that it is not possible to predict future returns using past returns or by predicting the distribution of returns. The second study used, use event study methodology, most of them imply the information is adjusted rapidly giving no chance to profit abnormal returns from this news. Last, the weak efficiency form states historical share prices won’t help in the process of picking up “winners”, there are no patterns for prices in assets, so Technical analysis has no use on investment decisions, but some forms of fundamental analysis can be used to make an excess return strategy. This form implies all movements in prices follow a random walk and future movements are determined by information that will be revealed unexpectedly in time and form. Two major statistical test have been employed to test the independence of securities returns over time, The run test have confirmed the independence in changes of stock prices over time, while the autocorrelation tests measure the significance of positive or negative correlation over time, those who believe the market s are efficient would expect a insignificant correlations for such combinations. Some finance practitioners, market commentators and economists disagree with these forms of efficiency hypothesis, they believe strong efficiency cannot be achieved due to some factors as slow diffusion of information, the great power of some investors, such as institutional investors, the existence of the so called sophisticated investors. The way the market reacts to news is not absorbed instantly according to them. For example a decrease of the interest rate made by a central bank can change prices in assets, movements in prices that can last, hours, even months. These types of news are not absorbed instantaneously, allowing market participants to gain excess returns thanks to this unexpected news. A participant of the market that have inside information, or public information before is released to the rest of the market need to act in a very discreet manner in order to not be caught by regulators, so it can be assumed the people with this information have
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influence in prices before news are released to the rest of the public. The most important discrepancy of this hypothesis is related to behavioral finance. The EMH in its strong form states that there is no fund manager capable of outperform the market during long periods of time in a consistently manner. We believe this is totally wrong, unreal. Some fund managers have the ability of recognizing a trend in its early stage and overweight their investments in the industries they believe will be most benefited. Or vice versa, underweight those industries where growth does not look good. Good fund managers should be able to recognize threats and opportunities, and they do. We can also make the case that is not that difficult to recognize industry leaders and invest in them. The semi-strong form affirms all information is digested by the market almost instantaneously, we believe this is not true, we will try to prove it by analyzing the price movements of the stock prices, we have reasons to believe these new events are discounted over a period of 10 days, not instantaneously, giving the chance to any investor to gain abnormal returns over short period of time, allowing the investors to create short term high profitable trading strategies. In the last stages of a bull market, investors start to ignore fundamentals and become more irrational, markets are driven by investors that don’t care about fundamentals, that are just following the trend, and want to be part of the easy money, ignoring P/E ratios, price to book ratios and some other relevant information that can alert them against “bubbles”. Behavioral finance states that investors are not motivated by valuations, they are most of the time affected by expectations, they take decisions based on their beliefs of where the market is going to, their expectations. EMH assumes investors are rational at all time, and this might not be possible. Another contradiction to the EMH is the fact that there are some famous well known investors as Warren Buffet, Jim Rogers and Peter Lynch among others, which have been able to consistently outperform the markets over long periods of time exploiting inefficiencies in the market, and making money when the market is not giving the correct price to certain assets. There is no doubt irrational investment behavior occurs from time to time, one of the most relevant examples can be the market crash of October 1987, when no important
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news where released in that month and the indices loose more than 20% of their value. Hence, EMH assumes market participants are rational, and this might not be true, at least not at all times. One more contradiction to EMH is that investors tend to over react or under react to news and events, mispricing information in this process, giving us the opportunity to doubt again the EMH. DeBondt and Thaler (1985) found that past winners tend to be future losers and vice versa. And they attribute these reversals to investors over/under reaction. They think investors tend to give a lot of weight on past performance and forget that company’s performance tend to be mean-revert. Again, investors sometimes are carried away by expectations mispricing the real value of firms, creating an opportunity and efficiency in the market.

1.3 Market Equilibrium Models Used to test Market Efficiency. There are some models of market equilibrium that can be used to test market efficiency; the following three, are the most important models. A. Expected returns are positive. This model simply states that expected return of “j” from time “t” to time “t-1” is always higher than Zero, it is positive. According to this model, if the market is efficient and this model is correct then any analyst who forecast a negative return or a recommendation to sell is incorrect. Some analysts feel that the market is not efficient and this motivate them to expect negative expected returns on certain equities. Such type of analyst represents a good source of tests of market efficiency. B. According to Keown et al (2005) “Analyst would agree with the proposition that the market always sets prices so that its assessed expected returns are positive. But they would disagree with the proposition that the market is efficient. They feel that in setting prices, the market sometimes neglects relevant information or draws incorrect inferences from it, so that sometimes the true expected returns are negative. They feel that they see more information or are better able to analyze available information than the market. Such analysts represent a potentially fertile source of test of market efficiency.
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If they record the times when they asses’ negative expected returns on securities, then one can simply compute the returns that are later realized. One or few such observations are not much evidence for or against market efficiency; but as a history of the predictions of analyst is built up, a reliable average return for periods when he assesses negative expected return can be obtained. If the average is negative and if the sample of predictions is sufficiently large to make the negative average return a low probability event if true expected returns are positive, then we can conclude that the analysts is able to identify period when true expected return are negative. If we are willing to stick by the model of market equilibrium which says that the market always sets prices so that its expected returns are positive, then the predictions of the analysts establish that the market sometimes either neglects available information in setting prices or analyzes information incorrectly. In either case, the analysts are living evidence for the existence of market Inefficiency”. C. Expected returns are constant. At any given time “t-1” the market sets the price of a security “j” in such a form that its assessment of the expected return on the security, So that expected returns on a security “j” remain constant trough time, then any analyst that predicted the opposite is wrong. But if the analyst is capable of predicting that returns will not be constant and the market prove him right, and then we could have evidence that the market is not efficient. In this case the equation stated before does not hold, and the market is presumable inefficient. 1.4 The Ball and Brown Study. Accounting and finance researchers have been analyzing and investigating for decades, the relationship between earning announcements and prices of equities. A study by Ball and Brown (1968) provided the first evidence of the adjustments experimented by stock prices during the release of earnings related news. Ball and Brown raised the question of whether or not positive unexpected changes in earning report results were associated with positive changes in stock prices, and whether or not negative surprises affect stock prices. Even though there are too many factors that can affect prices of stock, Ball and Brown isolated the effect of earnings by observing at cross-sectional changes in earnings and the correspondent change in prices. As stated by Ball and Brown (1968) “it has also been demonstrated that stock prices, and therefore rates of return from holding stocks, tend to move together. In one
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study it was estimated that about 30 to 40 percent of the variability in a stock’s monthly rate of return over the period of March 1944 through December 1960, could be associated with market-wide effects. Market-wide variations on stocks returns are triggered by the release of information which concerns all firms. Since we are evaluating the income report as it relates to the individual firm, its contents and timing should be assessed relative to changes in the rate of return on the firms stocks net of market wide effects. The impact of market wide information on the monthly rate of return from investing one dollar in the stock of firm “j” may be estimated by its predicted value from the linear regression of the monthly price relative of firm “j” common stock on a market index of returns”.

