Reg FD eases effects of earnings sticker shock

NEW YORK — Earnings surprises have had less impact on stock prices since the Securities and Exchange Commission passed the Fair Disclosure Regulation in 2000, according to Goldman Sachs, New York.

Among other things, Regulation FD bars public companies from selectively disclosing information to certain shareholders or investors. It was passed primarily to level the playing field between institutional and individual investors — previously, companies would often disclose information on earnings in conference calls with a select group of investors.

The Goldman Sachs study, published in the firm's most recent quantitative management report, examined the return patterns of 75 stocks between 1994 and 2004 and their reactions to positive and negative earnings surprises.

The study found that earnings surprises affected share prices most 20 days prior to earnings announcements, usually because of pre-announcements or forecasts by analysts.

Before Reg FD went into effect on Oct. 23, 2000, the average price of the securities went up 1.39% 20 days before the "most positive" earnings surprise, and dropped 1.73% 20 days before the "most negative" earnings event.

After Reg FD, however, investors seemed to show less reaction to the "most positive" earnings surprise — the average price of the stocks went up only 0.48% 20 days before. But investors still reacted strongly to the "most negative" surprises, with the price going down 2.01%.

"The introduction of Regulation FD appears to have resulted in less ‘leakage' of positive earnings surprises prior to the reporting date," said the study.

The study also noted that, despite a significant average drop in share price after a negative earnings surprise, stocks recovered quickly. "Both (trading) volume and volatility spiked on the announcement day, but declined relatively quickly afterwards."

The study showed that the average share price rebounded just 20 days after the most negative earnings surprise. The average share price went down 0.47% on the day the most negative earnings surprise was announced, but went up 0.85% 20 days afterward, according to first-quarter numbers.

"When we looked at stocks with the most negative surprises, we found that the market tended to overreact to them," said Ingrid Tiernen, a vice president in Goldman's equity derivatives research group who worked on the study. "We also found that the market did not take long to digest positive earnings announcements."

Werner DeBondt, a finance professor at the Driehaus Center For Behavioral Finance at DePaul University, Chicago, and editor of the Journal of Behavioral Finance, said the evidence that investors react more strongly to negative earnings surprises gives credence to the behavioral finance tenet of "loss aversion." According to this principle, people tend to lament loss more than they take pleasure in gains, and when faced with a choice, they will therefore tend to avert loss.

"This (the Goldman study) is completely consistent with loss aversion," said Mr. DeBondt. "This says that people react very negatively to loss. People react not so much to price levels as they do to expectations. They are more sensitive to shortfalls relative to these expectations. If expectations are exceeded, that's easy to deal with."

The study also found that earnings surprises had less impact in the fourth quarter than in the first. Between 1995 and 2004, share prices went up an average of 2.53% 20 days prior to the most positive earnings surprise in the first quarter. In the fourth quarter, however, the stock prices rose only 0.39%.

On the day earnings surprises were announced, share prices, on average, rose 1.31% in the first quarter, vs. just 0.66% in the fourth.

"Investors tend to look at first quarter results as trend-setters for the year," said Ms. Tiernen, "whereas in the fourth quarter, people see an earnings surprise and say ‘yep, I've already dealt with that.' Also, in the fourth quarter, when the fiscal year is ending, a lot of companies tend to push through changes in their accounting, and investors know this."