Michael S. Drake

Should Investors Follow the Prophets or the Bears? Evidence on the Use of Public Information by Analysts and Short Sellers

We investigate whether shorts and analysts differ in their use of fundamental and other information that is predictive of future returns. Remarkably, open short interest is significantly associated in the expected direction with all eleven variables examined. In contrast, analysts tend to positively recommend stocks with high growth, high accruals, and low book-to-market ratios -- despite these variables having a negative association with future returns. These results suggest that short sellers can serve as an alternative information intermediary for investors. We then investigate the profitability of using short interest in trading. We find abnormal returns (1.11 percent per month) from a zero-investment strategy that 1) shorts firms with highly favorable analyst recommendations (buy signal) but high short interest (sell signal), and 2) buys firms with highly unfavorable analyst recommendations (sell signal) but low short interest (buy signal). Short interest, therefore, captures predictive information that can be used by investors in trading against analysts’ recommendations to increase returns.

The Determinants and Consequences of Information Acquisition via EDGAR

Using a novel dataset that tracks all web traffic on the SEC’s EDGAR servers from 2008-2011, we examine the determinants and capital market consequences of investor information acquisition of SEC filings. The average user employs the database very few times per quarter and most users target specific filing types such as periodic accounting reports; a small subset of users employ EDGAR almost daily and access many filings. EDGAR activity is positively related with corporate events (particularly restatements, earnings announcements, and acquisition announcements), poor stock performance, and the strength of a firm’s information environment. EDGAR activity is related to, but distinct from, other proxies of investor interest such as trading volume, business press articles, and Google searches. Finally, information acquisition via EDGAR, both to obtain earnings news and to provide context for it, has a positive influence on market efficiency with respect to earnings news. Overall, our results provide a unique, user-based perspective on investor access of mandatory disclosures and its impact on price formation.

Disclosure Quality and the Mispricing of Accruals and Cash Flow

In this paper, we investigate the role that disclosure quality plays in the accurate valuation of accruals and cash flow. We predict that stock prices of firms with higher-quality disclosures more accurately reflect the persistence of accruals and cash flow. We test our predictions using analyst ratings of disclosure published in the annual Association for Investment Management and Research (AIMR) Corporate Information Committee Reports for the years 1982 through 1996. The results provide strong evidence of mispricing for the subset of firms with lower-quality disclosures and of a significant reduction in mispricing for the subset of firms with higher-quality disclosures. We confirm the results of our Mishkin tests using returns regressions that also control for investor sophistication, analyst following, and firm life cycle stage. Overall, our results demonstrate the mitigating effect that higher-quality disclosure has on mispricing.

The Media and Mispricing: The Role of the Business Press in the Pricing of Accounting Information

This study investigates the role of the business press in the pricing of accounting information. Using a comprehensive dataset of more than 111,000 earnings-related business press articles published from 2000–2010, we find that press coverage of the annual earnings announcement mitigates cash flow mispricing, but has a negligible effect on accrual mispricing. We provide evidence that this impact is driven primarily by the press disseminating the information more broadly, rather than by the creation of new content that helps investors understand the implications of accounting information. Our results suggest that the business press plays an important role in facilitating the market’s ability to efficiently impound accounting information into stock prices and provide new insights into the role of the business press as an information intermediary in capital markets.

Acquirer Valuation and Acquisition Decisions: Identifying Mispricing Using Short Interest

We use short interest as an investor-based measure of over- or undervaluation that distinguishes between the misvaluation and Q-theories of mergers. Using this measure, we find that misvaluation is a strong determinant of merger decision-making. Firms in the top quintile of short interest are 54% more likely to engage in stock acquisitions and 22% less likely to engage in cash acquisitions. Stock (but not cash) acquirers have higher short interest than their targets. Overall, our results suggest that the previously documented underperformance of stock acquirers and the overperformance of cash acquirers can be explained by misvaluation, as captured by short interest.