This design provided the confidence to assume that all these changes were attributed only by earning reports and not other factors. The study used a sample of 261 companies over the period of 1946 trough 1968. They used annual earnings announcements and they classified them in two, favorable and non favorable, using a simple expectation model. Their findings provide relevant support for the influence of earnings. Their study shows that the increment or decrement of stock prices was gradual rather than instantaneous as the efficient market hypothesis would affirm. And also found that the changes experimented by stock prices follow the direction of the surprise. A positive surprise cause the stock price to raise and a negative surprise cause the stock price to drop. Although, they were capable of determining the relationship between the direction of the movements relative to the direction of the announcements, they stated they study couldn’t determine the magnitude of this changes, it was not possible to measure and create a reliable way of forecasting the size of the surprise against the magnitude of the change. They raised several questions as well, one of them was how is the market capable of determining future changes in profits of particular companies, what media was used for his purpose, and if the market knows something is going before the day of the announcement, why they wait until the earnings announcement was released to make a decision. According to Hirst and Hopkins (2000) “Specifically, having advance knowledge that a company will have a positive earnings change yield, on average, a 7% market adjusted return on that stock. Likewise having advance knowledge that a company will have a negative change yields, on average, a 9% negative market adjusted return on that stock”.
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Beaver, Clark and Wright (1979) went even further than Ball and Brown, they decided to investigate not only the direction of the changes but also the size and magnitude of them, they analyzed a group of companies, and this group was formed by 276 publicly traded companies. They divided this group into 25 portfolios; each portfolio had companies with different magnitude of change. This study determined there was no relationship between the magnitude of the changes in announcements and the prices of stocks, and determined the reaction was not uniform. We concur with the findings of Beaver, Clark and Wright, that there is no relationship between the magnitude of the changes in announcements and the magnitude in changes of stock prices, we believe the direction of the surprise will be the same but magnitude cannot be established. Mainly because there are several factors that intervene in the size of the stock price change, factor like future earnings guidance, comments made by the company CEO, these factors cannot be measured, the reaction can be strong or weak, There are no educated or scientific ways to measure these factors, reaction may vary from case to case, giving no opportunity to create a numerical relationship. The following table shows the average residual change in earnings and the average residual change price for the top 5 portfolios and the bottom 5 portfolios, this table is part of the Beaver et al Study. Table 1.4.1

Portfolio #1 was formed with companies that experimented the largest decline in earnings (unexpected). Portfolio #10 was formed with stocks whose reports had the largest positive earnings surprise. As we can observe in the table, there is an asymmetric
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reaction, and these reactions are not uniform for all levels of negative or positive surprises. Beaver at al did not address what are the reasons behind the magnitude of the reaction on stock prices to a certain level of change in EPS. This reaction is known as the “earnings response coefficient” (ERC). Apparently there is no way to determine the size in the change of stock prices in relationship to the magnitude of unexpected changes in earnings returns, but there is a directional relationship between them. It is worth mentioning, that there is a significant difference between the founding’s established by Eugene Fama and the statements made by Ball and Brown. Fama assumes all new information is absorbed by market participants almost instantaneously, a scenario where abnormal returns can be made only if you get lucky, and an environment where fund managers are not capable of consistently outperform the indexes. Ball and Brown study shows that price increment or decrement in stock prices are gradual rather than instantaneous. Even though the size or magnitude of the change in prices will remain unknown, the direction of the trend is known, allowing investors to be part of the trend and obtain abnormal gains. We could make the case that Ball and believed in a very weak form of market efficiency, a form where the changes take place in days rather than seconds. This significant difference might be the key to understand why it is possible to outperform the market in a consistent manner, in a world where information travels instantaneously trough the internet, but market participants take their time to price this new information. 1.5 Random walk theory. Random walk theory has been a relevant point concerning the value of historical data of stock prices, and how these values can predict, or not, the future value of the securities. The theory has two important axioms, the first one state that price changes are dominated by some type of probability distribution, and that successive price changes are independent. It is important to mention that according to Young E (1971), “considerations of the type of probability distribution generating the process have been primarily concerned with portfolio risks where the Markowitz expected return variance concept of an efficient portfolio does not hold for some distributions”. The independence assumption is related to the statement that knowledge of previous prices has no value in predicting future prices. The independence assumption
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can be represented as follows: ) In the most elementary sense, the change in price for a unit of time is completely a random variable, bringing up a scenario where past prices are not helpful to predict future prices. In order to put the Random walk theory into perspective, we will describe, in a brief and general manner, the two major approaches used to predict future prices. These approaches are known as the Technical analysis approach, and the fundamental or intrinsic value analysis approach. Technical analysts affirm that prices have memory and history tends to repeat itself. Patterns can be used to recognize trends and future prices of stock, this kind of analysts basically assume that successive price changes in stock prices are dependent, following a sequence of price changes. We could say this kind of analysis is surrounded by mysticism, a sort of an astrologist of the financial markets, not reliable. Fundamental analysis approach is assumes that in any point in time an individual security has an intrinsic value which depends in the earning potential of this security. The earnings potential are estimated and valued upon the outlook of the industry, the economy, growth, etc. Using this information an analyst is able to predict future prices. We could say that fundamental analysis is more accurate because prices of stock tend to reach their intrinsic value. Eugene Fama (1965) affirms that “Successive price changes might not be strictly independent, but the actual amount of dependence might be so small as to be unimportant”. Taking into consideration that the future is uncertain, and that news in the future can be positive or negative, news might change the intrinsic value of a company in a matter of seconds, we can assume the direction of prices in both directions, is uncertain. If it is uncertain then a random walk makes sense. In the other hand, once a new piece of information is released to the market, this information may affect the intrinsic value of the security forming a short term period of certainty, causing a trend where random walk not longer applies, at least for the

