Messod Daniel Beneish

Information Costs and Liquidity Effects from Changes in the Dow Jones Industrial Average List

We examine the stock market effect of changes in the composition of the Dow Jones Industrial Average (DJIA). Unlike S&P 500 listing studies, we find that the price and the trading volume of newly listed DJIA firms are unaffected. We attribute this result to a lack of index fund rebalancing, since index trading is limited for most of our sample period and index funds mimic the S&P 500, not the DJIA. Firms removed from the index, however, experience significant price declines. We consider information signaling, price pressure, imperfect substitutes, and information cost/liquidity explanations for these asymmetric findings. The evidence is consistent with the information cost/liquidity explanation, which holds that investors demand a premium for higher trading costs and for holding securities that have relatively less available information.

Contextual Fundamental Analysis Through the Prediction of Extreme Returns

This study examines the usefulness of contextual fundamental analysis for the prediction of extreme stock returns. Specifically, we use a two-stage approach to predict firms that are about to experience an extreme (up or down) price movement in the next quarter. In the first stage, we define the context for analysis by identifying extreme performers; in the second stage we develop a context-specific forecasting model to separate winners from losers. We show that extreme performers share many common market-related attributes, and that the incremental forecasting power of accounting variables with respect to future returns increases after controlling for these attributes. Collectively, these results illustrate the usefulness of conducting fundamental analysis in context.

Information friction and investor home bias: A perspective on the effect of global IFRS adoption on the extent of equity home bias

This paper provides a perspective on the effect of IFRS adoption on the tendency of investors to under-invest in foreign equities. We consider explanations for the home equity bias described in prior research and discuss research relevant to the informational consequences of global adoption of IFRS. Specifically, we evaluate whether IFRS adoption reduces information processing costs or decreases investor uncertainty about either the quality of financial reporting or the distribution of future cash flows. We predict that the effect of any reduction in information processing costs from the adoption of IFRS is likely to be small relative to the effects of other determinants of home bias such as the strength of investor protection mechanisms in foreign countries, behavioral biases toward familiar equities, and informational advantages related to geographical proximity. We conclude that global IFRS adoption is unlikely to reduce home bias and propose avenues for future research.

Earnings Manipulation and Expected Returns

An accounting-based earnings manipulation detection model has strong out-of-sample power to predict cross-sectional returns. Companies with a higher probability of manipulation (M-score) earn lower returns on every decile portfolio sorted by size, book-to-market, momentum, accruals, and short interest. The predictive power of M-score stems from its ability to forecast changes in accruals and is most pronounced among low-accrual (ostensibly “high-earnings-quality”) stocks. These findings support the investment value of careful fundamental and forensic analyses of public companies. In our study, we investigated the investment value of a particular form of financial analysis associated with the detection of earnings manipulation. The statistical model we examined (the Beneish model) represents a systematic distillation of forensic accounting principles described in the practitioner literature. Specifically, we investigated a potential link between the probability of manipulation (M-score) generated by the Beneish model and subsequent returns. Although relatively few companies are indicted for accounting fraud, the incidence of earnings manipulation among public companies is likely much higher. We posited that the M-score is informative about a company’s expected returns because the “typical earnings manipulator” is a company that is growing quickly, experiencing deteriorating fundamentals, and adopting aggressive accounting practices. Our main hypothesis was that companies that share traits with past earnings manipulators (i.e., those that “look like manipulators”) represent a particularly vulnerable type of growth stock. Although the accounting games they engage in might not be serious enough to warrant regulatory action, we posited that their earnings trajectory is more likely to disappoint investors (i.e., they have lower “earnings quality”). To the extent that the pricing implications of these accounting-based indicators are not fully transparent to investors, companies that “look like” past earnings manipulators will also earn lower future returns. We found that companies with a higher probability of manipulation (M-score) earn lower returns in every decile portfolio sorted by size, book-to-market, momentum, accruals, and short-interest ratio. These returns are economically significant (averaging just below 1% a month on a risk-adjusted basis) and survive a host of risk controls. We further found that a large proportion of the abnormal return is earned in the short three-day windows centered on the next four quarterly earnings releases, suggesting that our results are due to a delayed reaction to earnings-related news rather than risk-based factors. The robustness of these results, even among highly liquid companies, implies that they are unlikely to be fully explained by transaction costs. We performed three sets of analyses to better understand the nature of the information conveyed by M-score. First, we conducted detailed tests on the joint ability of accruals and M-score to predict returns. We found that the dominance of M-score over accruals is evident in both independent sorts and nested sorts. When companies are sorted on these two variables independently, M-score is particularly effective in predicting returns among low-accrual companies (i.e., companies that have “high earnings quality” according to their accruals ranking). For example, in the lowest-accrual quintile—companies typically viewed as “buys”—the spread in size-adjusted returns between high- M-score companies and low- M-score companies is –19.8% over the next 12 months. Second, we used a difference-in-difference test to examine which individual components of the model contributed the most to its incremental predictive power. Our results show that variables related to a predisposition to commit fraud (sales growth, asset quality index, and leverage) are more important than variables associated with the level of aggressive accounting (accruals, days in receivables, and depreciation expense). Third, we found that the Beneish model’s efficacy is associated with its ability to predict the directional change in current-year accruals (i.e., whether the accruals component of current-year earnings will continue into next year or disappear). Specifically, we found that high- M-score companies have income-increasing (-decreasing) accruals that are more likely to disappear (persist) next year; we observed the exact opposite among low- M-score companies. In other words, M-score provides useful information about the future persistence of current-year accruals. Our study adds to the literature on the effective use of financial information by documenting the usefulness of earnings manipulation detection techniques for earnings quality assessment and return prediction. Our evidence on how and why such techniques work suggests new directions for earnings quality analysis and should enhance future efforts to identify potential over- and undervaluations. Overall, our analyses provide substantial support for the use of forensic accounting in equity investing.

