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Span Econ Rev (2009) 11:207241
DOI 10.1007/s10108-008-9048-4
REGULAR ARTICLE
Post-earnings announcement drift: Spanish evidence
Carlos Forner Sonia Sanabria
Joaqun Marhuenda
Published online: 10 October 2008
Springer-Verlag 2008
Abstract This paper analyses whether earnings announcements in the Spanish stock
market are followed in subsequent months by a return drift in the same direction as
the earnings surprise. Two alternative earnings surprise measures are used and they
both provide strong post-earnings announcement drifts. In order to nd an explanation
for this anomaly we rst make several unconditional adjustments, which include the
CAPM, the FamaFrench (J Financ Econ 33:356, 1993) three-factor model, a liquid-
ity factor, controlling portfolios by size and book-to-market ratio, and controlling for
the momentumeffect. Second, we make a conditional analysis following two different
approaches: (i) studying the relation with the business cycle and (ii) studying whether
this phenomenon can be explained through a conditional version of the CAPMand the
Fama-French model. None of these adjustments are able to satisfactorily capture the
Spanish post-earnings announcement drift. Anal analysis offers some slight evidence
in favour of the limits-to-arbitrage explanation.
A previous version of this paper is available in the Working Paper Series of FUNCAS (no. 221, 2005),
who we thank for their collaboration in the research diffusion in Spain. We also acknowledge the nancial
support of the Ministerio de Ciencia y Tecnologa (SEJ2005-09372/ECON), Conselleria dEmpresa,
Universitat i Cincia (GV06/196) and University of Alicante (GRJ06-03). This version has beneted from
interesting comments made by Gonzalo Rubio, Beln Nieto, Natividad Blasco, Renata Herreras and
Carina Sponholtz, as well as by various anonymous referees. Any remaining errors are the sole
responsibility of the authors.
C. Forner (B) S. Sanabria J. Marhuenda
Department of Economa Financiera, Contabilidad y Marketing, University of Alicante,
Campus de San Vicente del Raspeig, 03080 Alicante, Spain
e-mail: carlos.forner@ua.es
S. Sanabria
e-mail: sonia.sanabria@ua.es
J. Marhuenda
e-mail: marhuenda@ua.es
1 3
208 C. Forner et al.
Keywords Post-earnings announcement drift Business cycle
Conditional analysis Under-reaction
JEL Classication G14 G11 M41
1 Introduction
Several studies in the nancial literature have demonstrated the existence of systematic
behaviour inabnormal returns after earnings announcements; stockprices keepmoving
after the announcement in the same direction as the earnings surprise: positive (nega-
tive) surprises are followed by price increases (decreases). This return pattern is known
as the post-earnings announcement drift anomaly (hereafter PAD). As Kothari
(2001) suggests, this phenomenon provides a serious challenge to the market efciency
hypothesis because this anomaly has survived rigorous verication over the last three
decades, and cannot totally be explained through other documented anomalies.
Ball and Brown (1968) and Jones and Litzenberger (1970) were the rst to observe
this PADphenomenoninthe USmarket. Since then, manyresearchers have extensively
analysed the return drift after earning announcements in the same market (Foster et al.
1984; Bernard and Thomas 1989, 1990; Ball 1992; Bernard 1993).
Findinganexplanationfor this abnormal returnbehaviour has caught the attentionof
many researchers. The three basic explanations offered are: (a) methodological prob-
lems, (b) misspecication of the asset-pricing model used to compute the abnormal
returns, and (c) incorrect price reaction to the earnings announcement information.
Although the limitations and biases suffered by the rst studies developed in this
area suggested that the rst two explanations were the sources of this phenomenon,
later studies have shownthat once correctedfor methodologyandriskmisspecication,
the PAD phenomenon remains. Thus, for example, the study of Fama (1998), after a
deep analysis of the robustness of the methodologies used in the study of the different
market anomalies, concludes that only two remain unexplained: PADand momentum.
The difculty in explaining the PAD phenomenon with arguments consistent with
the efciency hypothesis has stimulated a great deal of research which suggests the
third explanation as the source of the PAD anomaly. See, for example Bernard and
Thomas (1990), Abarbanell and Bernard (1992), Bernard (1993), Ball and Bartov
(1996), Soffer and Lys (1999) and Bartov et al. (2000). These explanations are closer to
the behavioural nance literature, which states, unlike the efcient market hypothesis
arguments, that investors are not absolutely rational but present several psychological
biases which would explain their incorrect reaction to the information contained in the
earnings announcement. Consistent with this behavioural explanation, Mendenhall
(2004) demonstrates that the PAD strategy is subject to high arbitrage cost, which
would explain why the arbitrageurs are not able to eliminate this mispricing.
Notwithstanding the above, the explanation of the PAD effect is a controversial
issue and there is still no full understanding of its origin. In this sense, recent research
suggests the origin of the anomalies found in the market could be merely the result of
time-varying conditional expected returns correlated with the business cycle, which
wouldexplainwhytraditional unconditional riskadjustments are not capable of driving
1 3
Post-earnings announcement drift: Spanish evidence 209
these supposed anomalies. Curiously, this potential explanation has been scarcely stud-
ied in the PAD context, despite this is becoming a required analysis in the anomalies
literature (see, for example Chordia and Shivakumar 2002; Wu 2002 for the momen-
tum effect). To our knowledge, only the study of Chordia and Shivakumar (2006)
offers evidence in this sense. This study regresses the Gross Domestic Product (GDP)
growth on lagged values of the PAD strategy returns and nds a negative coefcient.
However, this countercyclical behaviour is precisely the opposite of what we would
expect in a risk-based explanation of the PAD phenomenon.
Another important recent paper that suggests a rational explanation of the PAD
is Sadka (2006). The PAD strategy involves high portfolio turnover and is therefore
likely to be subject to liquidity concerns. Following the literature that suggests that
liquidity risk is a factor priced in the market, Sadka (2006) shows that a substantial
part of momentum and PAD returns can be viewed as compensation for liquidity risk,
more concretely by its variable component.
In spite of the great interest that this anomaly has raised in the US market, this
phenomenon has been scarcely studied in other markets. For the UK market, Liu et al.
(2003) detect the presence of this phenomenon, even after controlling for risk and
microstructure market effects. Dische (2002) observes the same phenomenon in the
German market. Regarding the Spanish market, the only related evidence is Rueda
(2003), who found, for the period 19912000, a positive relation between the annual
earning surprise of the current year and the return yielded by the stocks in the twelve
moths after March of the next year.
The aimof this paper is topresent the rst comprehensive analysis of the existence of
the post-earning announcement drift in the Spanish stock market. To this end we use a
large sample which includes quarterly earnings; we also have the exact announcement
date, which allows us to better locate the analysis window.
To address the study of the PAD effect we include the following methodological
issues. First, in addition to the earnings surprises measure based on the earnings time
series, we use an alternative measure based on analyst forecasts. Second, following the
line of several papers dedicated to the study of market anomalies, we focus on whether
it is possible to implement an investment strategy which provides abnormal returns.
In this sense, we use the portfolio calendar-time approach of Chan et al. (1996). The
main advantage of this methodology with regard to the traditional event time scheme,
commonly used in the studies on PAD, is the fact that the proposed investment strategy
can be implemented in real time. Third, apart from the CAPM, we make several other
adjustments: (i) the Fama and French (1993) three-factor model, (ii) the Fama and
French model augmented with a liquidity factor, (iii) controlling portfolios by size and
book-to-market ratio (henceforth, BTM ratio), and (iv) controlling for the Jegadeesh
and Titman (1993) momentum effect.
In addition to the previously mentioned adjustments, another contribution of this
paper is to present some tests, which analyse the PAD anomaly from a conditional
perspective. To do this we apply two different approaches. First, following Chordia and
Shivakumar (2002), we study the relation of the PAD phenomenon and the business
cycle, and whether the PAD returns remain once the predictive power of the business
cycle is considered. Second, following Ferson and Harvey (1999), we study whether
the PAD strategy prots can be explained through conditional asset pricing models. In
1 3
this way, we allow time-varying factor loading and returns depending on the available
economic information at each moment. To our knowledge, our study is the rst to apply
these two conditional approaches to the PADstrategy. Moreover, we also offer the rst
US out-of-sample evidence of some of the Chordia and Shivakumar (2006) results.
Our results show that there is signicant evidence of post-earning announcement
drift. These results remain when we use diverse unconditional risk controls: (i) by
CAPM, (ii) by the Fama and French (1993) three-factor model, (iii) by liquidity,
and (iv) by size and BTM ratio control portfolios. Moreover, the PAD phenomenon,
although related to momentum, persists after a momentum effect control.
The results of the conditional analysis are twofold. On the one hand, the PADreturns
are related to the business cycle and the PAD strategy does not yield signicant prots
once the returns are adjusted by the predictive power of some variables which are
supposed to predict the economic cycle. Nevertheless, consistent with Chordia and
Shivakumar (2006), the relation with the business cycle is countercyclical, far from
what was expected in a risk-based explanation of the PAD phenomenon. On the other
hand, the regressions using a conditional version of the CAPMand a Fama and French
(1993) three-factor model show that although some of the factor loadings are in fact
time-varying, these models are not capable of capturing the time-varying behaviour of
the expected PAD returns. Moreover, the PAD strategy still yields highly signicant
positive returns after these conditional adjustments.
Finally, given the difculty in explaining the Spanish PADaccording to a risk-based
explanation, we check, following Mendenhall (2004), the limits-to-arbitrage story by
analysing whether the Spanish PAD is related to arbitrage risk. The results do not
show a signicant relationship with arbitrage risk. Notwithstanding, we nd some
evidence of a negative relationship between PAD and the stock price characteristic.
This evidence is consistent with the idea of limits to arbitrage in the sense that the
higher the cost of trading (low prices), the more difcult it is for the arbitrageurs to
drive a stocks price to its fundamental value.
The study has the following structure. In the second section we present the data,
the earnings surprise measures used, and the methodology. The third section analyses
the returns yielded by the PAD strategy, the marginal power between the two surprise
measures SUE and REV, and the robustness to different unconditional adjustments:
(i) CAPM, (ii) Fama and French (1993) three-factor model, (iii) Fama and French
model augmented with a liquidity factor, (iv) size and BTM ratio control portfolios,
(v) momentum effect. The fourth section is dedicated to the conditional analysis. The
fth section analyses the limits-to-arbitrage story. Finally, we present the conclusions.
2 Data and methodology
2.1 Data
The sample used for this study comprises 172 rms quoted on the Spanish capital
market from January 1992 to December 2003. The available data are:
Quarterly earnings announcement dates and the consolidated earnings data, or
individual data when consolidated data are not available. Data obtained from the
1 3
Comisin Nacional del Mercado de Valores (CNMV). This sample is composed
of 5,283 rm-quarterly earnings announcements.
Monthly data of analyst earnings consensus forecasts and number of analysts fol-
lowing a rm, collected from the JCF Quant database.
Annual data of book value of rms equity at the beginning of the year. These data
are collected from the Records of Interim Financial Reports for all quoted Spanish
rms, which is published by the CNMV. We have deleted all negative data.
Daily stock close prices, euro volume and dividends for the Spanish market,
obtained from the Servicio de Interconexin de las Bolsas Espaolas (SIBE).
Using these data, we calculate: (i) monthly stock returns adjusted by dividends,
seasoned equity offerings and splits, (ii) monthly value-weighted market returns,
computed as the capitalization weighted average of the available stock returns in
each month, and (iii) monthly dividend yield, calculated as the ratio between the
sum of the dividends over the last 12 months and the stock price at the end of the
last month.
Monthly stock market capitalization, calculated as the number of shares issued
multiplied by the stock price. The book-to-market ratio (BTM) is the book value
of a rms equity at the beginning of the year divided by the aforementioned market
capitalization. Both variables are available from COMPUSTAT.
We use monthly data of 1-month Treasury bill repo rates as a proxy of the return
on the risk-free asset. This is calculated from the historical series of the Boletin
de la Central de Anotaciones published by the Bank of Spain on its website.
Monthly data of the Internal Rates of Return of 10-year government bonds (secu-
rities), as proxy of the long-term interest rate. These data are provided by the
Boletn Estadstico of the Bank of Spain journal.
2.2 Earnings surprise measures
The PAD phenomenon assumes that, after an earnings announcement, returns show a
drift with the same sign as the surprise in the earnings announcement. Consequently, it
is necessary to dene a measure of earnings surprise for each rm and announcement.
We use two different alternatives.
The rst measure is the standardised unexpected earnings (SUE). The SUE for each
company i and for each quarter t is given by,
SUE
i,t
=
X
i,t
E(X
i,t
)
FP
i,y
, (1)
where X
i,t
is company i s earnings for quarter t, E
X
i,t
is expected earnings for