Short Selling Around Restatement Announcements When Do Bears Pounce

This paper draws on two distinct literatures – one that investigates the impact of accounting restatements and another that investigates the trading behavior of short sellers – to further our understanding of how sophisticated investors process and respond to news about accounting corrections. We examine short-seller behavior in the days surrounding restatement announcements to determine when short sellers identify restatements and how they trade on restatement news. Our findings suggest that short sellers do not appear to anticipate restatement announcement dates, but we find that abnormal short selling is significantly higher than is typical when restatements are announced, especially for restatements announced transparently (i.e., in press releases or 8-Ks). Short sellers target small companies, whose information environments may be weaker, and companies making restatements that reduce previously reported income. In addition, we find that restating companies targeted most heavily by short sellers experience the most negative subsequent abnormal returns over horizons of up to 40 trading days following the restatement disclosure. Overall, our results suggest that short sellers respond to, but do not anticipate, restatement announcements and trade as if they understand the post-announcement stock price implications of restatement disclosures.

March Market Madness: The Impact of Value-Irrelevant Events on the Market Pricing of Earnings News

Each year, the NCAA basketball tournament (March Madness) is a daytime distraction for millions of people, providing a largely exogenous shock to investor attention. We investigate whether March Madness influences the market response to earnings by diverting investor attention away from earnings news. We find that the price reaction to earnings news released during March Madness is muted. This result generally holds across several samples and additional analyses. We also find that the result is more muted for low institutional ownership firms, consistent with the effect being driven by less sophisticated investors. Further, we find that it takes the market 30 to 60 days to correct for the distraction effect. Overall, we provide a unique test of the theory of limited attention by documenting that extraneous events can have a significant impact on the pricing of earnings.

Short Selling Around Restatement Announcements

This article draws on two distinct literatures—one that investigates the impact of accounting restatements and another that investigates the trading behavior of short sellers—to further our understanding of how sophisticated investors process and respond to news about accounting corrections. We examine short-seller behavior in the days surrounding restatement announcements to determine when short sellers identify restatements and how they trade on restatement news. Our findings suggest that short sellers do not appear to anticipate restatement announcement dates, but we find that abnormal short selling is significantly higher than is typical when restatements are announced, especially for restatements announced transparently (i.e., in press releases or 8-Ks). Short sellers target small companies, whose information environments may be weaker, and companies making restatements that reduce previously reported income. In addition, we find that restating companies targeted most heavily by short sellers experience the most negative subsequent abnormal returns over horizons of up to 40 trading days following the restatement disclosure. Overall, our results suggest that short sellers respond to, but do not anticipate, restatement announcements and trade as if they understand the post-announcement stock price implications of restatement disclosures.

Are Liquidity Improvements Around the Mandatory Adoption of IFRS Attributable to Comparability Effects or to Quality Effects

Using a treatment sample of more than 5,000 firms from 22 countries that required reporting under International Financial Reporting Standards (IFRS) on or before fiscal 2005, we find an increase in aggregate market liquidity around mandatory IFRS reporting. We examine whether the positive market effect on liquidity of mandatory IFRS reporting is attributable to the convergence of diverse accounting standards into a single set of accounting standards (i.e., Comparability Effects), to improved financial reporting quality (i.e., Quality Effects), or both. We find evidence suggesting that liquidity improvements are attributable to increased comparability. In addition, we find that the Quality Effect around the IFRS mandate is generally negative, suggesting that the markets in our sample behave as if the mandatory adoption of IFRS will not increase financial reporting quality (beyond domestic generally accepted accounting principles) in most sample countries.

The Comovement of Investor Attention

Prior literature has documented that investor attention and constraints on that attention are associated with the pricing of stocks. We introduce the concept of attention comovement, which is the extent to which investor attention for a firm is explained by attention paid to the firm’s industry and the market in general. We find that attention comovement is non-trivial for the average firm and is related to firm characteristics, such as size and visibility. We also find that the comovement of investor attention has market consequences, in that it is positively associated with excess stock return comovement. Finally, we show that a firm’s earnings announcement contributes to the transfer of attention from one firm to its peer firms. Our results provide insights about the information flows underlying return comovement and aid in understanding the micro- and macro-nature of investor attention.