Reinforcing Events

The second category of earnings 8 8 is what I call reinforcing events. Rather than changing investor perceptions about a stock, these 8 18 8 reinforce the current beliefs about the company. Since they confirm the current market opinion, they should have much less impact on stock prices. Reinforcing events are defined as positive 8 8 8 on favored stocks or negative 8 8 8 on out-of-favor stocks. A posidve 8 8 on a favored stock reinforces the previous perception that this is an excellent company. Good companies should do well. If they have positive 8 8 8, it is only to be expected.

In 1994, Duracell was a highly regarded growth stock. It reported a number of positive earnings 8 8 8 that year. Once again, however, investors expected a top company to deliver excellent results, and the stock merely kept pace with the market for the year.

Similarly, investors have low expectations for out-of-favor stocks and negative 8 8 5 simply reinforce their perceptions of the company. Negative 8 8 8 have relatively litde impact on their prices in the surprise quarter, and none in the nine months following.

An example of a reinforcing event on an out-of-favor stock was the announcement in late 1994 by of a large unexpected loss from trading in derivatives on interest rate futures. The losses would cancel much or all of its fourth quarters eamings. The announcements resulted in this stock declining only moderately. The next year it was up over 50%, and another 100% by late 1997. A reinforcing event has only a minimal impact on stock price movements.

Figure 6-A shows just how different the impact of eamings su rise is on event triggers and reinforcing events for the su rise quarter (on left), as well as for the full year (on right). The figure uses price-to-book value to measure the su rise effect, but measuring by price-to-cash flow or by price-to-eamings ratios results in very similar numbers. The two types of event triggers (negative su rises on favored stocks and positive su rises on out-of-favor stocks) have substantially more impact on stock prices than reinforcing events (positive su rises on favored and negative 8 18 8 on out-of-favor issues).

Look first at event triggers in Figure - , the two adjoining columns on the left side of the chart, for both the quarter and the year. We see that

ingly poor reappraisal of the company drops the stock even lower. The event trigger in this case continues over a number of quarters. The same is true for a series of positive 8 8 8 on an out-of-favor company.

15% /

-10%

-15%

Surprise Quarter

5.0%1 -1.4%

(+) (-)

(-) (+)

Full Year

jrs%i

0.0%

(+) (-) (-) (+)

Event Trigger Reinforcing Event Event Trigger Reinforcing Event

I Low P/BV Quintile

□ High P/BV Quintile

Total of

Absolute Surprises:

8.7%

3.7%

19.4%

1.8%

0% = Market Retum (3.6% quarterly, 15.6% annually) All figiu-es are market adjusted.

adding them together, the total price impact is 8.7% (+3.7% and -5.0%) in the surprise quarter. By contrast, adding the reinforcing events together results in a much smaller 8 18 impact-3.7% (2.3% and -1.4%) for the same quarter. For the full year, we also see that the size of the event triggers more than doubles, resulting in a total impact of 19.4%. Reinforcing events, on the other hand, have a negligible 1.8% impact on prices after one year.

Figure 6-4 demonstrates not only two distinct categories of 8 18 8, event triggers and reinforcing events, but that their response to unanticipated good and bad news is remarkably different. Event triggers resuh in a perceptual change, which continues through the end of the year, and has a major impact on stock prices.

The effect of reinforcing events on prices, on the other hand, is minor by the end of the 12 months following the 8 18 . The event trigger moves stock prices about 2A times as much as the reinforcing events in the quarter of the su rise, and 10 times as much after one year. The

Figure 6-4

The Impact of Event Triggers & Reinforcing Even

Price/Book Value 1973 - 1996

The Effects of Surprise Over Time

We have seen the results of surprise on best and worst stocks for up to one year after the 8 8 is announced. Are there lingering effects beyond that? Figure 6-5, which measures the performance of the best and worst groups of stocks by P/E ratios for five-year periods following an earnings su rise, provides the answer. Let us look first at the two types of event triggers (good news on "worst" stocks and bad news on "best"). The figure indicates that the lowest P/E group showing positive earnings 8 18 8 (low P/E positive) outperforms the market in all 20 quarters after the su rises, and records an above-market return of 34.7% for die five-year period. Conversely, the highest P/E group receiving negative 8 18 8 (high P/E negative) unde erforms in every quarter for the fol-

Figure 6-5

Positive and Negative Surprises

Compustat 1500 1973-1996

-1-1-1-1-1-1-1-1-1-1-r-

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Quarter

Low P/E Positive Surprise

Low P/E Negative Surprise

High P/E Positive

High P/E Negative Su rise

- Low P/E Positive Low / Negative ~« Higli P/E Positive -» ~ High / Negative

20-Quarter Return:

34.7%

18.2%

-27.1%

-44.7%

0% = Market Retum

chart is statistically significant at the 0.1% level, which means there is only a 1 in 1,000 possibility it could be sheer chance.