quarter t , and FP
i,y
is the book value of the rms equity at the beginning of the
reported earnings year.
1
As expected earnings for the current quarter, E
X
i,t
, we use
1
We have decided to use this measure instead of the more broadly used standard error of unexpected
earnings because the estimation of this parameter requires an eight-quarter estimation period that reduces
the analysed period to 19992003. Nevertheless we have replicated the main tests of this paper with this
alternative measure for the 19992003 period and the results, available for any interested parties, are in line
with those presented in this paper.
1 3
the earnings reported in the same quarter in the previous year:X
i,t 4
. In this sense,
Foster et al. (1984) nd that the random walk model performs as well as other more
complex models. In the Spanish market Reverte (2002) nds that, although additional
variables improve the 2- and 3-year earnings predictions, for 1-year predictions the
current earnings are enough.
The second measure of earnings surprise is based on revisions in analyst earnings
consensus forecasts. As noted by Schipper (1991) and Lang and Lundholm (1996),
analyst earnings forecasts are probably a good proxy of the information available to
investors. In this sense, we measure earnings surprise as the change in analyst earnings
forecasts divided by the book value of a rms equity at the beginning of the earnings
announcement year:
REV
i,t
=
FY
i,t
FY
i,t 1
FP
i,y
(2)
where FY
i,t
is rmi s consensus forecast of current scal year earnings (FY1) inmonth
t . If the change of scal year (normally January) occurs in month t, the revision in
analyst forecast will be the current year forecast (FY1) at month t minus the 2-year
forecast (FY2) at month t 1.
2
An advantage of this measure is that it allows us to have monthly data, whereas
with the previous measure we only have quarterly data. However, it has a possible
disadvantage in that, as Chan et al. (1996) show, the analyst earnings forecasts can be
affected by incentives such as the wish to encourage investors to trade and generate
brokerage commissions. In this sense, Larrn and Rees (1999) nd that the Spanish
analyst forecasts suffer from an upward bias and that Spanish forecasts are even less
precise than those of the USA and UK.
2.3 Descriptive analysis
Panel A of Table 1 presents the mean, minimum, and maximum number of stocks per
month with the required data of return, size and BTM, for each year of the sample
period. The number of monthly observations increases year by year until 2002 with a
minimum and maximum of 61 and 135 observations.
Panel Bof Table 1shows the mean, maximumandminimumnumber of observations
per month for each earnings surprise and for each year of the sample period. It also
reports the number of months without earnings surprises (0) or with a low number
(between 1 and 10) throughout the year. To calculate the SUE measure of surprise, we
need the data corresponding to the quarterly earnings announcement of the previous
2
We have also used a third measure based on the prices immediately surrounding earnings announcements.
Specically, we have used the cumulative market-adjusted return in a 4-day period around the announce-
ment. This expression gives an indirect measure of earnings surprise, since it captures the earnings news
reected in stock prices immediately around the earnings announcement. However, returns are not signif-
icant when we use this measure. This result is consistent with Foster et al. (1984), who nd that whereas
standardized unexpected earnings (SUE) helps to predict future returns, the abnormal returns around the
earnings announcement do not have such power. Nevertheless this is contrary to the results of Liu et al.
(2003). These results are available for all interested readers.
1 3
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1 3
year. Accordingly, we only can compute this measure from 1993 onwards so we have
decided to calculate the two measures from 1993 in order to present results for an
analogous period.
As expected, the average number of earnings surprises per month is much greater
with the REVmeasure, since this has a monthly periodicity whereas the other measure
is quarterly. In addition, the average number of SUE surprises is quite reduced in the
rst 2 years: 1993 and 1994, with 3 and 2months respectively, where there is no
surprise data.
Panel Cof Table 1 reports the average number of surprises for both earnings surprise
measures and for each of the 12months of the year. On the one hand, we observe that
the monthly number of SUE surprises is not homogenous, rejecting the hypothesis
of equality throughout the different months of the year. In particular, we detect a
signicant concentration of surprises in the following months: February and March,
tied to earnings of the fourth quarter; May, results of the rst quarter; August, tied to
the earnings of the second quarter, and November, results of the third quarter. On the
other hand, the analyst forecasts measure has a stable monthly distribution. In fact, in
this case, the hypothesis of equality among the number of surprises in the different
months of the year is accepted.
2.4 Methodology: portfolio construction
In order to analyse the PAD, we construct portfolios based on earnings surprises,
and analyse whether the best earnings surprise portfolios outperform, on average,
the worst earnings surprise portfolios. Following the study of Chan et al. (1996) for
the US market, these portfolios are constructed by calendar-time (at the beginning
of every month) instead of event-time (i.e. using the exact announcement date). This
calendar-time approach has the advantage of providing an easy to implement invest-
ment strategy, since it resolves the problem of look-ahead bias (all the necessary
information is available on the portfolio formation date). Moreover, it facilitates the
construction of a self-nanced portfolio (the buying and selling positions are made
simultaneously).
The process of portfolio construction is as follows. First, at the beginning of every
calendar month t (formation date) all the stocks with current data (of return, size
and BTM) and earnings surprises in the previous 3 months
3
are selected and ranked
according to earnings surprise. In cases in which there were more than one earnings
surprise in the three previous months, we take the most recent. Next, three equally-
weighted portfolios with the same number of stocks are constructed:
4
portfolio C1
corresponds to the 1/3 low surprises, portfolio C2 to the 1/3 medium surprises, and
portfolio C3 to the 1/3 high surprises. These portfolios are held over the following 3,
3
Given the unequal monthly distribution of the SUE surprise, forming the portfolios according to the
previous months surprise will result in very low diversied portfolios in some formation dates.
4
Given the small cross-section of the Spanish stock market, we consider it more appropriate to work with
three portfolios instead of quintiles or deciles, in order to improve the portfolio diversication.
1 3
6, 9 and 12months (holding period). Then, a zero-cost investment strategy which buys
the C3 portfolio and short-sells the C1 portfolio is formed (PAD strategy).
Since we require earnings surprise data for the previous 3 months and because of
the small number of available observations of SUE surprises in the rst months of
1993, we have chosen January 1994 as the rst formation date in all cases.
In order to study the PAD strategy behaviour, we calculate the return an investor
would have obtained in every calendar month, if he had followed the sequence of
purchases and sales of the PAD strategy at the beginning of each month, and had held
these positions for h = 3, 6, 9, 12months. This return is computed as the average
return of all stocks implied in the strategy that month. It is important to understand
that during calendar month t , the PAD strategy is formed by the high earnings surprise
portfolio (C3) and low earnings surprise portfolio (C1) constructed in the last h for-
mation dates. Therefore, every calendar month we will have h portfolios C1 and C3,
reviewing 1/h of their stocks at the beginning of each month. For example, during
calendar month t , the PAD strategy with a holding period of h = 3 will be formed by
portfolios C1 and C3 constructed at the beginning of months t 2, t 1 and t . At
the beginning of the next calendar month, t +1, the position on portfolios C1 and C3
constructed in the month t 2 will be eliminated and replaced by the new portfolios.
Following this procedure we obtain a return for each calendar month and for each
portfolio:
R
c,t
; t = 01/94, 02/94, . . . , 12/03
; c = C1, C2, C3 (3)

