Gil Sadka

Liquidity and the Post-Earnings-Announcement Drift

The post-earnings-announcement drift is a longstanding anomaly that conflicts with market efficiency. This study documents that the post-earnings-announcement drift occurs mainly in highly illiquid stocks. A trading strategy that goes long high-earnings-surprise stocks and short low-earnings-surprise stocks provides a monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43 percent in the most illiquid stocks. The illiquid stocks have high trading costs and high market impact costs. By using a multitude of estimates, the study finds that transaction costs account for 70–100 percent of the paper profits from a long–short strategy designed to exploit the earnings momentum anomaly. One of the most persistent anomalies that seem to violate the semi-strong-form market efficiency as defined by Fama is the post-earnings-announcement drift (PEAD), or earnings momentum. This anomaly refers to the fact that companies reporting unexpectedly high earnings subsequently outperform companies reporting unexpectedly low earnings. More specifically, a company’s standardized unexpected earnings (SUE) is defined as the difference between the last available quarterly earnings and the earnings during that same quarter in the previous year, scaled by the standard deviation of this difference over the previous eight quarters. A trading strategy that each month goes long the stocks in the top decile of SUE and short the stocks in the bottom decile of SUE earns, on average, 90 bps per month (10 percent annually) over the 1972–2005 period. The goal of this article is to demonstrate that stock liquidity is an important consideration for understanding the persistence of the PEAD anomaly over the years. Previous studies have not taken trading costs into account in the calculation of abnormal returns. We studied the impact of illiquidity on the profitability of the PEAD trading strategy and show that this strategy is likely to be unprofitable after adjusting for transaction costs. First, we studied the relationship between the PEAD and illiquidity by using double-sorted portfolios. Our findings suggest that the PEAD is prevalent mainly in illiquid stocks. We examined the profitability of the long–short SUE strategy after sorting stocks into decile portfolios on the basis of their illiquidity. For this analysis, we used the Amihud measure of stock illiquidity, which is the average of the daily price impacts of the order flow (i.e., the daily absolute price change per dollar of daily trading volume). Returns to the long–short SUE strategy increased monotonically from 0.04 percent per month for the most liquid stocks to 2.43 percent for the most illiquid stocks. Because we found that the PEAD is more prevalent in illiquid stocks, following a PEAD trading strategy will generate high transaction costs and a substantial price impact. We used several transaction-cost estimates to calculate the net returns to PEAD trading strategies. Our results show that transaction costs consume 70–100 percent of the potential profits. This lack of profitability can thus explain the persistence of the PEAD anomaly and is consistent with Jensen’s definition of market efficiency and Rubinstein’s definition of minimally rational markets.

Financial Reporting, Growth and Productivity: Theory and International Evidence

This paper investigates the relation between financial reporting, total factor productivity (TFP) and economic growth. The paper develops the theory that public sharing of financial reports (market transparency) and other associated sources of information such as analyst reports, can help firms learn from their competitors and improve their production process and firm organization. The model illustrates that, up to a point, financial reporting directly increases TFP and GDP growth. Employing data from 30 countries over the period of 1985-1999, the paper provides empirical evidence consistent with this hypothesis. However, the theory suggests that excessive transparency might reduce incentives for undertaking profitable and socially beneficial investments.

Illiquidity and Earnings Predictability

This paper studies whether illiquidity affects the predictability of fundamental valuation variables. Firm-level, cross-sectional analyses show that returns of illiquid stocks contain less information about their firms future earnings growth compared to those of more liquid stocks. A natural experiment utilizing an exogenous variation in liquidity amid the reduction of tick size on the NYSE indicates that an improvement in liquidity causes an increase in earnings predictability. At the aggregate level, stock returns contain less information about future growth in aggregate earnings, GNP, and industrial production during illiquid periods. The results highlight the importance of liquidity for forecasting fundamentals and stock-price efficiency.

Uncertainty and Sectoral Shifts: The Interaction Between Firm-Level and Aggregate-Level Shocks, and Macroeconomic Activity

This study predicts and finds that the interaction of firm-level and aggregate-level shocks explains a significant portion of shocks to macroeconomic activity. Specifically, we hypothesize that the relation between uncertainty and economic growth is most pronounced when both firm-level and aggregate-level uncertainty are high simultaneously. Similarly, we hypothesize that aggregate performance affects unemployment most when both firm-level dispersion is high and aggregate performance is low, based on the sectoral shift theory. Our hypotheses and empirical results show that the interactive effect of firm-level and aggregate-level shocks are larger than the sum of the individual effects. This paper was accepted by Mary Barth, accounting.

Do Debt Covenants Unnecessarily Constrain Leverage? Evidence from SFAS 160

Prior evidence shows a reduction in leverage after covenant violations, but we do not know whether covenants affect leverage before they are violated. In this study, we use an exogenous accounting-based shock to debt covenants that relaxed covenant tightness (SFAS 160) and examine whether covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that SFAS 160 increased debt levels in firms that were close to violation. This increase in debt was driven by financially healthy firms, suggesting that the likelihood of future covenant violations could impede borrowing by firms. We also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting the additional debt was used to make legitimate investments. Because SFAS 160 was passed in the midst of the financial crisis, it is difficult to generalize our findings to more normal financial periods.

Macroeconomic Activity Under Uncertainty: How Firm-Level and Aggregate-Level Uncertainties Interact

This study predicts and finds that the interaction of firm-level and aggregate-level shocks explains a significant portion of shocks to macroeconomic activity. Specifically, we hypothesize that the relation between uncertainty and economic growth is most pronounced when both firm-level and aggregate level uncertainty are high simultaneously. Similarly, we hypothesize that aggregate performance affects unemployment most when both firm-level dispersion is high and aggregate performance is low, based on the sectoral shift theory. Our hypotheses and empirical results show that the interactive effect of firm-level and aggregate-level shocks are larger than the sum of the individual effects.

Industry Sensitivity to External Forces and Firm-Level Disclosure

This paper examines whether analysts have an industry-level information advantage over managers when forecasting a firm’s earnings. We argue that such an advantage is more likely to exist for firms that operate in industries that are characterized by more uncertain operating environments due to industry-level shocks. We find that for firms in such industries, analysts provide more accurate forecasts than managers. We further find that managers of firms in such industries provide fewer and less precise (e.g., range versus point estimates) forecasts, and that these results are more pronounced when analyst following and institutional ownership are higher. These findings suggest that analysts have an informational advantage over managers with respect to industry-level information for industries with certain characteristics.

Corporate Diversification and Overinvestment: Evidence from Asset Write-Offs

This paper documents that diversified firms are more likely to overinvest than undiversified firms. Prior research on inefficient investment in diversified firms has been criticized on the measurement errors in measuring the unobservable marginal investment opportunities. Using an ex post measure of overinvestment that does not rely on investment opportunity set-asset write-offs, we find that diversified firms are more likely to incur tangible write-offs as well as goodwill write-offs and that the extent of the write-offs increases as firms become more diversified. In addition, we show that the diversification discount is related to subsequent asset write-offs, suggesting that diversified firms trade at a discount because investors expect overinvestment and correctly anticipate future write-offs.