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Earnings "Torpedoes" Can Sink Growth Stocks

4/17/2003 --

During the stock-market bubble of the late 1990s, investors piled into high-growth stocks, hoping to cash in on above-average returns. When the earnings news was positive, these high-flyers did outperform value stocks, which rose at a more moderate pace. However, once the market soured and the glamour stocks began to miss their earnings forecasts, something surprising happened. The prices of high-growth issues suffered unusually sharp declines---much greater than expected---whenever earnings shortfalls were announced.

Were these “earnings torpedoes,” as they're called, just flukes in a super-heated market? Not so, say Douglas J. Skinner and Richard G. Sloan of the University of Michigan Business School. Their research shows high-growth stocks do exhibit disproportionately large reactions to negative earnings surprises. They also report investors seem more concerned about the fact the earnings forecast was missed than about the magnitude of the shortfall. Furthermore, disappointing results appear to have the greatest impact when first disclosed to investors, even when a company "pre-announces" adverse earnings surprises in advance.

“When firms miss their forecasts, the effect is dramatic,” say Sloan and Skinner. They reason that investors have overly optimistic expectations about the prospects of future earnings growth for stocks trading at high-valuation multiples, and when these expectations are not met, it results in lower subsequent stock returns. This large differential reaction to bad news accounts for the overall under-performance of growth stocks relative to value stocks, explain Skinner and Sloan, who observed the “earnings torpedo” effect on Oracle and Rainforest Café in the late 1990s.

To confirm their predictions, the two researchers used a sample of 103,000 firm-quarters between 1984 and 1996 as the basis for their study and tracked stock-return behavior over 20 quarters. Value stocks rose or fell in the same magnitude as the earnings surprise for both good and bad news, generally reaching a maximum of 5 percent, but growth stocks did not. Instead, the price of these high-flyers climbed steeply to a maximum of 10 percent when the earnings news was positive, but fell rapidly, losing 10 percent to as much as 20 percent of their value when they disappointed on earnings. These research findings help to explain why managers of growth firms have incentives to manage reported earnings and/or analysts' expectations in order to avoid negative earnings surprises.

Skinner is the KPMG Professor of Accounting and Sloan is the Victor L. Bernard PricewaterhouseCoopers LLP Collegiate Professor of Accounting and Finance. More details are presented in their research article, “Earnings Surprises, Growth Expectations, and Stock Returns: Or Don't Let an Earnings Torpedo Sink Your Portfolio,” which appeared last year in the Review of Accounting Studies.

For more information, contact:
Bernie Degroat
Phone: 734.936.1015 or 734.647.1847