where R
c,t
is the return in calendar month t of portfolio c. The PAD return of each
calendar month is the difference between the high and lowearnings surprise portfolios,
R
PAD,t
= R
C3,t
R
C1,t
; t = 01/94, 02/94, . . . , 12/03
(4)
The return for each calendar month t can be calculated as an equally weighted
average of the returns of the portfolio stocks that month. In this case, we are assuming
that the portfolios rebalance their composition each month throughout the holding
period to keep the initial equal-weight: rebalancing portfolios. Another alternative
consists of keeping the portfolios throughout the holding period without making any
readjustment: buy-and-hold portfolios. In this case, since the portfolios lose their initial
equal-weight as their stock returns differ, it is rst necessary to obtain the weight of
each stock inside the portfolios each calendar month. We have decided to use buy-
and-hold portfolios given their advantages over rebalancing portfolios, mainly from
the point of view of transaction costs, as well as to avoid the biases associated with
the rebalancing portfolios (see Blume and Stambaugh 1983; Barber and Lyon 1997;
Lyon et al. 1999).
5
These weights are also used when we calculate the size and BTM
characteristics of the portfolios.
5
The buy-and-hold procedure has mainly been used in the nancial literature for diverse reasons. Among
them, the price spread bias seems to have less impact on the buy-and-hold procedure and, the rebalancing
procedure looks less attractive in terms of transaction costs and, perhaps, less tted for a medium/long
investment horizon.
1 3
Finally, an important question to consider is what happens when a stock is de-listed
during the holding period. We have decided to replace the de-listed stock return by
the average return of the remaining stocks in the portfolio. If the PAD effect really
exists, the most logical strategy is to invest the amount obtained by the liquidation of
the de-listed stock in the remaining titles in the portfolio.
3 Post-announcement drift prots
In this section we analyse the average returns provided by the PAD strategy. Given
that the JarqueBera test broadly rejects the normality hypothesis for most of the strat-
egy returns series, the Generalized Moment Method methodology (GMM) is used to
compute the p values in all the tests carried out in this section (the results with t
standard p values are quite similar). We have used as moment conditions the orthogo-
nality condition between the instruments (Z) and the residuals dened by the equation
Z
(y X) = 0. We have taken the explicative variables as instruments (Z = X),

so the estimator is the same as with OLS. We have used the heteroscedasticity and
autocorrelation consistent weighting matrix with the Bartlett Kernel option and the
xed bandwidth selection of NeweyWest. The explanatory variables are those spec-
ied in each regression. When we test average returns we use the constant only as an
explanatory variable.
Table 2 shows the average monthly returns for both SUEand REVsurprise measures
with holding periods of 3, 6, 9 and 12months. The SUEPAD strategy yields positive
and statistically signicant returns for the 3 and 6-month holding periods and the REV
PADstrategyfor all the holdingperiods. However, for anyholdingperiod, higher return
levels are obtained with the SUE measure. In addition, the results show the existence
of a decreasing relationship between the PAD return and the holding period length.
We have checked the robustness of the previous results by using a bootstrap analysis.
Concretely, we have used the procedure proposed by Lyon et al. (1999), who apply
the bootstrap methodology to the asymmetry adjusted t-statistic developed by Johnson
(1978). This methodology has been applied using 10,000 repetitions with replacement
and bootstrap samples with the same size as the original sample (120 observations).
Table 2 PAD average monthly return for different holding periods
h
Panel A: SUE Panel B: REV
3 6 9 12 3 6 9 12
R% 0.7161 0.5649 0.4232 0.3523 0.4732 0.4447 0.3819 0.2634

GMM p value [0.004] [0.023] [0.104] [0.144] [0.001] [0.001] [0.003] [0.034]
Bootstrap p value [0.008] [0.022] [0.086] [0.103] [0.004] [0.006] [0.018] [0.064]
Average monthly calendartime returns,

R, of the cost-zero strategy that buys the favourable earnings
surprise portfolio (C3) and sells the unfavourable surprises portfolio (C1), and keep these positions during
the next h months. p values calculated with GMM and with bootstrap
1 3
The p values obtained with this procedure are in the last row of Table 2. These results
conrm those obtained with the GMM p values.
We have also checked the robustness of these results to: (i) The calculation of
cumulative buy-and-hold returns for the 12months after the formation date. Given
that these data overlap, we use a moving block version of the bootstrap (Efron and
Tibshirani 1993) consistent with autocorrelation. (ii) The use of the rms total asset,
market capitalization or standard deviation of unexpected earnings instead of
the rms book-value to standardise the SUE measure. To obtain a trustworthy
estimation of standard deviation, eight quarterly observations are required (current
quarter plus the seven previous). This restriction results in a reduction of the nal
number of earnings surprises we can calculate, so the analysis with this alternative
measure is restricted to the period 19992003. (iii) The use of actual earnings instead
of FY
i,t
in the denition of REV (Eq. 2):
X
i,y(d)
FY
i,d1
/FP
i,y
, where X
i,y(d)
is
the earnings of company i for year y (announced on day d) and FY
i,d1
is the earnings
consensus forecast for rmi for year y published on day d1. This alternative reduces
the surprise observation frequency to annual, given that the analyst forecasts are only
for annual earnings. Therefore, the portfolios are constructed annually every April. As
we construct the portfolios yearly, 12-month holding periods are required in order to
have the complete sequence of monthly calendar returns, fromApril 1994 to December
2003.
6
All these results are available for any interested parties.
We have also examined whether the SUE and REV measures both have explana-
tory marginal powers or, on the contrary, one of them subsumes the other. To do this,
following Liu et al. (2003), we have used a double-rank portfolio construction pro-
cedure. The intersection of the three SUE and REV PAD strategies results in nine
portfolios. Then we construct two PAD strategies, one using SUE and the other using
REV, controlling for the inuence of the other surprise measure in the same way
as Fama and French (1993) factors. Additionally, we also construct a mixed invest-
ment strategy that buys those stocks that simultaneously have the best SUE and REV
surprises and short-sell those stocks that simultaneously have the worst SUE and
REV surprises. The results, not presented but available for any interested parties,
show that although both strategies are highly related, they have additional explanatory
power.
In the following sub-sections we subject the PAD strategy prots to a large number
of adjustments: CAPM, Fama-French three-factor model, liquidity factor, control port-
folios and momentum. Hereafter, we only present the 6-month holding period to sim-
plify the presentation of results. This is the period also used by Liu et al. (2003), as
6
When we use this alternative surprise measure, which changes FY
i,t
to the actual earnings in the denition
of REV, the PADstrategy yields a rawreturn of 1.1754%(GMM p value of 0.000 and a bootstrap p value of
0.000). This return is higher that that observed with the REV measure. As an anonymous referee suggested,
this increase in the PAD return could be due to the fact that the REV does not exactly measure surprises
in earnings, but revisions or surprises in analyst forecasts. Since forecasted earnings are only imprecise
estimates of actual earnings, the magnitude of investor reaction should be smaller. The drawback of this
alternative surprise measure is the signicant reduction in the observation frequency, with only ten formation
dates (one each year from 1994 to 2003).
1 3
well as in many of the highly related momentum anomaly works. Notwithstanding, in
the last subsection we discuss the results obtained with the other holding periods.
3.1 PAD prots and the CAPM model
First, we consider the CAPM model to examine whether the return-risk relation-
ship explains the pattern detected in the post-earnings announcement returns. More
precisely, we adjust the ex-post CAPM version running a time-series regression on
monthly returns of each portfolio,
(R
c,t
r
t
)=
c
+
c
(R
M,t
r
t
)+
t
, t =01/94, 02/94,,12/03
c=C1, C2, C3, and PAD = (C3 C1) (5)

