Earnings Announcements and Systematic Risk

• Date: 01 February 2016
• Published date: 01 February 2016
• Author: PAVEL SAVOR,MUNGO WILSON
• DOI: http://doi.org/10.1111/jofi.12361

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 1 •FEBRUARY 2016

Earnings Announcements and Systematic Risk

PAVEL SAVOR and MUNGO WILSON∗

ABSTRACT

Firms scheduled to report earnings earn an annualized abnormal return of 9.9%.

We propose a risk-based explanation for this phenomenon, whereby investors use

announcements to revise their expectations for nonannouncing firms, but can only

do so imperfectly. Consequently, the covariance between firm-specific and market

cash flow news spikes around announcements, making announcers especially risky.

Consistent with our hypothesis, announcer returns forecast aggregate earnings. The

announcement premium is persistent across stocks, and early (late) announcers earn

higher (lower) returns. Nonannouncers’ response to announcements is consistent with

our model, both over time and across firms. Finally, exposure to announcement risk

is priced.

FIRMS ON AVERAGE EXPERIENCE stock price increases during periods when they

are scheduled to report earnings. This earnings announcement premium was

first discovered by Beaver (1968) and has subsequently been documented by

Chari, Jagannathan, and Ofer (1988), Ball and Kothari (1991), Cohen et al.

(2007), and Frazzini and Lamont (2007). Kalay and Loewenstein (1985) obtain

the same finding for firms announcing dividends. None of these papers find

that the high excess returns around announcement days can be explained in

the conventional manner by increases in systematic risk.

In this paper, we propose and test a risk-based explanation for the announce-

ment premium that combines two ideas. First, earnings reports provide valu-

able information about the prospects of not only the issuing firms but also their

peers and more generally the entire economy. However, investors face a signal

extraction problem: they only observe total firm earnings and hence must infer

the news relevant to expected aggregate cash flows, the common component of

∗Pavel Savor is at the Fox School of Business at Temple University. Mungo Wilson is at the

Said Business School and the Oxford-Man Institute at Oxford University. We thank Cam Harvey

(the Editor), an anonymous Associate Editor, two anonymous referees, John Campbell, Robert

de Courcy-Hughes, ˇ

Luboˇ

sP

´

astor, Stephanie Sikes, Rob Stambaugh, Laura Starks, Amir Yaron,

and seminar participants at Acadian Asset Management, AHL, American Finance Association

annual meeting, Arrowstreet Capital, Auckland Finance Meeting, Bristol University, Carnegie

Mellon University (Tepper), the European Summer Symposium in Financial Markets, Georgia

Institute of Technology(Scheller), Kepos Capital, NBER Summer Institute Asset Pricing Workshop,

Quantitative Management Associates, PDT Partners, SAC Capital Advisors, UCLA (Anderson),

the University of North Carolina (Kenan-Flagler), and the University of Pennsylvania (Wharton)

for valuable comments. The authors gratefully acknowledge financial support from the George

Weiss Center for International Financial Research at the Wharton School.

DOI: 10.1111/jofi.12361

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84 The Journal of Finance R

an announcing firm’s earnings news.1This spillover from the cash flow news

of an individual announcer to the wider market creates a high conditional

covariance between firm- and market-level cash flow news, generating a high

risk premium for the announcing firm. Although nonannouncing stocks also re-

spond to the news in announcements, they should respond less, since investors

learn less about these firms.

Second, realized firm-level returns contain a component unrelated to ex-

pected future cash flows, namely, discount rate news (Campbell and Shiller

(1988)). If discount rate news is more highly correlated across firms (Cohen,

Polk, and Vuolteenaho (2003)), market betas will mainly reflect covariance be-

tween firm- and market-level discount rate news (Campbell and Mei (1993)). In

consequence, an announcing firm can have higher fundamental risk than the

market, even after controlling for its market beta.2In other words, although

a firm’s market beta may rise on the day it announces earnings, the increase

in its expected return will be larger than can be explained by its higher beta

alone. This means that we expect a positive announcement return even if the

actual earnings surprise is zero.3

Under our hypothesis, the market return will be a poorer predictor of future

aggregate earnings than the returns of announcing firms. Moreover, nonan-

nouncing firms, and the market in general, will respond more to announce-

ments offering more informative signals about aggregate earnings, such as

those by firms announcing early in a given period, when less is known about

aggregate earnings. The response to the announcement portfolio return should

be stronger when more firms are announcing, since this provides a more precise

signal of aggregate cash flow news. The sensitivity of nonannouncing firms to

announcements will also increase with the time that has elapsed since their

own last announcement. Finally, exposure to announcement risk, which in our

model is a proxy for aggregate cash flow risk, should command a risk premium.

