Here is advice from Dan Bernhardt, co-author of “The Dynamics of Earnings
Forecast Management,” on how investors may use earnings forecast
revisions to time stock purchases. Bernhardt is IBE Distinguished Professor
of Economics at the University of Illinois.
positive abnormal returns, suggesting that profitable purchases are possible.
There is a VERY clear message for investors: If you are going to buy a
stock near-term that has experienced a late increase in the consensus forecast
(i.e. in the two weeks prior to the earnings announcement), wait
until AFTER the earnings announcement, as the firm is likely to generate a
negative earnings surprise. Conversely, if you are going to buy a stock
near-term that has experienced a late decline in the consensus, buy it
BEFORE the earnings announcement.
The abnormal returns from buying stocks that had large reductions in the
consensus; or from selling stocks that had large increases in the
consensus just prior to the earnings announcement are each about
0.3% to 0.5% over the three-day window around the earnings
announcement, which is VERY large when annualized, but may not be large
enough to trade on directly to profit because of round trip transaction
costs.
Thus, the above advice on timing of trading is useful if you are going to
buy or sell, as then the trading costs would be incurred in any event.
2. Downward revisions were more prevalent later in later years, although I
have not looked at what the returns were post earnings announcement on a
year by year basis.
3. There is a REAL puzzle about the downward management of the consensus
that enables a firm to beat earnings. While the share price rises once
the earnings announcement reveals that earnings beat the (reduced)
consensus, share prices tend to fall by EVEN more following the more
pessimistic forecasts that were what lowered the consensus. Phrased
differently, the NET effect of managing forecasts down is clearly
negative once one factors in the fact that lower forecasts also reduce the
share price.
The question is then WHY do firms manage forecasts down (which they
CLEARLY do)?!?