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upcoming short term future. In the case of this study, we try to exploit this fact to gain abnormal return while taking a short term high reward low risk momentum approach. 2.0 Research Strategy. 2.1 Hypothesis. This project aims to study the influence of surprises in quarterly corporate earnings reports on share prices. Observe how many days it takes for the market to digest this information, study the behaviour of prices after the information is known by market participants. All these observations will be helpful to determine if profits can be made by buying or selling shares the day of the announcement, and analyze the size of the gains or losses relative to the neutral, positive or negative surprises. By determining the number of days it takes the market to absorb the new information, we will be also testing how efficient and how fast market efficiency really is. 2.2 Research Design. The research will be carried out by Positivism research philosophy, assuming the role of an objective analyst with an emphasis on quantifiable observations and statistical analysis. Inductive research approach will be applied in this study. Inductive approach is the adequate way to conduct this study since we do not have an initial hypothesis. We decided to first observe the outcome of the study, analyze it and establish a valuable conclusion at the end. We will be able to determine if according to this study, gaining abnormal returns by buying or selling stock the day of the announcement is possible or not, and if it is possible quantify and measure the gains. We will follow the cross-sectional studies research strategy, employing quantitative methods. The software that will be used to process the data is Microsoft Excel 2007. The study will be a picture, a “snapshot” of the phenomena. We will be using a group of companies and reports from the first quarter of 2008 the detailed list of companies and its characteristics are further explained in the following paragraphs.

2.3 Research Data.
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It is mainly based in secondary data. Using raw data in the case of historical data such as stock prices, and compiled data in the case of earnings expectations. According to Saunders, Philip and Thornhill, (2003) “Documentary secondary data are often used in research projects that also use primary data collection methods. However, you can also use them on their own or with other sources of secondary data, in particular for historical research. Research based almost exclusively on documentary secondary data is termed archival research and, although this term has historical connotations, it can refer to recent as well as historical documents”. In this sense we will attempt to conduct a research focused in a particular period of time, the reports of the first quarter of 2008. Most historical data such as stock prices, estimated earnings per share, and earnings per share reports will be collected from Thomson markets, Bloomberg, and electronic databases from the New York Stock Exchange and NASDAQ Exchange. Athens online, Google scholar and the library of the Bradford School of Management will be the main sources of documentary data applied in this project. 2.4 Sampling. Since we can not look at individual cases because prices of shares might change due to a large number of different factors, a representative sample will be required. First we determined the size of the sample using a level of confidence of 95% (Z=1.96) and an error of 1, estimating a total population of 5000. The result was a sample size of 68. We increased the sample size to 80 to decrease the margin of error. After that we choose a combination of quota sampling and judgement sampling as a sampling design. Using a stock screener we first got a group of companies that are listed in the U.S.A exchanges and trade more than 1 million shares per day. We can say the first criterion was to take only companies with good marketability, acceptable liquidity. Some companies where trading is thin, can experiment high fluctuations with low volume. We prefer not to consider this type of companies for this study. After that, we separated this big group into four groups. The criterion for each group was market capitalization. The first group was made with companies that have market capitalization from $.2 billion to $5 billion; the second one was formed with companies whose market capitalization lies between $5 billion to $25 billion. Third group companies from $25
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billion to $75 billion, and the fourth group was formed with companies that have more than $75 billion in market capitalization. After making these 4 groups, we took out 20 companies from each group. The criteria used to take these twenty companies was industry category, each sub-group has companies from different industries such as consumer discretionary, consumer staples, energy, financials, health, industrials, information technology, materials, telecommunications, retail and utilities. In this last phase of the sampling we used judgement sampling design, getting 20 companies from different industries. We end up with a sample of 80 companies. We are certain that this is a representative group of the universe of companies we want to test, which are companies with high liquidity from different industries and different sizes (market capitalization). The following table shows a complete list of the companies that are part of the sample. Table 2.4.1.
SAMPLE. (80 Companies) Report Date Company 1 2 3 4 5 6 7 8 9 1 0 11 1 2 1 3 1 4 1 5 1 6 1 7 1 3m Co. Accenture Ltd. Advanced Microdevices Inc Air Prods & Chems Inc. Alcoa Inc. Alpha Natural Res. Altria Group Inc. America Movil S.A.B. American Express Co. American International Group. American Superconductor. Arena Resources Inc. At&T Inc. Boeing Co. Bucyrus Int. Buffalo Wild Wings Caterpillar Inc. Cepheid Inc. Ticker Symbol MMM ACN AMD APD AA ANR MO AMX AXP AIG AMSC ARD T BA BUCY BWLD CAT CPHD Market Cap (Billions, USD) 52.96 23.71 4.68 21.66 32.36 6.65 43.14 97.81 51.76 84.75 1.79 1.80 214.89 53.37 5.81 0.56 49.74 1.62 Window Event = 0 24-Apr-08 27-Mar-08 27-Apr-08 23-Apr-08 7-Apr-08 5-May-08 24-Apr-08 24-Apr-08 25-Apr-08 8-May-08 8-May-08 8-May-08 22-Apr-08 23-Apr-08 24-Apr-08 29-Apr-08 18-Apr-08 1-May-08 $ EPS Estimate 1.35 0.56 -0.51 1.2 0.48 0.17 0.37 0.88 0.81 -0.76 -0.11 0.45 0.74 1.35 0.49 0.36 1.33 -0.08 $ EPS Actual 1.38 0.64 -0.51 1.23 0.44 0.39 0.37 0.74 0.84 -1.41 -0.04 0.51 0.74 1.61 0.55 0.36 1.45 -0.03