We start our empirical analysis by establishing that the earnings announce-

ment premium is a significant and robust phenomenon. A portfolio strategy

that buys all firms expected to report their earnings in a given week and sells

short all the nonannouncing firms earns an annualized abnormal return of

9.9%. The premium is remarkably consistent across periods, is not restricted

to small stocks, and does not depend on the choice of a particular asset pricing

model. The weekly Sharpe ratio for the value-weighted (equal-weighted) long-

short earnings announcement portfolio is 0.112 (0.055), compared to 0.049 for

the market, 0.076 for the value factor, and 0.072 for the momentum factor. The

announcement portfolio has positively skewed returns and exhibits positive

coskewness, which means that the high announcement premium is not due to

negative skewness (assuming investors are averse to negative skewness as in

1Patton and Verardo (2012) evaluate this idea in the context of firms’ stock market betas.

2If realized returns were only affected by cash flow news, announcing firm and market returns

would be perfectly correlated, so that announcers’ high returns would be fully explained by their

market betas.

3This prediction is shared by models based on the resolution of uncertainty in the sense of

Knight (1921).

Earnings Announcements and Systematic Risk 85

Harvey and Siddique (2000)). Furthermore, our announcement premium based

on expected announcement dates likely understates the true premium, since

any algorithm for forecasting announcement dates misses many announce-

ments.

The announcement risk premium is quite persistent across stocks: those

with high (low) historical announcement returns continue earning high (low)

returns on future announcement dates.4This effect exists for horizons as long

as 20 years, and is distinct from the earnings momentum first documented by

Bernard and Thomas (1990) and recently explored by Brandt et al. (2008), as

it holds when we exclude announcement returns over the previous year. When

we sort weekly announcers into portfolios based on average announcement

returns over the previous 10 years, those in the lowest quintile enjoy excess

returns of 0.07%. As we move to the highest quintile, the excess returns grow

monotonically to 0.44%. The abnormal return of the corresponding long-short

portfolio (highest minus lowest) is 0.37% (t-statistic =6.06), or about 19.2%

on an annual basis. This evidence is consistent with our intuition. Different

firms have different exposure to earnings announcement risk, and it is likely

that this characteristic does not change frequently. If announcement returns

do indeed represent compensation for this risk, then we would expect them to

be persistently different across stocks, which is exactly what we document.

Another proxy for a firm’s exposure to announcement risk is the timing of its

earnings announcement. For a given period in which all firms report earnings,

such as a calendar quarter, investors should learn more from firms announcing

early in the period than from those announcing late, making the former riskier

and thus resulting in higher expected announcement returns (we confirm this

intuition formally in our model). To test this hypothesis, we examine whether

the amount of time between the start of a quarter and the expected announce-

ment date is related to abnormal announcement returns. The findings confirm

our hypothesis: early announcers enjoy higher (0.16%, with a t-statistic of 2.29)

abnormal returns and late announcers earn lower (−0.23%, with a t-statistic

of −3.83) abnormal returns than “regular” announcers.

We next explore which factors influence the relation between the market

return (or the returns of just nonannouncing firms) and announcement re-

turns. We find that the market responds more strongly to early announcers,

which is consistent with the intuition that early announcers provide more new

information as well as with our result that such announcers enjoy higher an-

nouncement returns.5We also show that the covariance between the market

returns and the earnings announcement portfolio return is much higher when

more firms are reporting in a given week (controlling for diversification effects),

presumably because more announcements provide a stronger signal about the

common component of earnings. Finally, we find that the nonannouncing firms

that have reported their earnings a long time ago respond more strongly to

4Frazzini and Lamont (2007) obtain a similar result for monthly announcement portfolios.

5Patton and Verardo (2012) document a similar result, where individual firms’ stock market

betas increase more for early announcers.