The Post Earnings Announcement Drift, Market Reactions to SEC Filings and the Information Environment

This study examines whether the well-documented tendency of returns to move in the direction of the earnings surprise following the preliminary announcement can be partially explained by investors who react to confirming information in the immediately subsequent SEC filings. We show that market reactions around SEC filings are positively and significantly associated with the preliminary earnings surprise, i.e. that information in SEC filings confirms, on average, the preliminary earnings surprise. We further show that the average hedge portfolio daily return on extreme earnings surprises is largest during the SEC filing window than during any other window between the two preliminary announcements, and larger than the return during a same length window just prior to the SEC filing. Finally, we show that analysts revise their earnings forecasts for the subsequent quarter based on information in SEC filings that confirm the preliminary earnings surprises, and that their forecast accuracy improves after the SEC filings. The above tests also examine the effects of the information environment on market reactions to confirming information in SEC filings. Overall, our evidence is consistent with a drift caused by an initial underreaction to earnings surprises, which is corrected later on when the market reacts to new confirming information. The Post Earnings Announcement Drift, Market Reactions to SEC Filings and the Information Environment One of the most resilient market anomalies is the Post Earnings Announcement Drift (drift or Standardized Unexpected Earnings, SUE), which is the tendency of stock prices to move in the direction of extreme earnings surprise after earnings are announced in preliminary earnings press releases. The drift has been documented to persist through the subsequent three quarters, reverse in the fourth quarter, and to concentrate around subsequent earnings announcements (Bernard and Thomas, 1989, 1990). One of the explanations for the drift is investors’ initial underreaction, which is subsequently corrected when new information tends to confirm the initial earnings surprise. However, the drift literature has not studied market reactions around the Securities and Exchange Commission (SEC) filings filed immediately after the preliminary earnings announcements, which presumably may contain new information that can help investors assess the implications of the initial earnings surprises about future earnings. Whether SEC filings are associated with significant market reactions is far from clear. While prior level and long-window association studies indicate that corporate disclosures in SEC filings on such items as cash flows, pensions and postretirement benefits provide valuation relevant information (e.g., Livnat and Zarowin, 1990, Barth, 1991 and Amir, 1993), research on short-window market reactions to the SEC filings remains inconclusive (Hollie et al., 2005). The purpose of this study is to investigate whether the drift is associated with significant market reactions around SEC filings and whether this relationship depends on the information environment. The information environment may 1 The next section surveys this literature in detail. be important for our investigation because prior studies show that the drift is inversely related to the level of investors’ sophistication and firm size (Bartov et al., 2000; Brown and Han, 2000). Thus, we study whether the relationship between the drift and market reactions to the immediately subsequent SEC filings is attenuated for firms with better information environment. To address these research questions, we first investigate whether returns around the SEC filing dates are positively associated with the preliminary earnings surprise (SUE), which becomes available in the immediately preceding preliminary earnings announcement. A positive and statistically significant association provides evidence that the market reacts to additional information in these filings that confirms the previously disclosed SUE. We then construct a hedge portfolio based on SUE and examine whether the average daily arbitrage return in the short window centered on the SEC filing date is greater than the average daily return between the preliminary earnings announcement and the SEC filing date, and between the SEC filing date and the preliminary earnings announcement for the subsequent quarter. This sheds light on whether more confirmatory information is disclosed in the subsequent SEC filing than on any other day in the window between two consecutive quarterly earnings announcements. We also test whether the direction and magnitude of analyst revisions of the next quarter’s earnings forecast following the SEC filings is positively correlated with the previous SUE, and the effects of such revisions on the bias and error of the forecasts. Finally, our tests examine the sensitivity of the primary analyses to the information environment of the firm and, specifically, to such factors as size, proportion of institutional investors, analyst coverage, book/market ratio, availability of balance sheet and cash flow information in preliminary