where r
t
is risk-free asset return on calendar month t, R
M,t
is the value-weighted
7
market portfolio return on month t,
c
is market risk of portfolio c, and
c
is Jensens
alpha, which gauges the abnormal return.
The two rst rows of each portfolio in Panel A of Tables 3 and 4 show the results of
this analysis for the SUE and REV measures respectively. First, we nd that the risk-
adjusted returns increase with the surprise level for both earnings surprise measures. In
addition, we reject the hypothesis of equality between the returns achieved with each
portfolio (Chi-squared statistics of 5.21 and 13.48 for SUE and REV respectively).
In this sense, the results support the proposal that an earnings surprise affects the
stocks average return in the holding period. We also nd that the PAD strategy yields
signicantly positive risk-adjusted returns for both surprise measures.
8
With regard to the betas pattern, it has a U-shape for the SUEmeasure, meaning that
the portfolios with extreme surprises are riskier than intermediate portfolios, although
there are no signicant differences in the risk level between the best and worst earnings
surprise portfolios. However, when the REV measure is used, we observe that the
stocks of the best surprises portfolio, with higher returns, are less risky than the stocks
of the worst. So, we nd a negative relationship, as opposed to the positive prediction
of the CAPM.
3.2 PAD and size and book-to-market characteristics
We have just veried that the returns differences do not seem to have their origins
in market risk differences, as proposed by the CAPM. Nevertheless, the nancial
literature has shown that the size characteristic (market capitalization) and BTM ratio,
along with the market beta, play an important role in explaining the cross-section
7
The results are robust to the use of an equally weighted market portfolio instead of the value-weighted
portfolio. These results are available to any interested parties.
8
We also observe that both the raw returns and the CAPM alphas are lower for the REV than for the SUE
measure for each of the three portfolios. This difference could be due to an upward bias in analyst forecast.
The reluctance of analysts to give bad forecasts could make low REV surprises more bad-signalling than
low SUE surprises and high REV surprises less good-signalling than high SUE surprises.
1 3
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1 3
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1 3
dispersion of expected returns. A stocks mean returns tend to decrease (increase) as
the size (ratio BTM) goes up. Therefore, it is possible that the pattern observed in the
returns is no more than a consequence of the stocks with favourable (unfavourable)
surprises being on average small (big) stocks and with higher (lower) BTM ratios.
Here we examine the size and BTM characteristics for the different portfolios. The
rst row for each portfolio in Panel B of Tables 3 and 4 show this information. We
observe that the best SUE surprise portfolios, C3, exhibit a lower BTM ratio than the
worst portfolios, C1, although their size levels are similar. Favourable REV surprise
portfolios have higher size levels than the unfavourable REV portfolios, with similar
BTM ratios. Summarising, the size and BTM characteristics of the extreme surprise
portfolios are either not relevant or have a sign opposed to what is expected if the PAD
phenomenon was simply a support of the well-known size and book-to-market effects.
As with Liu et al. (2003), our evidence makes the understanding of this phenomenon
more difcult still.
3.3 FamaFrench three-factor model
So far, we have established that neither the CAPM market beta nor the size and BTM
ratio characteristics are able to separately explain the PAD prots. In this section we
study what happens when these three variables are considered jointly through the
FamaFrench three-factor model (1993). This model adds two additional factors to
the CAPM:
E(R
i
) = r +
i
[E(R
M
) r] + s
i
E(SMB) + h
i
E(HML) (6)
where SMB is the small stocks return minus the big stocks return. HML is the
difference between the higher BTM portfolios returns and those of the lower BTM
portfolios.
Panel Aof Tables 3 and 4 (third and fourth rowof each portfolio) reports the results
obtained when we adjust the ex-post version of the FamaFrench three factor model
(1993) to the time-series of monthly returns running the next time-series regression:
(R
c,t
r
t
) =
c
+
c
(R
M,t
r
t
)+s
c
SMB
t
+h
c
HML
t
+
t
,
t = 01/94,02/94,,12/03} c = C1, C2, C3, and PAD = (C3 C1) (7)
where the SMB and HML factors are calculated following Fama and French (1993).
In general, the SMB and HML factors loadings are statistically signicant for the
C1, C2 and C3 portfolios. So, we conrm that these factors capture common variation
in stock returns missed by the market return. However the coefcients associated with
the new factors are not statistically signicant for the PAD strategy. Moreover, there is
no signicant change between these alphas and those of the CAPM model. Therefore,
the FamaFrench model would not be able to explain the PAD strategy abnormal
returns.
1 3
3.4 Control portfolios by size and BTM ratio
We have just found that PAD strategy prots do not disappear when we use the Fama
French three-factor model (1993). However, Lyon et al. (1999) report that an alterna-
tive procedure consisting of monthly calendar returns adjusted by size and BTM ratio
control-portfolios provides more conservative tests. This procedure presents some
advantages over the FamaFrench three-factor model. The rst is that it does not
require linearity in the three factors and it allows interaction between them. Further-
more, Mitchell and Stafford (2000) suggest that the FamaFrench model regression
assumes that factor sensibilities are constant throughout time, 120months in our case.
This situation seems quite improbable since the portfolio composition changes every
month. Additionally, Daniel and Titman (1997) note that the average returns cross-
section variation is better explained by characteristics than by factor sensitivity.
Bearing this evidence in mind, in this section we analyse the PAD strategy prots
using the control portfolios procedure. At the start of each month t , we construct a
total of nine portfolios according to a double criterion ranking: three size portfolios
and three BTM ratio portfolios. We take the size and BTM ratio of the previous month
(t 1) and we use the 1/3 and 2/3 percentiles as breaking points. Next, we calculate
the returns of these portfolios for month t . Finally, we take each stock return and
subtract the control-portfolio return to which the stock belongs. The PAD returns are
calculated with the new adjusted returns.
The composition of the control portfolios is updated at the beginning of every month
and it can change throughout the holding period. This procedure is similar to that used
by Nagel (2001), Lee and Swaminathan (2000) and Moskowitz and Grinblatt (1999)
on the analysis of the momentum effect.
The second row for each portfolio in Panel B of Tables 3 and 4 shows the mean
control-portfolios adjusted returns. We observe that the PAD strategy prots decrease
with regard to those obtained with the FamaFrench model although they are still
highly signicant. Therefore, these results conrm that possible risk factors related to
the size and BTM ratio characteristics do not seem to explain the high PAD strategy
returns.
3.5 PAD and liquidity risk
There is some recent literature that demonstrates that liquidity risk is a factor priced in
the market (see, for example Pastor andStambaugh2003; Acharya andPedersen2005).
Stocks whose returns decrease in adverse liquidity shocks (with positive covariances
relative to market-wide liquidity) are required to offer extra expected returns. As Sadka
(2006) suggests, portfolios that are formed to test market anomalies often involve high
portfolio turnover (as is the case of the PAD strategy) and are therefore likely to be
subject to liquidity concerns. In this sense, Pastor and Stambaugh (2003) nd that their
liquidity risk factor accounts for half of the prots of a momentumstrategy, and Sadka
(2006) shows that a substantial part of momentum and PAD returns can be viewed as
compensation for the variable component of liquidity risk.
1 3
The liquidity literature has suggested different alternatives to proxy the liquidity
factor. Martinez et al. (2005) evaluate three competing liquidity factors in the Spanish
market and nd that systematic liquidity risk is signicantly priced in the Spanish stock
market exclusivelywhenthe Amihud(2002) illiquidityalternative is used. Miralles and
Miralles (2006) also nd favourable results for this illiquidity measure. The Amihud
(2002) illiquidity ratio for stock j in month t is given by
ILLG
j,t
=
1
D
j,t
D
j,t
d=1
R
j,t,d
V
j,t,d
(8)
where R
j,t,d
and V
j,t,d
are, respectively, the return and euro volume on day d in month
t , and D
j,t
is the number of days with observations in month t of stock j . This measure
is multiplied by 10
6
. A high value of ILLQ indicates that the stock price moves a lot
in response to trading volume and, therefore, the stock is illiquid. The cross-section
aggregate of this measure gives us a proxy for the market-wide illiquidity factor. In
order to have a liquidity factor the illiquidity factor is multiplied by minus one.
Panel A of Tables 3 and 4 (fth and sixth row of each portfolio) reports the results
obtained when we adjust the ex-post version of the FamaFrench three factor model
(1993) augmented with this liquidity factor to the time-series of monthly returns:
(R
c,t
r
t
) =
c
+
c
(R
M,t
r
t
) + s
c
SMB
t
+ h
c
HML
t
+ l
c
LQ +
t
,
t =1/94,2/94,,12/03} c = C1, C2, C3 and PAD = (C3 C1) (9)
where LQis the liquidity factor. Despite the favourable evidence obtained by Martinez
et al. (2005) and Miralles and Miralles (2006) for this risk factor, the inclusion of
this additional factor does not improve the specication of the model when earnings
surprise portfolios are analysed. The adj-R
2
are quite similar to those obtained with the
Fama and French model and the coefcients of the liquidity factor are, except for the
REV-C3 portfolio, not statistically signicant. Moreover, the level of PAD abnormal
returns increases, instead of reducing. Although the PAD abnormal return for the SUE
measure is not statistically signicant, the loss of signicance is originated by the
increase of the standard error of the coefcient estimation, probably caused by the
inclusion of a non-relevant explicative factor.
3.6 PAD versus momentum
Along with the PAD, another important phenomenon detected in the return behaviour
is the momentum effect of Jegadeesh and Titman (1993): the winner stocks (those
with higher returns in the previous 312months) continue beating the loser stocks
(those with lower returns) in the following 312months. As the winner (loser) stocks
are probably stocks with favourable (unfavourable) past news, and since the earnings
announcements are the most important regularly disclosed corporate information, we
can suppose that there is a relationship between momentumand PAD. The relationship
1 3
between momentum and PAD has been studied by Chan et al. (1996), Chordia and
Shivakumar (2006) for the US market and Liu et al. (2004) for the UK market.
Regarding the Spanish momentum evidence, Forner and Marhuenda (2006) nd
that, although its presence is very robust before 1990, this phenomenon seems to
weaken considerably in the nineties. Consistent with this previous evidence, we do
not observe momentum in our analysis period (19942003). Specically, we nd that
the momentum strategy that buys (sells) at the beginning of every month the rst 30%
of stocks with higher (lower) returns in the months 7 . . . , 2 and keeps them for the
following 6 months (1 . . . , 6),
9
provides an average return of 0.3397 ( p value: 0.285)
and a Jensens alpha of 0.4415 ( p value: 0.169).
However, in spite of the weakness of the momentum effect in our study period, it
is interesting to analyse the relationship between this effect and the PAD effect. To do
this, we rst adjust the PAD returns by adding a fourth momentum factor to the Fama
and French (1993) model which is the return of the momentum strategy previously
described:
10
(R
c,t
r
t
) =
c
+
c
(R
M,t
r
t
) + s
c
SMB
t
+ h
c
HML
t
+ m
c
MOM +
t
,
c = C1, C2, C3 and PAD = (C3 C1) (10)
The results of this regression are shown in Panel A of Tables 3 and 4 (seventh
and eighth row of each portfolio). For both SUE and REV surprise measures, the
PAD strategy returns are positive and signicantly affected by the momentum factor.
Nevertheless, only when the earnings surprise is measured by SUE, can this model
explain the PAD returns. For the REV surprise, the PAD strategy keeps providing
signicantly positive abnormal returns after tting this four-factor model.
In order to look deeper into the relationship between these two phenomena, we
use a double-criterion portfolio construction procedure classifying by past earnings
surprises and past returns. At the beginning of each month (formation date) we form
three portfolios with the same number of stocks based on the earnings surprise (C1,
C2 and C3), and simultaneously and independently we form three portfolios using
the return in the months 7, . . . , 2 (PR1, PR2 and PR3), this time using the 30 and
70% percentiles. The intersection of these portfolios results in nine portfolios that are
held for the next 6months. For example, the [C1; PR1] portfolio will contain stocks
which have simultaneously experienced an unfavourable earning surprise and poor
past return performance. Finally, a PAD strategy orthogonal to the momentum effect
is constructed in the same way as Fama and French (1993) when they constructed their
orthogonalized factor portfolios:
9
It is usual to jump a month between the ranking period (7, . . . , 2) and the holding period (1, . . . , 6)
in order to avoid possible effects related to the market microstructure.
10
This is the most commonly studied momentum strategy. However, the rst study to include this
factorCarhart (1997)classies the winner and loser stocks according to the returns yielded in months
12, . . . , 2 and keeps them for only 1month. The results obtained when the factor is constructed in this
way are very similar and are available for interested readers.
1 3
Table 5 PAD versus Momentum
SUE REV
PAD
ctr.Mom
PAD&MOM PAD
ctr.Mom
PAD&MOM
R% 0.5264 0.9720 0.3019 0.7815