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8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 2 9 3 0 3 1 3 2 3 3 3 4 3 5 3 6 3 7 3 8 3 9 4 0 4 1 4 2 4 3 4 4 4 5 4 6 4 7 4 8 4 9

CF Industries. Chesapeake Energy Corp. Chipotle Mexican Grill. Cisco Systems Inc. Citigroup Inc. Coca-Cola Co. Concur Technologies. CSX Corp. Cybersource Corp. Darling International. Du Pont. Exterran Holdings Inc. Exxon Mobil Corp. Flir Systems Inc. Ford Motor Inc. General Dynamics Corp. General Electric Co. General Motors Corp. Hess Corp. Hewlett-Packard Co. Hologic Inc. Home Depot Inc. Honeywell International Inc. Illumina Inc. Intel Corp. Intl. Business Machines Corp. Johnson & Johnson. JP Morgan Chase & Co. Juniper Networks inc. Lehman Brothers Holding Inc. Lincoln Electric Co.

CF CHK CMG CSCO C KO CNQR CSX CYBS DAR DD EXH XOM FLIR F GD GE GM HES HPQ HOLX HD HON ILMN INTC IBM JNJ JPM JNPR LEH LECO

9.04 33.10 2.88 155.18 109.35 125.85 1.56 26.37 1.20 1.31 42.45 4.73 469.91 5.31 14.57 34.31 288.76 9.19 41.17 117.67 6.00 46.17 41.66 4.56 120.66 174.03 185.55 136.86 12.66 15.06 3.58

24-Apr-08 1-May-08 23-Apr-08 6-May-08 18-Apr-08 16-Apr-08 30-Apr-08 15-Apr-08 29-Apr-08 8-May-08 22-Apr-08 7-May-08 1-May-08 25-Apr-08 26-Apr-08 23-Apr-08 11-Apr-08 30-Apr-08 30-Apr-08 20-May-08 1-May-08 20-May-08 18-Apr-08 17-Apr-08 15-Apr-08 16-Apr-08 15-Apr-08 16-Apr-08 24-Apr-08 18-Mar-08 23-Apr-08

2.13 0.93 0.48 0.36 -0.95 0.63 0.11 0.75 0.14 0.21 1.28 0.68 2.14 0.22 -0.6 1.29 0.51 -1.6 2.02 0.85 0.24 0.37 0.82 0.24 0.25 1.45 1.2 0.64 0.25 0.71 1.21

2.77 1.09 0.52 0.38 -1.02 0.67 0.13 0.8 0.16 0.26 1.31 0.78 2.03 0.24 -0.09 1.42 0.44 -0.62 2.34 0.87 0.26 0.41 0.85 0.26 0.25 1.65 1.26 0.68 0.27 0.82 1.24

25

5 0 5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 6 0 6 1 6 2 6 3 6 4 6 5 6 6 6 7 6 8 6 9 7 0 7 1 7 2 7 3 7 4 7 5 7 6 7 8 7 7 7 9 8 0

Lindsay Corp. Macy's Mastercard Inc. Mcdonald's Corp. McMoran Exploration Co. Merck & Co. Inc. Microsoft Corp. National Oilwell Varco. Nvidia Corp. Pfizer Inc. Potash Corp. PPL Corp. Priceline Com Inc. Procter & Gamble Pulte Homes Inc. Red Hat Inc. Research in Motion Ltd. SanDisk Corp. Savient Pharmaceuticals. Sirius Satellite Radio Inc. Sprint Nextel Corp. Supervalu Inc. Sysco Corp. The Walt Disney Co. United States Steel Corp. United Technologies Corp. Verizon Communications Inc. Wachovia Corp Wal-Mart Stores Inc. Weatherford Int. Williams Companies Inc.