Director Independence and Insider Trading

We provide evidence that outside directors’ trading and ratification decisions are incrementally useful in assessing their independence. Because crises test the independence of boards, we first investigate the CEO replacement decision in firms caught intentionally misreporting earnings. We predict and find that outside directors’ selling that emulates selling by the CEO and inside directors makes them appear aligned and thus less willing to replace the CEO. Our findings derive from opportunistic rather than routine selling, and from collusive selling involving inside and outside board members rather than from selling by outside directors alone. We also predict and find that outside directors who ratify one or more value-destroying mergers in the misreporting period are less willing to replace the CEO. We further test the usefulness of our proxies for board independence on the Execucomp universe and find that firms whose boards exhibit collusive trading and ratify value-destroying mergers overpay their CEOs and are less likely to force CEO turnover.We use an observable action (non-executive directors’ insider trading) and an observable outcome (the market assessment of a board-ratified merger) to infer collusion between a firm’s executive and non-executive directors. We show that CEOs are more likely to be retained when both directors and CEOs sell abnormal amounts of equity before the delinquent accounting is revealed, and when directors ratify one or more value-destroying mergers. We also show that a good track record, higher innate managerial ability, and the absence of a succession plan make replacement more costly. We find retention is less likely when the misreporting is severe and directors fear greater litigation penalties from owners, lenders, and the SEC. Our results are robust to controlling for traditional explanations based on performance, founder status, corporate governance, and CFOs as scapegoats. Overall, our analyses increase our understanding of the retention decision by about a third; they suggest that financial economists consider collusive trading and merger ratification as additional means of assessing the monitoring effectiveness of non-executive directors.

The Long and Short of the Accrual Anomaly

The paper provides evidence that the relation between accruals and future returns is not symmetric. We find that firms with low accruals generate insignificant abnormal returns in asset pricing regressions that control for either earnings quality or operating volatility. In contrast, we find that accrual hedge returns are driven by firms with large positive accruals and firms with high probabilities of earnings overstatement. This asymmetry is consistent with our view that upwards rather than downwards earnings management is an important contributor to accrual mispricing. We also find that firms with high accruals are smaller and have higher arbitrage risk (residual return volatility), suggesting that short sellers are unlikely to arbitrage away these negative abnormal returns. We conclude that an omitted risk factor explains results for low accruals and that transaction costs/limits to arbitrage explain the persistence of mispricing for high accruals.

NONPRICE COMPETITION, COST SHOCKS, AND PROFITABILITY IN THE AIRLINE INDUSTRY.

Abstract The paper uses stock market data to assess the profit elasticity of nonprice competition and to compare the effects of oil shocks across regulatory regimes in the airline industry. We use the natural experiment provided by the oil shocks of the 1970s to provide market-based estimates of the effect of capacity competition on profits. The 1973 OPEC oil embargo led to oil price increases that resulted in negotiated reductions in scheduled capacity. We show that these negotiated reductions, which essentially amounted to rights to collude on service competition, increased the value of air carriers by insulating the rents created by rate of return regulation from the effects of service competition. The findings include the following. First, the paper provides an empirical estimate of the effect of service competition on profits. We find that a 7% scheduled capacity reduction increases airline expected profits by 16.1%, suggesting that airline profits are very sensitive to nonprice competition. Second, the effects of the oil shocks are negative and similar across regulatory regimes. This result obtains after disentangling the oil price and capacity reduction effects. Failure to distinguish these effects leads to the erroneous conclusion that, under regulation, airlines were sheltered from the oil price shock of 1973. Third, the adverse effects of the 1978–1980 crisis are smaller, the greater the ability of airlines to reorganize their operations to compete in a deregulated environment. In particular, the more involved is the carrier in “hubbing,” the lower the profit effect of the oil shock. At a time when the financial health and competitiveness of the airline industry are being scrutinized and politicians are considering re-regulating the industry, the results suggest that price re-regulation is an ineffective means of promoting financial health since airlines are likely to substitute scheduled capacity for price competition.