An analysis on markets reaction to earnings release

Fang Li May 11, 2013

Abstract The idea is older companies are more predictable and younger companies are less. We do a test on post-earning-release test on why this is the case.

1 A little background
Netix could be one of the least predictable company in history. Theres often some big change after its earning release, many involved a twenty percent change. On the other side, we seldom see apple rise or fall above ten percent any time. An earning realease generally moves apple stock around 3 percent. So there is potentially a relation between the market predictablity and how many years the company exists. There are denitely other issues like rm size, risk, diversication of business line, etc. We only examine the year eect. The assumption here is that market reach a consesus before the earnings release. Namely the day before, the market price best reects peoples expectation of how the stock should go. The move in the next day will show how people adjust thier valuation.

2 Sample
The sample of this test contains 100 companies from Nasdaq technology company category. The company examined have a history from 5 to 45 years. The reason to choose this sample is 1. Most companies are around twenty to thirty years old by the time of research. So we have enough data in a relatively small time window which will help better use in empiricle application. 2. Tech companies tend to uctuate more because its less likely for costumers to stick to this product, especially for small internet companies. So its potentially better for analysis. These 100 companies come from dierent age range, see graph below.

From the graph, we can see that number of companies within each group is controlled so that it can reect the fact-many rms arose from 1980s; many internet stars went public since 1990s. Its worth mentioning that two youngest rms are Homeaway and Facebook. They have less than 5 years of trading history.

3 Test 1: Not controlled by daily uctuation

1. Initial Study of Group Average

From the graph above, we can get the following information (a) The trend is downward. The older the group, the less average change. (b) There seems to be some at zones showing companies bear the same predictability to some adjacent groups 2. Regression Analysis

The regression has the formula: C = 0.11132 0.00190 Y where c represents the stock price dierence and Y represents the companies age. Both intercept and the coecient has p-value of t-score less than 0.0001 saying its very signicant. It predicts that market cannot predict the earnings well for young rms but can do a fair job for big companies.

The above graph displays the predicted group average and actual group average, the discrepancy is not large and mostly convincing.

4 Test 2: Consideration of daily uctuation

This graph shows average uctuation of our sample stocks in the last 10 years. This analysis is signicant as well but as we can see, the dierence is small. So, this potentially undermined our rst research topic because the large uctuation might be able to be explained by its nature-stock itself uctuates a lot.

5 Test 3: Taking into consideration of daily uctuation

I test post-release uctuation minus the daily uctuation. And the result shows a revised result.

We can see the deviation is larger but the trend is clear. The regression has the formula: C = 0.08436 0.00165 Y where c represents the stock price dierence and Y represents the companies age. Both intercept and the coecient has p-value of t-score less than 0.0001 saying its very signicant even after consideration of their daily uctuation.

6 Reason Analysis
Our test shows that older technology companies listed on Nasdaq tend to be more predictable by the market. There can be many reasons that lead to this result. (a) Older companies in our list is mostly large groups and those who survived the erce competition process for rst ten or twenty years. So their fundamentals are good and company operation is more smooth. (b) Older companies are more unwilling at taking risks. So they behave more cautiously. (c) The assets of those older companies are more diversied and better managed. This says the company itself is a portfolio, so deviation is lessened. (d) From Market side: These companies are carefully observed and well documented by large institutions. More people are onto this and more time is spent on this. So, based on the information theory, more is known for the older companies and less noise traders.

7 Application
This result can be used in the following way (a) When managing portfolios, we can adjust our portfolio accordingly, especially when we are doing high-risk trading. We can lower our weight on high uctuating stock to avoid the unexpected loss made solely by noise traders. For example, after we decide to short both apple and facebook, we want to assign more weight on apple because, it tends to uctuate less and our short sale loss is lessened because of unexpected rise is less. (b) Whether we want to decide to long or short a stock, we should take consideration of earnings release. Because this uctuation caused by earnings change is potentially big. So we want to take some position to hedge our asset risk. Say, if we shorted Netix, like a lot of people did last October, they lost huge in a single day-40%. Thats complete tragic. Based on our analysis, we can set a reasonable uctuation range and we can use options to hedge against it. And then sell the option. Our strategy will be long a straddle at a desired price (this price is not the close price the night before earning release, but our predicted target price) (c) We can simply make use of this phenomenon. For example, NetFlix has a volitility(unadjusted) 14% after earnings release, a straddle cost about 8% of its price, so we can make use of this information. However, betting on a single stock is risky, so we can bet on a group of stocks and make use of our group analysis.

8 Further Study
(a) Digging out whats the key factor that drives a young company unpredictable. (b) Apple and Microsofts pathway to a lower standard deviation. If they experience a path that smoothed gradually, then the result is even more convincing.