[0.042] [0.029] [0.024] [0.052]
% 0.4972 1.0297 0.3046 0.8980
[0.052] [0.022] [0.022] [0.034]
Mean return (

R) and CAPMJensens alpha () of the PADstrategy controlled by momentum[PAD
ctr.Mom
],
as well as of the mixed strategy PAD&MOM. Six-month holding period. In brackets are the GMM p values
PAD
ctr.Mom
=
[C3; PR1] + [C3; PR2] + [C3; PR3]
3
[C1; PR1] + [C1; PR2] + [C1; PR3]

3
(11)
If this strategy does not provide signicant returns it means that the PAD phenom-
enon is explained by the momentum effect. Additionally, a mixed investment strategy
that simultaneously considers both phenomena is constructed:
PAD&MOM = [C3; PR3] [C1; PR1] (12)
Table 5 shows, for both SUE and REV earnings surprise measures, the mean return
and the Jensens alpha of the two previously proposed strategies. Although the mag-
nitude and p values of the PAD
ctr.Mom
strategy returns decrease, these continue being
signicantly positive. Unlike the results obtained with the previous analysis for the
SUE surprise measure, these new results indicate that the PAD phenomenon, although
related, has additional explanatory power beyond the momentum effect. Additionally,
the PAD & MOM strategy return is greater than that provided by both strategies sepa-
rately, which again suggests that both phenomena have additional explanatory power.
However, although the PAD & MOM strategy return is signicant, it is less so than
the PAD strategy return. However, this is probably the logical consequence of a worse
diversication of the PAD & MOM strategy.
11
3.7 Sub-period analysis and robustness to other holding periods
In this section we examine the robustness of the PADphenomenon throughout different
sub-periods. The monthly average return of the PAD strategy for each year of the
11
Despite there being no signicant momentum effect observed in the Spanish market in the analysed
period, the results show that the momentum effect explains part of the PAD phenomenon. One explanation,
from a market inefciency point of view, could be that both, momentum and PAD, reect an under-reaction
to recent news but, since momentum identies stocks with good (bad) news indirectly via past return
performance, the stock selection process is not as good as the PAD process, which identies stocks with
good (bad) news via one of the most important information disclosures: the earnings announcement.
1 3
sample period shows that the SUEPAD seems to be especially concentrated in the
second half of the period, while the REVPAD exhibits high stability throughout the
whole period. When the REV surprise is used, we only observe a monthly average
negative return in the last year analysed, 2003, but the magnitude is quite reduced
(0.01%). In addition, the PADstrategy return is analysed for two sub-periods: 1994
1998 and 19992003. When we use the SUE measure, we nd that the PAD strategy
only provides signicantly positive returns (both raw and CAPM-adjusted) in the
second sub-period. However, when we use the REV measure, the PAD strategy is
protable for both sub-periods (even after adjusting for risk).
We have also replicated the previous analyses for the three, nine and twelve holding
periods. The results are in general consistent with those presented for the 6-month
holding period. The only one peculiarity to highlight is that, although the SUEPAD
strategy did not yield signicant positive raw returns for the 9 and 12 month holding
periods (Table 2), they show signicant positive abnormal returns when the Fama and
French three factor model and the sizeBTM control portfolios adjustments are used.
All the results of this subsection, although not presented, are available upon request.
4 Conditional analysis
The evidence obtained in the previous sections has shown the difculty in explaining
stock price trends over the 6months after an earnings announcement. However, it is
important to consider that, until now, we have based our study on an unconditional
risk adjustment. If the expected returns are time-varying, it could explain why these
unconditional adjustments are not able to capture this phenomenon.
This possibility has been analysed in the context of the momentum anomaly by
Chordia and Shivakumar (2002), Wu (2002), and Grifn et al. (2003), among others.
However, it has not had enough attention in the case of the PAD. In order to do this
analysis we have taken two different approaches: one following the work of Chordia
and Shivakumar (2002) and another following Ferson and Harvey (1999).
4.1 PAD and business cycle risk
Chordia and Shivakumar (2002) show that momentum prots can be explained by a
set of lagged macroeconomic variables. These prots disappear once stock returns are
adjusted for their predictability based on these variables. The authors suggest that their
results provide a possible role for time-varying expected returns as an explanation for
momentum. In this section we apply this approach in the context of the PAD strategy.
For each stock i and for each month t , the predicted return is the one-period-ahead
forecast from the following regression:
R
i,t
= c
i,0
+ c
i,1
BTM
agr
t 1
+ c
i,2
DIV
agr
t 1
+ c
i,3
TE
t 1
+ e
i,t
(13)
where BTM
agr
and DIV
agr
are the aggregate BTM and aggregate dividend-yield ratio,
both calculated as the cross section average of the individual ratios, and TE is the
1 3
Table 6 PAD monthly returns after adjusting for returns predicted by the business cycle
SUE REV
Adj.% Adj.-jandum% Raw% Adj.% Adj.-jandum% Raw%
0.6956 0.5257 0.4197 0.6662 0.7299 0.4303
[0.421] [0.547] [0.080] [0.167] [0.082] [0.001]
Adjusted stock returns are measured as the unexplained portion (intercept and predicting error) of the
following model: R
t
= + Z
t 1
+ JANDUM
t
+ e
t
, where Z is a vector representing the variables
aggregate book-to-market, aggregate dividend yield and the term spread. JANDUM (included only in the
estimation of Adj.-jandum) is a dummy variable that takes the value 1 for January and 0 in all other months.
The model parameters are estimated using data fromtime t 1 through t 60 with a minimumof 2 years of
data. The table also presents the rawreturns fromthe PADstrategy for the subsample used in the computation
of the adjusted returns. In brackets are the GMM p values
term spread, measured as the difference between the average yield of 10-year Trea-
sury bonds
12
and the 1-month risk-free rate.
13
The parameters of the model, c
i, j
, are
estimated each month, for each stock, using the returns of the previous 60months. We
restrict this regression to stocks that have at least 24 observations over the estimation
period.
The holding period returns for each stock are now adjusted for the predicted return
obtained from model (13), and represent the unexplained portion of returns dened as
the intercept plus the predicting error. Table 6 presents the average returns of the PAD
strategyusingthese adjustedreturns. For bothsurprise measures, the PADstrategydoes
not yield signicant adjusted returns. When we include a January dummy the results
are quite similar. These results show that earnings surprises have not predictive power
in future returns once we have controlled by the predictive power of the economic
cycle.
To reduce the noise in the parameter estimates that arises with the use of individual
stock regressions in Eq. (13), the same analysis is replicated but this time directly
regressing the raw returns of the PAD strategy on the macroeconomic predictor vari-
ables. Again we use the past 5 years of data to estimate the parameters to predict the
1-month-ahead payoffs, but now we only require 1 year of data for these regressions.
12
We have checked the robustness to the use of zero coupon rates for 10-year maturity instead of aver-
age yield of 10-year Treasury bonds. The zero coupon rates have been calculated with the methodology
developed in Contreras et al. (1996) where the Vasicek and Fong (1982) term structure estimation method
is adapted to the Spanish Treasury market. We thank Antonio Daz Prez for offering this valuable data
on his website http://www.uclm.es/area/aef/Etti.asp. Both variables are highly correlated (99.66%) and the
results, available for any interested parties, are quite similar.
13
Chordia and Shivakumar (2002) use lagged values of market dividend yield, default spread, termspread,
and yield on the 3-month T-bills as explicative variables. For data availability we use the aggregate BTM
instead of the default spread. In this sense, Nieto and Rodrguez (2002) show the relative ability of this
variable to predict future returns in the Spanish market over the period 19821999. This evidence is con-
rmed in our sample, where the OLS regression of the quarterly equally-weighted market returns against
the lag of the aggregate BTM has a coefcient of 0.10168 with a t-statistic of 4.0044 (these results hold for
a value-weighted index, as well as for a Newey-West adjustment). Moreover, we have checked our results
with the inclusion of our risk-free rate instead of the 3-month T-bills used by Chordia and Shivakumar
(2002) as independent variable and the results are quite similar.
1 3