LNN M MA MCD MMR MRK MSFT NOV NVDA PFE POT PPL PCLIN PG PHM RHT RIMM SBDK SVNT Siri S SVU SYY DIS X UTX VZ WB WMT WFT WMB

1.54 7.81 38.28 67.94 1.68 75.15 369.43 34.69 6.37 120.22 71.91 19.02 4.92 201.19 2.87 4.27 79.82 5.45 1.34 3.93 23.38 7.11 18.18 64.11 20.34 67.03 103.31 36.48 234.69 30.51 22.60

17-Mar-08 14-May-08 29-Apr-08 22-Apr-08 17-Apr-08 21-Apr-08 24-Apr-08 30-Apr-08 8-May-08 17-Apr-08 24-Apr-08 2-May-08 8-May-08 30-Apr-08 23-Apr-08 17-Mar-08 2-Apr-08 17-Apr-08 7-May-08 12-May-08 2-May-08 17-Apr-08 28-Apr-08 6-May-08 29-Apr-08 17-Apr-08 28-Apr-08 14-Apr-08 13-May-08 20-Apr-08 1-May-08

0.47 0.02 2 0.7 0.32 0.86 0.44 1.09 0.38 0.66 1.52 0.62 0.6 0.9 -0.77 0.19 0.7 0.26 -0.32 -0.07 0.22 0.71 0.41 0.51 1.81 1.01 0.61 0.4 0.75 0.5 0.52

0.79 0.02 2.59 0.81 0.47 0.89 0.47 1.11 0.36 0.61 1.74 0.61 0.76 0.92 -2.75 0.2 0.72 0.21 -0.33 -0.07 0.18 0.73 0.43 0.58 1.77 1.03 0.61 -0.14 0.76 0.51 0.57

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2.5 Window Event Methodology. In order to analyze the behaviour of prices and the gains and losses during the observation period, event study methodology will be employed. This methodology is generally used to determine the economic impact of different general corporate events. These events might be related to changes in interest rates, mergers, economic cycles, earnings. In this case, the goal is to determine the influence of quarterly earning reports on stock prices. Under Fama’s efficient market hypothesis, the economic effect should be fully reflected in the share price the same day of the announcement. The purpose of this particular paper is to study if this really takes places the day of the announcement, or during several days after the event. According to Elton, Gruber, Brown and Goetmann (2007) the event study methodology needs to follow 8 steps, these steps are further detailed below. Step 1. Collect a sample of firms that had a surprise announcement. A sample of 80 companies has been selected using the criteria and methodology described before; this group of companies will be used for the study. A complete list of the sample is available for review on appendix, exhibit “A”. Step 2. Determine the precise day of the announcement and designate this day as day “ “Zero”. The announcements of the corporate earnings reports take place in different days, these events occur at different points in the calendar time. “Day Zero” is the day where the announcement was made. In the case of Pfizer day zero is April 17, while General Electric’s day zero is April 11. Eexact dates of the announcements for all companies sampled can be found with the sampling list in the appendix. This study will use intervals of one day. All reports are from the first quarter earnings of 2008. Step 3. Define the period to be studied.

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This study will consider 50 days. Twenty five days before the event and twenty five days after the event. Since the main objective of this paper is to determine if successful short term trading can be made to gain abnormal returns using surprises in earnings announcements, we believe 50 days is enough time to determine if a short term trading can be made. Since we don’t know the results yet, we also decided to analyze 25 days prior the announcement in the case that the market get ahead of itself and it might be pricing these surprises before they actually happen, in the remote case that this info is leaked to some investors before the earnings are released to the whole public.

Step 4. For each of the firms in the sample, compute the return on each of the days being studied. For each firm in the sample, a daily return will be calculated for each of the 50 days of the window using the following formula.

Step 5. Compute the abnormal return for each of the days being studied for each firm in the sample. The return of the S&P 500 index will be used as the expected return. The index model will be used to calculate the abnormal return. Using the following formula.

Step 6.. Compute for each day in the event period the average abnormal return for all of the firms in the sample. Once we have determined the return of the each company over the 50 day period, and we have calculated the abnormal return we will proceed to calculate the average abnormal return for all of the firms using the following formula.
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Step 7. Calculate the cumulative abnormal return from the middle of the window (day zero) to the end of the window period (day 25). Step 8. Examine and discuss the results. Once the analysis is performed, the results will be examined and conclusions will be drawn, and we will be able to establish the influence of these reports on stock price in current times, where the information flow is really fast and electronic trading is in use. 3.0 Analysis of data. 3.1 Window event Analysis and price behaviour. After performing the window event study using the methodology previously mentioned, we found that group #1, formed by those companies whose earnings reports were positive, above expectations, got a cumulative abnormal return of 7.51% over a period of 26 days. While companies in group #3 whose reports were negative, behind expectations, suffered a negative cumulative abnormal return of -3.17%. Companies where earnings were exactly the same as expected, group #2 gained a 4.75%. After observing the behaviour of prices around the day of the event, we could see that news was gradually absorbed by the market. It took days for the market to digest these reports and fully price the news into stock prices. For example in group #1, where reports where better than expected, the average gain in the first day of the event was 2.45%, but those companies gained an extra 5.1 % during the following days. Giving us reasons to believe that news were not fully and instantaneously priced as assumed by the EMH, and suggesting that buying the stock after the spike of the first day was still a profitable trade. In group #3 stock prices felt an average of 2.91%, after few days they totally recovered but finished loosing value at the en of the period, this movement suggest that after some short period of volatility priced was adjusted finishing with a loss at the end of the event period. The behaviour of prices in group #2 was quite interesting, they appreciated during a period of 10 days approximately, after that they started to decrease, suggesting some market participant over react after the news were released, and prices got adjusted by the market after this so called overreaction. Some companies that
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reported positive surprises yielded a negative return and vice versa, apparently the market in these cases put more attention to the future earnings guidance given by company officials who made some warnings about future negative or positive expectations for the next trimester reports. In the following graphic, we can observe the behaviour of stocks. Graphic 3.1.1

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Average Cumulative Abnormal Return From day Zero to day 25. Day Positive Surprises Neutral Surprises
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Negative Surprises

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

2.43% 3.86% 4.43% 4.26% 4.88% 4.96% 5.07% 5.00% 5.67% 5.67% 5.93% 6.41% 7.09% 7.48% 7.52% 7.31% 7.48% 6.99% 6.88% 7.07% 7.05% 7.67% 7.83% 7.82% 7.27% 7.52%

1.50% 4.48% 4.38% 4.59% 3.79% 3.44% 4.94% 4.39% 4.93% 5.21% 6.74% 5.55% 6.56% 6.92% 6.53% 7.11% 5.97% 5.79% 4.99% 5.01% 5.19% 4.99% 5.34% 5.69% 5.14% 4.76%

-2.92% -2.93% -2.70% -3.04% -1.86% -1.58% -0.86% -1.20% -1.44% -1.08% -0.26% -0.14% 0.07% -0.06% -0.08% 0.68% -0.06% -0.61% -0.36% 0.19% -0.57% -1.44% -2.64% -3.29% -2.85% -3.17%

Table 3.1.1 CAAR, from day zero to day 25.

