Focus on the Big Picture
By Liz Nelson
Thinking about investing in General Motors? Your first reaction might be to focus on analysts’ predictions of GM’s future earnings, but recent research by P. Eric Yeung, Peter B. Orthwein '68 Sesquicentennial Fellow in Accounting at Johnson, suggests that you should pay close attention to the information embedded in GM’s earnings forecast about the outlook of the overall auto industry. Focusing on the specifics of a particular firm can obscure more general industry information that should affect how you value shares.
In “Underreaction to Industry-Wide Earnings and the Post-Forecast Revision Drift” (Journal of Accounting Research, September 2013), Yeung and his co-author, Professor Kai Wai Hui of the Hong Kong University of Science and Technology, provide compelling evidence on this issue. The primary objective of their study was to explore whether investors undervalue industry-wide earnings news provided in analysts’ reports, and if so, why. Yeung and Hui examined 25,195 individual forecasts from 1,347 distinct analysts employed by 128 distinct brokerage houses that are extracted from industry reports on manufacturing industries from 2004-2008 and widely circulated among investors.
Yeung and Hui conclude that investors tend to underweight the industry-wide component of forecasted earnings relative to how they weight the firm-specific component, despite the fact that it is the industry component that likely causes more long-lasting impact on firm performance than does the firm-specific component. Yeung and Hui explain that “although more successful firms tend to lose their competitive edge due to new entrants and learning of other firms, unsuccessful firms tend to improve their performance by imitating others and taking corrective actions” (706). In other words, relative competitive positions of firms within an industry change at a much faster rate than the overall industry fundamentals that help determine firm performance, such as consumer taste, production technology, and regulatory environment. Therefore, a long-term investor should be really buying the industry with good prospects, not necessarily a particular company due to its temporary performance.
The underweighting of industry information leads to individual companies displaying “post-forecast revision drift,” with their share prices moving in the direction implied by industry information long after that information has been available to the public. Yeung and Hui found economically and statistically significant evidence of post-forecast revision drift in their sample, and also show that post-forecast revision drift is caused primarily by investors’ initial underreaction to industry-wide earnings news embedded in analysts’ forecasts, rather than their reaction to firm-specific news. Furthermore, the more closely a firm’s earnings tend to move with industry-wide profits, the greater the drift. They also observed that investors made corrections in response to forecast revisions around subsequent earnings announcements, indicating that a portion of investors’ delayed response is due to misestimates of future earnings, which are corrected as information about subsequent earnings becomes available. This further supports the idea that investors’ underreaction to news about industry-wide fundamentals is the primary cause of post-forecast revision drift.
How can such mispricing persist in today’s stock market? Young and Hui show that trading friction in the market and the high cost of arbitrage helps perpetuate post-forecast revision drift. Therefore, knowledgeable investors may not be able trade aggressively against the initial underreaction to industry-wide information, insuring that the effect of the initial underreaction is durable in the near term.
“People pay too much attention to the earnings forecasts of individual companies that they hold stock in,” says Yeung. “So if I hold stock in GM, I look at GM’s forecast and fail to pay enough attention to other auto makers’ forecasts, when actually aggregating the forecasts of all auto makers would give me a much better idea of how GM will do in the long run.” This is important information for investors. If investors know that they should value industry-wide information more heavily, they will be better informed and make better investment decisions than their less-informed counterparts.
Yeung’s work in this area continues. He has further investigated this phenomenon in another working paper, “On the Persistence and Pricing of Industry-Wide and Firm-Specific Earnings, Cash Flows, and Accruals,” which takes the idea of underreaction to industry-wide fundamentals to a new level. In this new working paper, co-authors Yeung, Kai Wai Hui, and Karen Neilson (Rice University) test the underreaction hypothesis in firms across all industries, as opposed to strictly manufacturing. They also focus on investors’ reactions to annual reported earnings to rule out the possibility that investors simply discount certain information in analysts’ predictions. In other words, Yeung’s new paper will show whether investors’ underreaction to analysts’ projections can be generalized to industry-wide information embedded in financial statements. This follow-up paper will further cement the ideas proposed in the first and provide valuable information for investors looking to make more informed investment decisions.