Table 7 PAD monthly returns after adjusting for returns predicted by the business cycle
RES% INT% JANDUM% BTMagr DYTagr TE
Panel A: SUE
Averaged coef. 1.5191 1.4827 0.0046 0.7566 3.4664
p value [0.222] [0.268] [0.473] [0.138] [0.003]
Averaged coef. 0.1008 0.2849 0.4658 0.0066 0.364621 3.0408
p value [0.951] [0.867] [0.500] [0.167] [0.547] [0.008]
Panel B: REV
Averaged coef. 0.8801 1.0735 0.003529 0.1096 3.6118
p value [0.159] [0.116] [0.097] [0.653] [0.000]
Averaged coef. 0.7199 1.0266 1.1449 0.006699 0.1323 3.9994
p value [0.294] [0.179] [0.000] [0.006] [0.611] [0.000]
Average coefcients of the following model: R
PAD,t
= + Z
t 1
+ JANDUM
t
+ e
t
, where Z is a
vector representing the variables aggregate book-to-market, aggregate dividend yield and the term spread.
JANDUM (included only in the estimation of Adj.-jandum) is a dummy variable that takes the value 1 for
January and 0 in all other months. The model parameters are estimated using data from time t 1 through
t 60 with a minimum of 1 year of data. The need of an estimation period reduces the analysed period
from January 1995 to December 2003. In brackets are the GMM p values
The unexplained returns (RES) for each month are calculated as the estimated intercept
(INT) plus the predicting error.
The time-series averages of RES and the coefcients on predictor variables are pre-
sented in Table 7. These results conrm those observed in the previous analysis: none
of the two strategies yield signicant adjusted returns, whether the January dummy
is included or not. Regarding the predictive power of the explicative variables, the
coefcient of the aggregate BTM is relevant with the REV surprise strategy, while the
termspread shows signicant coefcients for both PADstrategies. This result suggests
systematic differences across the best and worst earnings surprise portfolios in their
exposures to the business cycle.
There is alternative analysis of the possible relation between PAD prots and the
economic cycle. It consists of examining the returns of the strategy in good and bad
economic states. If the strategy yields bad returns in states when investors have high
marginal utility this makes this strategy risky and it would explain its high prots.
Following Grifn et al. (2003) we use seasonally adjusted real GDP growth
14
as well
as the value-weighted market index to identify good and bad economic states. Table 8
shows the average return of the PAD strategy in states with positive and negative
values of these variables, as well as for their three terciles. Contrary to what would
be expected in a risk explanation of the PAD phenomenon, the returns of the PAD
strategies tend to be higher in bad states. Only when the positive and negative GDP
growth states are considered is this not true, but the reduced number of negative GDP
growth months (only six) leads us to view this last result with scepticism.
14
Data collected from the Instituto Nacional de Estadstica (http://www.ine.es/).
1 3
Table 8 PAD and Macroeconomic States
GDP Market
<0(6) >0(114) 1 2 3 <0(50) >0(70) 1 2 3
SUE 0.0010 0.5946 1.0806 0.5852 0.0605 0.9188 0.3121 0.6619 0.4730 0.5598
[0.998] [0.021] [0.004] [0.081] [0.923] [0.005] [0.349] [0.101] [0.147] [0.245]
REV 0.1911 0.4580 0.7363 0.4623 0.0839 0.6896 0.2698 0.8482 0.3956 0.0902
[0.565] [0.002] [0.012] [0.027] [0.730] [0.005] [0.167] [0.005] [0.082] [0.732]
PAD average returns (%) in different economic states based on quarterly real GDP growth: negative and
positive GDP growth rates as well as GDP tertiles. Analogous results are presented using the value-weighted
market index. In parenthesis the number of months with negative of positive values of the state variable.
GMM p values in brackets
This evidence of countercyclical PAD returns is consistent with the evidence
observed by Chordia and Shivakumar (2006) in the US market. They regress future
GDPgrowth on lagged values of the PADreturns and the FamaFrench factors and nd
that the coefcient on PAD returns is signicantly negative, irrespective of whether
FamaFrench factors are included as additional explanatory variables. We have repli-
cated the analysis of Chordia and Shivakumar (2006), regressing the compounded
growth in seasonally adjusted real GDP over months t + 1 through t + 12 on the
compounded returns of the PAD and the FamaFrench factors over months t 11
through t . As only quarterly GDP data is available, the regressions use quarterly data:
GDP
[t +1:t +12]
= c
t,0
+ c
t,1
PAD
[t 11:t ]
+ c
t,2
Mkt
[t 11:t ]
+ c
t,3
SMB
[t 11:t ]
+c
t,4
HML
[t 11:t ]
t = 12/94, 3/95, 6/95, . . . , 12/03 (14)
The results of this regression are shown in Table 9. For the SUE surprise (similar
to the SUE measure used by Chordia and Shivakumar 2006) we also observe a sig-
nicantly negative coefcient on PAD lagged returns. However, for the REV surprise
measure the coefcient is not signicantly different from zero.
In summary, the different results observed in this section suggest that, although the
PAD returns are related to the macroeconomy and they can be explained by lagged
values of macroeconomic predictor variables, the negative correlation between PAD
returns and the economic cycle is inconsistent with PAD being a compensation for
macroeconomic risk exposure. Chordia and Shivakumar (2006) suggest that the study
of Chordia andShivakumar (2005) offers one potential explanation, arguingthat under-
reaction to earnings surprise partly results from an ination illusion.
4.2 Conditional CAPM and FamaFrench three factor model
In this section we apply a conditional version of the previously used asset price mod-
els (the CAPM and the three-factor FamaFrench models) which include information
about the economic moment. With these models we will allow risk loading and, there-
fore, the expected returns, to be time-varying depending on the available information at
1 3
Table 9 Regression of 12-month-ahead growth in real GDP on 12-month compounded PAD and Fama
French factors
Factors SUE REV
I II I II
Intercept 0.034179 0.036065 0.036637 0.033273 0.032152
[0.000] [0.000] [0.000] [0.000] [0.000]
PAD
[t 11:t ]
0.045070 0.034804 0.007042 0.033148
[0.040] [0.091] [0.885] [0.332]
Mkt
[t 11:t ]
0.021105 0.015840 0.023553
[0.003] [0.056] [0.005]
SMB
[t 11:t ]
0.014196 0.001465 0.022991
[0.257] [0.903] [0.107]
HML
[t 11:t ]
0.026064 0.025434 0.026163
[0.039] [0.030] [0.032]
R
2
adj.
0.415628 0.146244 0.496351 0.031343 0.411042
GMM p values in brackets
every moment. We incorporate this dynamism by using the Cochrane (1996) method-
ology of scaled models. Lettau and Ludvigson (2001) demonstrate that the conditional
versions of the CAPM perform better that the unconditional specication for the USA
market. Ferson and Harvey (1999) suggest that applications of the Fama and French
(1993) three-factor model should control for time-varying betas, and that doing so
provides some improvement in the USA market. Regarding the Spanish market, Nieto
and Rodrguez (2005) nd that, although the results are not altogether satisfactory,
there is some evidence in favour of the conditional versions of the CAPM and the
Fama and French (1993) models against the unconditional versions.
For the three-factor Fama and French (1993) model we have the following expres-
sion:
15
R
c,t
r
t
=
0,c
+
1,c
Z
t 1
0,c
+ Z
t 1
1,c
(R
M,t
r
t
)
SMB
t
HML
t
+
c,t
(15)
where Z is a vector of L 1 state variables which contain information about the state
of the economy, reecting investors return expectations, and
0,c
,
1,c
,
0,c
and
1,c
are the model parameters.
0,c
is a scalar,
1,c
is L 1,
0,c
is 31 and
1,c
is L 3.
We have used the same state variables as in the previous section: aggregate BTM
ratio, aggregate dividend yield, and the term spread. In this sense, Nieto (2004) shows
that the conditional models using aggregate BTM ratio and the aggregate dividend
yield as state variables work better than the static models. Nevertheless, given the
15
A similar approach is used in Wu (2002) for the analysis of the momentum effect.
1 3
level of correlation between the aggregate BTM and the aggregate dividend-yield
and term spread (0.239 and 0.214, respectively, both statistically signicant), we
have use the residuals of regressing the aggregate BTM over the other two state vari-
ables. In this way, the conditioning index (Belsley et al. 1980) of the equation (15)
is 17.11. According to these authors, only values above 20 have the possibility of
multicollinearity problems.
16
As a preliminary analysis previous to the study of Eq. (15), we run the earning
surprise portfolios returns on the lagged instruments, that is, only the rst parenthesis
of Eq. (15). The chi-squared test indicates that the lagged state variables are relevant
for predicting the future returns of the different surprise portfolios, suggesting that,
according to the previous section evidence, the earnings surprise portfolios expected
returns are time-varying depending on the business cycle. This is also true for the
PAD strategies (although only at a 10% level for the REV measure), indicating that
this time-varying behaviour is different between portfolios C1 and C3, a necessary