This information leads us to believe abnormal returns can be made by using these earning reports with the proper strategy. Challenging the EMH that assumes fund managers cannot earn abnormal returns in a consistent basis. This information also confirms the findings made by Ball and Brown (1968), where they affirm information is gradually absorbed by the markets, and priced during a period of days rather than instantaneously as affirmed by Eugene Fama (EMH).
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Although stock prices follow a random walk, these prices are influenced by earnings reports in a significant way, giving us a chance to forecast future movements and profit from this price “spikes”. We could make the case the magnitude or size of stock prices movements after surprises in earning reports remain unknown, but the direction, in average, will follow the direction of the surprise. Therefore when surprises are positive the direction of the prices will be to the upside, causing a sudden appreciation of the company stock price, while negative surprises will cause a downtrend in prices. In the case of neutral news, the direction was in the upside; our interpretation of this fact is that investors buy these equities hoping the growth rate will remain intact commanding a premium in the price of the stock. In order to verify if abnormal returns can be made using the earning reports , we built a couple of portfolios, in a randomly manner we took 22 companies out of group #1 and made two subgroups of 11 companies. Day zero, the day of the event, was not considered, usually the news are released one day before after the market is closed or early in the morning, when the market opens prices usually gap higher giving no opportunity to but cheap, taking this into consideration we decided to built the portfolio with the closing prices of day zero. This gives more certainty that the entry point will be easy to reach. The total yield is lower, but is the realistic way to do it. A table containing the information of the portfolios is available in the appendix #2.

The strategy of creating an equal weighted portfolio by buying the stocks at the closing price of day zero, and holding it for 25 days gave us an average abnormal return of 3.34% for portfolio #1 and 3.23% for portfolio #2. Confirming us, a short term strategy can be built, using the information given by the companies in their earning reports. Once again, proving information is not digested by the market fully and instantaneously. Stock prices are adjusted gradually giving us a chance to profit from earnings news.

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The following graphic shows the performance of portfolios in the period between days 1, one day after the earning report was issued, and day 25, the end of the window. Graphic 3.1.2.

4.0 Conclusions. 4.1 Introduction. Financial statements are an important part of the investment decision making process. Earning reports are one of the most influential pieces of information on equity values. Positive, neutral or negative surprises in quarterly earnings corporate reports can cause an abruptly change in prices. Around corporate quarterly earnings announcements meaningful short time trends take place; these trends follow the direction of the surprise. Although the magnitudes of these changes are uncertain, the direction of them is not.
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After analyzing this fact, a new question appears how fast does prices affected by these surprises are. How long does it take for the market to digest them? And how reliable these new short term trends are? According to the efficient market hypothesis developed by Professor Eugene Fama at the University of Chicago in the early 60’s. In its strong form, The efficient market hypothesis assumes that financial markets are "informationally" efficient, reflecting instantaneously any news, providing difficulties to gain abnormal returns from this surprises. In this scenario prices change so rapidly that give no opportunity to react. But in reality, after analyzing the window event we can clearly see that although market efficiency exists, the speed of the change is far from being instantaneous, as stated by the EMH. Thus, giving the opportunity to profit from these short lived trends, giving fund managers a chance to outperform the market while gaining abnormal returns. 4.2 Methodology overview. The results of our study might be contradictory of the EMH when it states that there is no fund manager capable of outperform the market during long periods of time in a consistently manner. As our study shows, earning reports might be used to gain abnormal returns. Fund managers should be able to use this information and outperform the market indexes, taking advantage of these short lived trends. Or underweight those companies where earnings were a deception to the market.

Our window event methodology results also give us elements to believe that Ball and Brown studies are closer to reality. Ball and Brown affirm effect of earnings reports might be isolated from market wide effects. This design provided the confidence to assume that all these changes were attributed only by earning reports and not other factors. Ball and Brown study also shows that the increment or decrements of stock prices are gradual rather than instantaneous as the efficient market hypothesis would affirm. And also found that the changes experimented by stock prices follow the direction of the surprise. Our findings also show that Random walk theory might be right in the sense that there is no certain way to know if earning reports will bring positive, neutral or negative surprises, this uncertainty may cause a random walk, because price can go either way, it
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will depend in the unknown outcome. But once the outcome is known, a short term trend might be established giving certainty and destroying the random walk element. In plain words, once a new piece of information is released to the market, this information may affect the intrinsic value of the security, forming a short term period of certainty, causing a trend where random walk not longer applies, at least for the upcoming short term future. Although we believe the results of this study are relevant, due to time constraints, and difficult to access historical data, it was not possible to analyze more trimesters, but we feel comfortable that this study is representative due to the adequate size of the sample and the methodology taken. 4.3 Summary of results. The results of window event study using shows that group #1, companies whose earnings reports were positive, above expectations, got a cumulative abnormal return of 7.51% over a period of 26 days. While companies in group #3 whose reports were negative, behind expectations, suffered a negative cumulative abnormal return of -3.17%. Companies where earnings were exactly the same as expected, group #2 gained a 4.75%.

