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Research by Stephen Brown
Information asymmetry is one of the factors that drives the spread between
the buying and selling price of a stock and pushes up the cost of capital for
firms, so there is real economic significance to understanding what drives the
activity of privately informed investors and uninformed investors. Meeting or
beating analyst’s earnings forecasts has also become important, not just to
firms but to investors whose behavior is driven by them. But while it is clear
that earnings benchmarks are important to investors, and that earnings surprises
have a short-term effect on investor’s pricing associations and short-term
trading reactions, little has been known about how earnings surprises affected a
stock’s investment visibility and trading activity over the long term.
Stephen Brown, assistant professor of accounting and information assurance,
examined the effect of earnings surprises on information asymmetry between
informed and uninformed investors. With co-authors Stephen A. Hillegeist,
INSEAD, and Kin Lo, University of British Columbia, Brown conducted time-series
tests of the association between earnings surprises and the change in
information asymmetry before and after the earnings announcement.
Brown and his co-authors considered the trading activity level of informed
investors, those with some kind of private knowledge that would influence their
trading decisions, and uninformed investors, i.e. those who rely solely on
publicly available information or who trade for liquidity reasons. This latter
group includes both individual investors and certain professional investors such
as index funds, that maintain balanced portfolios.
They found that information asymmetry decreased in the quarter following a
positive earnings surprise, when a firm beat earnings forecasts, and increased
during the quarter following a negative earnings surprise, when firms failed to
meet an earnings forecast.
Earnings surprises attract media attention, and that extra attention raises
awareness of the firms in the minds of investors. When the surprise is positive,
there is increased trading activity in the stock. Brown expects this is because
newly-aware investors believe that a firm that beat its earnings forecasts
represent an attractive buying opportunity.
There are thousands of stocks for investors to choose from, so publicity and
media attention brings a stock to the awareness and attention of uninformed
investors. Good attention in the form of beating earnings expectations result in
a decrease in information asymmetry. Why?
“Beating expectations stop the private information events from occurring,”
says Brown. “Firms that are doing well are generally happy to share that good
news. You always hear about people getting engaged before they actually get
married, but you rarely hear about people getting divorced until it has already
happened. We humans are eager to share good news and reluctant to share bad
news.”
The increase in uninformed trading provides additional camouflage for
informed trading, because it is harder for the market maker to tell that any
particular trade is based on private information. After a positive surprise, the
level of informed trading appears to increase commensurately with the level of
uninformed trading on those days when informed traders have private information.
However, there are fewer such days on which they have such information and so
the overall level of information asymmetry is reduced.
Negative earnings surprises cause a reduction in the level of trading by both
uninformed and informed traders, despite the fact that the surprise may garner
just as much media attention. This may be because uninformed investors,
particularly individual investors, aren’t in a position to sell the stock short.
However, the reduction in trading by uninformed investors is disproportionately
greater than the reduction in trading by the informed and the overall level of
information asymmetry increases.
A company that doesn’t meet its earnings forecasts in a big way, particularly
when that follows a string of positive earnings surprises, is more likely to
cause greater media attention, which will then cause greater asymmetry.
These changes in information asymmetry persisted for at least a year
following the initial earnings surprise, whether it was positive or negative.
While it is commonly held belief that investors place importance on earnings
benchmarks, this study is valuable because it provides evidence for what
investors actually do, rather than what executives believe investors do.
“The effect of earnings surprises on information asymmetry,” is forthcoming
from the Journal of Accounting and Economics. For more information
about this research, contact
sbrown@rhsmith.umd.edu.
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