condition to provide explanatory power for the PAD returns. We have also analysed
the regressions for the FamaFrench three-factor portfolios on the lagged instruments.
Market and SMB factors have signicant chi-squared statistics, so they could help to
explain time-varying conditional expected returns. Consistent with Ferson and Harvey
(1999) the instruments do not seem to be relevant in predicting the HML portfolio
returns. The results of this regression are available for any interested parties.
Given this evidence, and as Ferson and Harvey (1999) suggest, it is possible that
the lagged instruments have explanatory power because they pick up time variation
in betas on the FamaFrench factors. This would imply that the FamaFrench model
should be implemented in a conditional form allowing the betas to be time varying, as
in Eq. (15). Table 10 shows the results of this equation for the FamaFrench model. We
have used the de-meaned state variables so the abnormal returns are reected directly
by
0
.
For the twoearnings surprise measures SUEandREV, the abnormal returns increase
sharply with the earning surprise levels, and the null hypothesis that all abnormal
returns are equal to zero is rejected (last column of each panel). Also, and most
importantly, the PAD strategy still provides highly signicant abnormal returns.
Consistent with the results of the preliminary analysis, the chi-squared statistics in
the last row of each factor show that there is more evidence of time-varying for the
market and SMB factors than for the HML factor. For the market and SMB factors,
two of the three earning portfolios have chi-squared statistics with p values under
5%, while for the HML factor, only one of the three portfolios has a signicant chi-
squared statistic. However, none of the factors have evidence of time-varying for the
PAD strategy (only the SMB factor of the SUEPAD strategy has a 10% signicant
chi-squared statistic), and this model is unable to explain the time-varying in the
PAD returns, given that the alphas are still time-varying (with signicant chi-squared
statistics).
17
16
When the aggregate BTM is used in Eq. (15) instead of the residuals, the conditioning index reaches a
value of 19.14, near the critical value of 20.
17
The conclusions reached with the conditional CAPM are quite similar. These results are available for
any interested parties.
1 3
Table 10 Conditional version of the three-factor model of Fama and French (1993)
SUE REV
C1 C2 C3 C3C1
2
C1 C2 C3 C3C1
2
(%) 0.056 0.542 0.647 0.7029 16.4182 0.125 0.179 0.435 0.560 16.1935
[0.799] [0.010] [0.025] [0.000] [0.001] [0.625] [0.457] [0.043] [0.001] [0.001]
res
t 1
(%) 1.330 1.412 0.254 1.0755 5.2639 1.248 0.474 0.602 0.646 2.4984
[0.380] [0.269] [0.878] [0.435] [0.154] [0.425] [0.696] [0.659] [0.595] [0.476]
DY
agr
t 1
(%) 0.771 51.929 118.087 117.32 11.9649 40.728 30.811 61.231 20.50 5.9053
[0.984] [0.153] [0.010] [0.245] [0.008] [0.335] [0.468] [0.066] [0.385] [0.116]
TE
agr
t 1
(%) 87.744 112.590 385.146 472.89 1.7918 620.553 307.682 17.686 638.24 11.2121
[0.759] [0.704] [0.407] [0.006] [0.617] [0.126] [0.367] [0.959] [0.001] [0.011]
2
1.1637 4.3783 6.9943 11.7100 3.0209 1.1395 4.2305 16.4387
[0.762] [0.223] [0.072] [0.008] [0.388] [0.768] [0.238] [0.001]
R
M,t
r
t
0.877 0.785 0.908 0.031 12.7915 0.934 0.887 0.857 0.076 5.5072
[0.000] [0.000] [0.000] [0.096] [0.002] [0.000] [0.000] [0.000] [0.026] [0.064]
xres
t 1
0.074 0.575 0.403 0.3290 23.0050 0.237 0.095 0.167 0.070 0.6753
[0.830] [0.053] [0.121] [0.568] [0.000] [0.233] [0.682] [0.436] [0.652] [0.713]
xDY
agr
t 1
10.446 2.624 6.741 3.705 4.5327 12.744 3.740 9.021 3.723 4.3870
[0.047] [0.501] [0.118] [0.852] [0.104] [0.008] [0.364] [0.021] [0.487] [0.112]
xTE
agr
t 1
60.999 36.328 6.344 54.655 4.2992 18.891 2.205 42.544 23.654 0.9323
[0.275] [0.509] [0.930] [0.716] [0.117] [0.738] [0.965] [0.429] [0.549] [0.627]
2
7.7825 3.9707 11.6213 2.0131 10.6177 1.6612 10.0610 1.1951
[0.051] [0.265] [0.009] [0.570] [0.014] [0.646] [0.018] [0.754]
SMB 0.583 0.306 0.770 0.187 32.6665 0.541 0.583 0.363 0.179 9.1106
[0.000] [0.000] [0.000] [0.431] [0.000] [0.000] [0.000] [0.000] [0.005] [0.011]
xres
t 1
0.198 0.072 0.360 0.1619 0.2904 0.802 0.197 0.395 0.407 4.3472
[0.626] [0.808] [0.377] [0.961] [0.865] [0.020] [0.464] [0.202] [0.127] [0.114]
xDY
agr
t 1
24.132 15.154 7.342 31.474 13.8961 20.155 8.229 2.037 18.118 15.3107
[0.041] [0.021] [0.573] [0.712] [0.001] [0.037] [0.393] [0.853] [0.192] [0.001]
xTE
agr
t 1
111.59 156.37 383.73 272.14 2.8007 301.24 213.28 169.89 131.35 1.2255
[0.527] [0.207] [0.004] [0.400] [0.247] [0.027] [0.169] [0.133] [0.302] [0.542]
2
4.3089 15.6948 12.8631 7.2712 10.0610 9.4912 5.9064 6.0515
[0.230] [0.001] [0.005] [0.064] [0.018] [0.023] [0.116] [0.109]
HML 0.230 0.031 0.124 0.106 22.7860 0.112 0.177 0.023 0.135 11.8269
[0.013] [0.704] [0.329] [0.000] [0.000] [0.224] [0.035] [0.815] [0.022] [0.003]
xres
t 1
0.066 0.837 0.812 0.746 3.0321 0.498 0.686 0.393 0.105 0.5962
[0.882] [0.030] [0.107] [0.343] [0.220] [0.244] [0.050] [0.480] [0.878] [0.742]
xDY
agr
t 1
16.382 8.557 5.460 21.842 7.5239 1.145 8.238 5.487 6.632 3.3149
[0.059] [0.269] [0.634] [0.707] [0.023] [0.910] [0.176] [0.613] [0.529] [0.191]
xTE
agr
t 1
4.118 199.812 159.073 163.19 2.9136 191.950 40.176 259.636 67.69 6.8068
[0.974] [0.063] [0.398] [0.057] [0.233] [0.140] [0.673] [0.050] [0.442] [0.033]
1 3
Table 10 continued
SUE REV
C1 C2 C3 C3C1
2
C1 C2 C3 C3C1
2
2
5.9543 7.9232 4.2594 3.6440 5.8014 5.8014 8.1048 0.7826
[0.114] [0.048] [0.235] [0.303] [0.122] [0.122] [0.044] [0.854]
R
2
adj.
0.8145 0.8253 0.7767 0.0286 0.8301 0.8520 0.8371 0.0707
Results of running the conditional version of the three-factor model of Fama and French (1993) to the
calendar-time monthly returns of the earnings surprise portfolios, C1, C2 and C3, as well as of the PAD
strategy that buys the favourable earnings surprise portfolio [C3] and short-sells the unfavourable one [C1]
Residuals of aggregated BTM ratios [RES], aggregated dividend yield [DY] and term spread [TE] have
been used as state variable. Six month holding periods. GMM p values in brackets.
2
columns are the
Chi-square statistics of the null hypotheses: H
0
:
C1
=
C2
=
C3
= 0; H
0
:
C1
=
C2
=
C3
The rows of
2
are the Chi-square statistics of the null hypotheses: H
0
:
res
=
DY
=
TE
= 0;
H
0
:
res
=
DY
=
TE
= 0
This result indicates that, despite the increase in their explanatory power (the R
2
of
the conditional models are in general higher that the unconditional version), this kind
of conditional models fail to explain the time-varying behaviour of PADportfolios, and
moreover, that the PAD prots remain highly signicant. These results are consistent
with the evidence of Nieto and Rodrguez (2005) that the conditional versions of these
models only provide slight improvements over the unconditional versions. As Nieto
and Rodrguez (2005) suggest, the benet of the conditional versions are limited when
short samples that do not include enough changes in the economic cycle are analysed,
as our case could be. Our evidence is also consistent with Ferson and Harvey (1999)
for the US market, which warn that even a conditional version of the model appears
to leave signicant predictable patterns in their pricing errors.
5 Pad and arbitrage risk
The results obtained in the previous sections have shown the difculty in explaining a
risk-based reason for the Spanish PAD. This evidence makes it very tempting to think
of a mispricing story. But, if in fact the PADphenomenon has its origin in a misreaction
of the investors to the information included in the earnings announcement, why do
arbitrageurs not exploit this drift as far as to eliminate it? The behavioural nance
literature suggests that there are some limits to arbitrage that could explain how this
could happen. In this sense, Wurgler and Zhuravskaya (2002) and Shleifer and Vishny
(1997) consider that many arbitrageurs are highly specialised and therefore hold a few,
relatively large positions at any one time. These authors propose that, in this realistic
scenario, securitys idiosyncratic risk matters (in contrast to the traditional portfolio
theory). Since the idiosyncratic risk cannot be hedged, this impedes arbitrage. So
according to this idea, stocks with higher idiosyncratic risk (also called arbitrage risk)
should be less attractive to arbitrageurs, and therefore, more probable to suffer from
misreaction to earnings announcement. Mendenhall (2004) demonstrates that in the
US market the PAD is positively related to the idiosyncratic risk.
1 3
In a similar way to Mendenhall (2004), we test this possibility by regressing com-
pound returns after the earnings announcement on earnings surprise and interaction
variable between this earnings surprise and the arbitrage risk. The interactions with
another ve variables are also included: explained (systematic) risk, price and vol-
ume (as proxies for transaction cost) and number of analysts (as proxy of investor
sophistication).
AR
i,[t :t +5]
=
0
+ X
i,t 1
[1, ARBRISK
i,t 1
, EXPRISK
i,t 1
, PRICE
i,t 1
,
VOL
i,t 1
, ANUM
i,t 1
]
X = SUE, REV (16)