4.4 Final Conclusions. Many conclusions can be drawn from this data, this information lead us to believe abnormal returns can be made by using these earning reports with the proper strategy. Challenging the EMH that assumes fund managers cannot earn abnormal returns in a consistent basis. This information also confirms the findings made by Ball and Brown (1968), where they affirm information is gradually absorbed by the markets, and priced during a period of days rather than instantaneously as affirmed by Eugene Fama (EMH). Although stock prices follow a random walk, these prices are influenced by earnings reports in a significant way, giving us a chance to forecast future movements and profit from this price “spikes”. The magnitude or size of stock prices movements after surprises in earning reports remain unknown, but the direction, in average, will follow the direction of the surprise.
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The performance of the two portfolios made out of companies whose reports where positive, show an abnormal return, in a relative high reward low risk environment, if we take into consideration the statistical behaviour of prices after such surprises. The strategy of buying the stocks at the closing price of day zero, and holding it for 25 days gave us an average abnormal return of 3.34% for portfolio #1 and 3.23% for portfolio #2. Confirming us, a short term strategy can be built, using the information given by the companies in their earning reports. Assuming we can do this exercise 4 times per year, we could be earning a yield higher than 12%, above the average yearly return of the S&P 500, which is 7, 29 %.

4.5 Answers to key questions. After a carefully analysis of the data, and conclusions were established, we can successfully respond to the key questions of this research, which are summarized in the following paragraphs. A) Why is it important to observe and measure the changes in price experienced by company’s stock prices when its earnings report is released to the market? It is important to observe and measure the changes in prices because they give us information about the behaviour of them around this kind of event, we can say prices change rapidly but not instantaneously, we can determine a short term trend, a short period of time where prices don’t follow a random walk, giving market participants a great opportunity to gain abnormal returns. B) Can we measure the intensity of these changes? Although the direction of the price change is directly correlated to the direction of the surprise, and the average response to these changes was established, we don’t have sufficient information to establish the relationship of a unit of surprise and a unit of change. Once the outcome of the earning report is know, we can be certain of the direction that prices will follow, but the magnitude of changes may remain uncertain in an individual basis. C) What is the average change in the stock price of a company whose results were above expectation against those companies who reported downside surprises? The average abnormal return of stock whose reports were positive was 7.51% while the average abnormal return of companies whose reports were negative had a negative abnormal return of 3.17%.
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D) Can we do short term trading and obtain abnormal returns using this information? What is the risk? Can we measure this risk? Can we measure the reward? As explained before, the strategy of buying the stocks at the closing price of day zero, and holding it for 25 days gave us an average abnormal return of 3.34% for portfolio #1 and 3.23% for portfolio #2. Confirming us, a short term strategy can be built, using the information given by the companies in their earning reports. In other to measure the risk, we think more events should be studied, a study that includes stocks traded in other markets and more events should be tested, in other to successfully establish the risk involved in this strategy. E) How fast news is priced into stocks in the year 2008? Our study showed evidence that prices move gradually rather than instantaneously.

Appendix 1. Dissertation Proposal.

Dissertation Proposal Academic Year: 2007 – 2008. Programme: MSc Finance

“The impact of unexpected changes in corporate quarterly earnings reports on stock prices”

Canditate: David Rascon Supervisor: Wenxuan Hou

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Statement of Authenticity Total Words: 1,643 “I certify that this assignment is the result of my own work and does not exceed the word count noted above.”

Signature:

David Rascon

Bradford, United Kingdom, May 26, 2008.

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1.0 Introduction. All public companies listed in organized stock exchanges are subject to certain regulations, among these regulations we find that these companies are required to provide financial statements on a quarterly basis, being the income statement report the most important of them. The purpose of releasing financial statements is to provide information about the company’s financial performance, its strengths and financial positions. Market participants evaluate the company’s stock price, trends of growth and future expectations depending on the content released on this reports. When this information is released the market immediately tries to price this news into the stock price. If news were considered to be neutral, meaning the results are very close to the results expected by investors the change in the price of the stock will not vary much, but in the cases when these news or results are way below or above market expectations, share prices will suffer drastic and unusual changes in price. There are plenty of studies that evaluate this variations, but its worthwhile to re-examine and re-evaluate these changes because of the new environment that we are experiencing in recent times, times where information flows more rapidly and easy trough the internet, times where electronic trading and quantum trading practices are growing. Now, transaction costs are very low also, we will try to find out if it is possible to profit from these announcements in a repetitive basis, and how profitable can it be.

1.1 Research objectives.

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A) The objective of this study is to observe and measure the changes experienced by stock prices during its quarterly earning report announcement. B) Evaluate the intensity of these changes. Under reaction and over reaction of stock market participants. C) Compare the changes of prices of companies whose results were close to expectations against to those companies whose results were different than expectations. D) Determine if an abnormal return can be obtained by using this information.

1.2 Research key questions. F) Why is it important to observe and measure the changes in price experienced by company’s stock prices when its earnings report is released to the market? G) Can we measure the intensity of these changes? H) What is the average change in the stock price of a company whose results were close to expectation against those companies who reported significant upside/downside surprises? I) Can we do short term trading and obtain abnormal returns using this information? What is the risk? Can we measure this risk? Can we measure the reward? J) How fast news is priced into stocks in the year 2008?

