Are investor actions well-calibrated when they punish or reward the stocks of all the companies in an industry based on the earliest earnings announcements among peer companies? In the December 2006 version of their paper entitled “Overreaction to Intra-Industry Information Transfers?”, Jacob Thomas and Frank Zhang test the efficiency of intra-industry information transfers by measuring whether the price responses of non-announcing firms to earlier peer group earnings announcements systematically relate to subsequent price responses when these same companies announce their own earnings a few days later. Using a sample of earnings announcement dates, stock returns and firm financial variables spanning 132 quarters over 1973-2005 (245,742 firm-quarter observations), they conclude that:
- Intra-industry sympathy trading overreacts to earlier earnings announcements, correcting the overreaction as peer companies announce their own earnings. In other words, there is a negative correlation between the reaction of a firm’s stock price to earnings announced earlier by peer firms and its reaction to the firm’s own earnings announcement. A hedge portfolio designed to exploit this negative correlation earns an average quarterly excess return of about 1% as the initial overreaction corrects.
- Sympathetic overreaction may be greater when: (1) earnings correlation is low within an industry; and, (2) several early earnings releases appear to confirm an industry earnings trend.
- No other negative correlations are evident for other pairs of price responses, including the early announcer’s price responses at the two dates.
- Results are persistent in subsamples and robust to various cross-sections. The effect may be stronger for small capitalization firms with low trading volume and low liquidity.
- This result is unusual in that most earnings-related investor responses indicate initial underreaction rather than overreaction.
The following chart, taken from the paper, shows the quarterly excess returns from a strategy that is long (short) the 10% of firms that show the smallest (largest) reactions to peer company earnings announcements occurring at least five days before the selected firms make their own earnings announcements. The strategy opens positions one day before selected firm earnings announcements and closes positions one day after the announcements.
In summary, investors appear to overreact systematically in projecting a firm’s earnings results to the near-term earnings announcements of peer companies.