AR
i,[t :t +5]
is the 6-month buy-and-hold returns adjusted by sizeBTMcontrol port-
folios from t to t + 5:
AR
i,[t :t +5]
=
t +5
=t
(1 + R
i,
)
t +5
=t
(1 + CR
i,
) (17)
where CR
i
is the sizeBTM control portfolio return for the stock i . These adjusted
returns are computed each April and October (t ) from 04/1994 to 04/2003 (a total
of 19 cross-sections).
18
X is the most recent earnings surprise (SUE or REV) data
in the previous 3 months (t 3 to t 1). ARBRISK is the arbitrage (idiosyncratic)
risk, measured as the residual variance of the market model regressed in the previous
60months (t 60 to t 1) with a requirement of at least 24 observations. EXPRISKis
the explained (systematic) risk measured as the explained variance fromthe regression
used to estimate ARBRISK. PRICE is the average daily closing stock price in the
month t 1. VOL is the average daily closing price times the daily shares traded in the
previous 6months (t 6 to t 1). ANUM is the average number of analysts reporting
quarterly forecast in the previous 3 months. To allow for time trends in variables and
to account for possible nonlinearities, all the explanatory variables are coded based
on the observations decile rank for the variable among all the observations available
the corresponding month. The ranks are then transformed to range between 0.5 to
0.5. Finally, is a six-column vector of coefcients.
Table 11 shows the coefcients of this pooled cross section test, as well as the p
values of both the standard t statistics and the FamaMacBeth t statistics. Consis-
tent with the Spanish PAD evidence observed in previous sections, the coefcient on
SUE and REV indicates that, for observations with median rm characteristics,
19
the
abnormal returns of those in the highest SUE (REV) decile yield 6-month abnormal
18
The selection of April and October guaranties the maximum number of observations in the pool as well
as avoiding overlapping in the dependent variable.
19
A hypothetical median observation between the two middle deciles for each control variable, so
ARBRISK, EXPRISK, PRICE, VOL and ANUM are all equal to zero.
1 3
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returns 4.4905 (6.9284) percentage points higher than those in the lower SUE (REV)
decile.
20
The main result of Table 11 is that, in contradiction to Mendenhalls (2004) US
evidence, the coefcients on SUE*ARBRISK and REV*ARBRISK are not statisti-
cally signicant, so the magnitude of the Spanish PAD does not seem to increase with
the arbitrage risk. Moreover, the coefcients are negative, contrary to expectations.
However, the coefcient on SUE*PRICE is signicant in the expected direction: PAD
prots are higher in those stocks with lower prices. If stock price is negatively related
to commissions, this result is consistent with the idea of limits to arbitrage in the sense
that the higher the cost of trading, the more difcult it is for the arbitrageurs to drive
a stocks price to its fundamental value.
As a robustness test, we use a double-rank portfolio construction by past earnings
surprise and arbitrage risk. For both ranks we use the 1/3 and 2/3 percentiles. Then we
compute the PAD prots in each of the three arbitrage risk partitions. If the arbitrage
risk explains the Spanish PAD we should expect to observe that the PAD increases
with the arbitrage risk. Consistent with the pool regression evidence, the results of this
alternative analysis (not presented here but available for any interested party) does not
show this expected relationship. When we replicate the same double-rank portfolio
procedure, but this time using the price characteristic instead of arbitrage risk, we nd
that, consistent with the regression results, the PAD prots are higher in those stocks
with lower prices, especially when the SUE measure is used.
6 Conclusions
This paper provides the rst comprehensive study of post-earnings announcement drift
for the Spanish market. We have tested the existence of this phenomenon on a sample
of companies quoted in the Spanish stock market for the period between January
1994 and December 2003, using two earnings surprise measures based on earnings
announcements, SUE, and mean analyst forecasts, REV. Another contribution of this
paper is to present a conditional analysis of the PAD, a question scarcely studied in
the previous literature on this phenomenon.
The results show that the PAD strategy, consisting of buying stocks with more
favourable earnings surprises andshort-sellingthose withmore unfavourable surprises,
yields signicant positive returns in the months following earnings announcement for
both SUE and REV measures. This evidence, which is similar to that observed in the
US and UK markets, reduces the suspicion that this phenomenon was a data snooping
result.
The PAD returns are robust to a large number of controls which include the tradi-
tional CAPM, the three-factor model of Fama and French (1993), a liquidity factor
based on the Amihud (2002) measure, and control portfolios by size and BTMratio. In
addition, PAD also seems to be robust to the momentum effect of Jegadeesh and Tit-
man (1993), suggesting that PADhas marginal explanatory power beyond momentum.
20
The PAD returns here are higher given that we are working with more extreme percentiles (deciles
instead of terciles)
1 3
We also observe that, in the sub-period 19941998, the REV measure has higher pre-
dictive power than SUE, whereas the evidence from the sub-period 19992003 is the
opposite.
The conditional analysis shows that the PAD returns are related to the business
cycle. Moreover, we observe that the PAD strategies do not yield signicant prots
when their returns are adjusted by the predictive power of economic related variables.
However, this relation seems to be countercyclical, the opposite of what we would
expect in an economic risk-based explanation.
Furthermore, when we adjust the PADreturns with a conditional version of the asset
pricing models, allowing investors risk valuation and expected returns to depend on
the economic cycle, although there is some evidence of time-varying in the factors,
they can not capture the time-varying behaviour of the PAD prots. Moreover, after
this conditional adjustment the abnormal returns of this strategy remain.
Finally, givingthe difcultyinexplainingthe SpanishPADaccordingtoa risk-based
explanation we check, following Mendenhall (2004), the limits-to-arbitrage story by
analysing whether the Spanish PADis related to the arbitrage risk. However, the results
do not show a signicant relationship. Notwithstanding, we nd some evidence of a
negative relationship between PAD and the stock price characteristic. This evidence
is consistent with the idea of limits to arbitrage in the sense that the higher the cost of
trading (low prices), the more difcult it is for the arbitrageurs to drive a stocks price
to its fundamental value.
In our opinion, the results obtained in this study show the great robustness of this
phenomenon, the difculty of giving a risk-based explanation consistent with the ef-
ciency hypothesis, and some evidence that the arbitrageurs would not be able to correct
the possible mispricing. Given this evidence, we think that it would be especially inter-
esting in future research to test the behavioural explanation that considers that the PAD
phenomenon has its origin in an under-reaction and/or over-reaction of investors to
the information included in the earnings announcement, a consequence of different
psychological bias that the agents commit in their investment decision making. On the
other hand, given the countercyclical evidence observed in the Spanish stock market,
consistent with the ndings of Chordia and Shivakumar (2006) in the US market, it
would also be interesting to test the ination illusion explanation suggested by these
authors.
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Span Econ Rev (2009) 11:207241

is expected earnings for

; c = C1, C2, C3 (3)

(y X) = 0. We have taken the explicative variables as instruments (Z = X),

R% 0.7161 0.5649 0.4232 0.3523 0.4732 0.4447 0.3819 0.2634

c=C1, C2, C3, and PAD = (C3 C1) (5)

R% 0.5264 0.9720 0.3019 0.7815

[C1; PR1] + [C1; PR2] + [C1; PR3]

X = SUE, REV (16)

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