2.0 Literature review. In the development of this study, the following literature will be relevant. 1.1 Eugene Fama and his efficient market hypothesis; financial markets are “informationally efficient”. Meaning that prices of traded assets are already reflecting all available information. The efficient market hypothesis also declares
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that is not possible to consistently outperform the market by using information that the market already knows. There are some controversial issues related to the efficient market hypothesis. For example how fast this information can be delivered to investors and the way that markets participants react to this information is also a flaw. Investor might under/over react to this information. In the other hand, behavioural finance states that when entering positions market participants, investors, are not motivated by weather the fundamental valuation and price looks cheap or expensive, but weather they are expecting the market to go higher or lower.

2.2 The Ball and Brown (1968) study; this research study established the first evidence of the adjustments of stock prices due to earning announcements, the size of the sampling was two hundred and sixty one companies over the period of twenty two years (from 1946 to 1968), in this study each event was classified as favourable or not favourable, using an simple expectation model. Ball and Brown concluded in their studies that only 10% to 15% of the information was not anticipated by the investors. In a research made in 1972 by Kiger, evidence was presented showing substantial change in volume and significant reaction to quarterly earnings announcements, this study was made using a sample of securities traded in the New York Stock Exchange. Another study made by May (1971) compares changes in prices on earning reports season against a season with no reports made. His results show that the intensity of the change in stock prices was higher on earning report season than no report season, suggesting more volatility when earnings reports are released. 2.3 Joy, Litzenberg and McEnally (1977). Almost all studies related to the release of quarterly information data state that this information is fully priced in to stock prices within minutes once the information is known by investors. Or is already priced in, before this information is released. On this research study they present evidence (over the period studied) that the changes in earnings reports are not fully priced in, at the time of release. They prove this changes cause a reaction among investors. Although they use an event window of twenty six weeks, and this study intends to use a smaller event window, it will help to compare some of the information.
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2.4 Elton, Gruber, Brown and Goetmann (2007). This book provides useful information and formulas that will be needed to develop the window event methodology, and information about the correct calculation of abnormal returns and cumulative abnormal returns. 2.5 Francis, Schipper and Vincent. (2002). this research study tries to prove the usefulness of earnings announcements, attributing the magnitude of changes in prices to the magnitude of the unexpected change in earnings. The change in stock price is bigger when the information released is significantly different to the information expected, suggesting a correlation between changes in stock prices to the magnitude of changes in earnings reports against expectations. In their study they calculated beta adjusted abnormal returns three days before and three days after the announcement. Their test confirms a positive association between market reaction and earnings announcements.

3.0 Research Methodology. This study will use and combine deductive an inductive approach. Using secondary data analysis of relevant archival data, collected from electronic sources such as Thomson markets, Bloomberg, and other research studies. The collection of data may include both qualitative and quantitative data. 3.1 Event study will be used in this study. According to Elton, Gruber, Brown and Goetmann (2007) the event study methodology is as follows: a) Collect a sample of firms that had a surprise announcement (the event). In the case of this study we will understand as surprise event those earning reports that were different (above/below) the consensus of analyst’s expectations. However those companies whose earnings reports showed no surprises will be also analyzed in order to compare both results.
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b) Determine the precise day of the announcement and designate this day as Zero. The interval will be one day. c) Define the period to be studied. This study will consider 20 days around the event. Meaning ten days before the event and ten days after the event. d) For each of the firms in the sample, compute the return on each of the days being studied. for each firm in the sample e) Compute the abnormal return for each of the days being studied for each firm in the sample. The return of the S&P 500 index will be used as the expected return. f) Compute for each day in the event period the average abnormal return for all of the firms in the sample. g) Calculate the cumulative abnormal return from the beginning of the period. h) Examine and discuss the results. Once the analysis is performed, the results will be examined and conclusions will be drawn, and we will be able to establish the influence of these reports on stock price in current times, where the information flow is really fast and electronic trading is in use.

3.2 Data sources. 3.2.1 Primary information. The compute of each day return, average abnormal return, and cumulative abnormal return fro each firm (stock) will be taken from my own calculations based on the information described below. 3.2.2 Secondary Information. Prices of stocks before and after the earnings announcements will be taken from Thomson markets and Bloomberg. Earnings estimates of the companies that are part of the sampling, and their results will be taken from Bloomberg consensus of estimate earnings reports and tables. 4.0 Schedule. Time Progress (2008) May June July
30th 1st to 15th 1st to 30th 45

Activity
Dissertation Proposal deadline Feedback on dissertation proposal Preparation trial/pilot

August

Analysis and interpretation of Data First Draft Revision and improvement of dissertation Dissertation deadline

1st to 10th 1st to 30th 1st to 15th 20th

4.1 Resources. This research will be elaborated using Windows programs such as Word 2007 and Excel 2007. The most important sources of information will be, related studies, academic research, historical data from Thomson markets and Bloomberg.

Bibliography.

- Ball, R. and Kothari, S. Security Returns around Earnings Announcements. (1991). The Accounting Review, vol 66, No 4. PP. 718-738. American Accounting Association. - Ball , R., and Brown, P. (1968). An Empirical Evaluation of Accounting Income Numbers. Journal of Accounting Research, Vol. 6, No2, PP.159-178. - Brownlee, E.R., Ferris, K.R., and Haskins, M.E.,(1990). Corporate Financial Reporting. 2nd edition. Boston: Donelly and Sons Co. - Chadwick, L, (2001). Accounting and Finance. Essex: Pearson publication. - Dongcheol, K.,Myungsun, K.(2003). The impact of earnings Announcements on the Share Price Behaviour of Similar Type of Firms. The Journal of Financial and Quantitative Analysis, Vol.38, No 2, PP. 383-398 - Elton, Gruber, Brown and Goetmann, (2007). Modern Portfolio Theory and Investment Analysis. New York: John Wiley and Sons, Inc. - Elliot, B., and Elliot, J.,(2008). Financial Accounting and Reporting, 12th edition. Essex. Pearson Education Limited.

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