What Do Measures of Real-Time Corporate Sales Tell Us About Earnings Surprises and Post-Announcement Returns?

Namho Kang is Assistant Professor of Finance at the University of Connecticut. This post is based on a recent paper authored by Professor Kang; Kenneth A. Froot, Research Associate at the National Bureau of Economic Research; Gideon Ozik, Affiliate Professor of Finance at EDHEC Business School; and Ronnie Sadka, Professor of Finance at Boston College Carroll School of Management.

The information asymmetry around earnings announcements has long been the center of finance and accounting research. At the time of an earnings announcement, managers have information not only about their firm’s performance over the last quarter (“within quarter”) but also about performance since the quarter-end (“post quarter”). The announced numbers and the disclosures they rely on help remove within-quarter information asymmetries between managers and external market participants. But these accounting disclosures cannot eliminate any post-quarter information asymmetries that managers could possess. Additional tools—discretionary accruals, formal guidance, and informal call tone—have therefore evolved wherein managers have the opportunity to convey post-quarter information in the current quarterly announcement. Are these discretionary tools, whose transmitted content is difficult to verify, used in the interests of shareholders, or could they instead be used against shareholders, in the interests of managers?

This is the question we ask in this paper. We gain some edge in answering it by constructing proxies for managers’ within-quarter and post-quarter internal corporate information around earnings announcements. These proxies are real-time measures of sales activity covering both within- and post-quarter periods, right up until the announcement date, typically four to six weeks after quarter-end. To construct our firm-level real-time corporate sales indexes, we estimate the amount of consumer activity at retail stores approximately in real time, utilizing proprietary data sources. An example would be the data we collect from approximately 50 million mobile phones, as well as tablets and desktops, pertaining to consumer activity at large US retailers. Using this underlying information, we derive two indexes, one measuring within-quarter sales activity, denoted by WQS, and the other measuring post-quarter sales activity up until the announcement date, denoted by PQS. For a given firm in a given quarter, WQS and PQS are the growth rates of consumer activity, defined as a data event associated with consumer intention to visit a particular retail store.

We first demonstrate that the WQS index is related to within-quarter fundamentals. We find that WQS significantly predicts current-period revenue growth, announcement surprises, and analyst forecast errors. For example, the R2 from a regression of quarterly revenue growth on WQS is 39%. Also, the average announcement excess return for stocks in the highest quintile of WQS is 2.14% and that for stocks in the lowest quintile is -1.26%, resulting in an economically significant return differential of 3.4% for the five-day period around earnings announcement dates. Our information, therefore, is strongly correlated with previously unannounced within-quarter sales. These predictions confirm that our novel information, embedded in both WQS and PQS, is potent.

Next, we study the PQS relation with post-announcement returns, discretionary accruals, announced guidance, conference call tone, and managers’ private discretionary trades in the post-announcement trading window. We call the organizing concept the Timely Disclosure Hypothesis, i.e., reflecting the notion that managers release through available channels all of their private post-quarter information at announcement. Our first and most important test of this null examines the predictability of post-announcement returns using PQS. If managers disclose all of their private information as measured by PQS, we should observe none. Second, Timely Disclosure implies that PQS is positively related to the announcement return over and above the effects of within-quarter information, including WQS.

The alternative to Timely Disclosure is the Leaning Against the Wind (LAW) Hypothesis. With this alternative, managers use discretionary channels to understate the private information contained in PQS. That is, managers do not fully disclose their private signal, withholding some of the surprise for the future, and even bias their disclosures downward at announcements. They thereby induce opposite-sign predictable components in announcement and post-announcement returns. Thus, under the LAW alternative, we should find that PQS is correlated negatively with the announcement returns, and positively with post-announcement returns. In testing the LAW alternative, we also examine whether managers’ tendency to bias their disclosures is symmetric. We examine whether managers understate both good news (i.e., bias disclosures negatively for positive information) and bad news (i.e., bias disclosures positively for negative information) and whether they do so symmetrically.

Our results favor the LAW alternative. Looking at stock returns themselves, we find that PQS strongly positively predicts post-announcement returns. This same conclusion holds using announcement returns, which are negatively correlated with PQS. Thus, the basic stock return data show that managers understate their post-quarter private information. However, our results on announcement returns show that Leaning Against the Wind behavior of managers is asymmetric. The relation between announcement returns and PQS is strongly negative when PQS is positive, while no statically significant relation exists between announcement returns and negative PQS. This suggests that while managers understate good news, they do not understate bad news.

We also look to the drivers of these results by examining the attributes of the announcements themselves. That is, if returns are reliably related to private information, the same pattern of implied disclosure distortion should be evident both indirectly in stock returns and directly in the channels of discretionary disclosure themselves. We consider three disclosure channels: discretionary accruals, guidance, and conference call tone. If we reject Timely Disclosure in favor of the LAW alternative, these should each, all else equal, be negatively related to PQS.

First, we examine discretionary accruals. The LAW alternative predicts that discretionary accruals appear suppressed when PQS is high, i.e., a negative correlation. Our empirical tests do not show a strong relation between discretionary accruals and PQS. Therefore, we cannot reject Timely Disclosure in favor of the LAW alternative based on accruals.

Second, we ask whether management forecasts or guidance issued around earnings announcement dates (often called bundled forecasts) reject Timely Disclosure, and, if so, whether they do so in favor of LAW. The evidence here is consistent with LAW. That is, the issuance of pessimistic bundled forecasts is systematically related to PQS. The probability of realized future earnings (or revenue) exceeding bundled forecasts is positively and significantly associated with PQS. As the LAW alternative would predict, managers issue more pessimistic forecasts in the presence of more positive post-quarter sales information.

Third, we examine managerial tone in announcement conference calls. We generate sentiment scores measuring managerial tone from managers’ speech using conference call transcripts. Managerial tone is a function of the ratio of the number of positive words relative to the sum of the number of positive and negative words [Loughran and McDonald (2011)]. As above, we find that call sentiment is significantly and negatively related to PQS. In addition, consistent with managers’ asymmetric LAW incentives, the negative relation is concentrated in the subsample of positive PQS.

Whether we look to announcement and post-announcement returns or whether we look to direct channels of managerial discretion, the conclusions we derive about managerial behavior from PQS are the same: Rejection of Timely Disclosure in favor of the LAW alternative. The next logical question is: Why would managers choose to understate or communicate the opposite of their private information, leading the information withheld to leak out only slowly, post-announcement? Clearly, if managers at announcement obscure fundamental information for a quarter, they enjoy a transitory informational asymmetry versus analysts and the market. This improves their post-announcement trade opportunities. That is, managers could wish to increase the predictable portion of their company’s stock price by understating the private information they have about post-quarter sales. Further, managers’ tendency to lean against the wind, while always at least somewhat present, is asymmetric. We find that understatement is much stronger when managers possess positive private information. This asymmetry is credible if understating bad news prior to insider sales leads to higher litigation risks (Skinner, 1994, 1997).

Is our rejection of Timely Disclosure consistent with insiders’ trades after earnings announcements? We find that the negative relation between PQS and announcement return is stronger when insiders subsequently purchase their firms’ shares. We also show that the positive predictability of PQS for post-announcement returns is even stronger in the presence of subsequent insider purchases. Our results show that this relation is driven by instances when PQS is positive. We do not observe any statistical relation of PQS with announcement returns and post-announcement returns, when PQS is negative and insiders subsequently sell. This result is consistent with managers’ asymmetric LAW incentives for personal trading purposes.

The complete paper is available for download here.

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