New Study Claims Corporate Executives Intentionally Mislead Investors for Personal Gain
It won't surprise any market-watcher to learn that in the run-up to earnings season, companies tend to lower the bar for top and bottom line performance, thereby giving themselves better odds of exceeding analysts' expectations.
However, a new working paper suggests that the sins of omission that occur during the corporate "cheating" season, as it was dubbed by Societe Generale Global Head of Quantitative Strategy Andrew Lapthorne, are far more insidious.
Authors Kenneth Froot, Namho Kang, Gideon Ozik, and Ronnie Sadka conclude that managers mislead analysts and shareholders during earnings reports, and that their penchant for massaging expectations downwards may be employed in order to open up a window to buy their stock on the cheap in the near future.
The analysis starts from the premise that when company officials are discussing the quarter's results on a conference call, they're already well into the next reporting period — and have a much better idea of how the firm's been faring than the average investor.
The researchers then drew upon data from around 350 million electronic consumer devices to track when individuals professed an intent to visit the physical location of a given store. The sample size was significant enough to develop a real-time corporate sales indicator for 50 publicly-traded U.S. retailers.
The authors' indicator serves as a useful proxy for real activity as it correlates well with reported revenue growth. Therefore, the team asserts this indicator is appropriate to use as a barometer for how a company has done since the end of the quarter, and before earnings are released.
The researchers developed two hypotheses: either managers make disclosures in a timely matter (and their forward-looking information is quickly reflected in stock prices) or members of the C-Suite actively "lean against the wind" to understate good or bad news — or even offer the completely wrong impression of what's transpired since the last quarter ended.
Their findings suggest that guidance (or "bundled forecasts") provided by managers as well as the general tone of the conference call (analyzed using a "bag of words" approach) "point toward rejection of Timely Disclosure in favor of the Leaning Against the Wind alternative."
"Managers’ forecasts and tones in conference calls are, according to objective measures, more pessimistic when managers have positive post-quarter information, suggesting that at announcement they actively manage down investor expectations and stock price," they write.
Now, why would managers do this?
A relatively charitable explanation offered by the team is the executives try to avoid litigation by ensuring that investors don't get too bullish on the company's near-term prospects.
A cynic, however, might suggest that by suppressing the stock price by failing to disclose accurate information about the current quarter, managers are giving themselves the opportunity to acquire shares at a discount to what they would've otherwise paid, once the blackout period is over.
The evidence is with the cynics.
The team found that the relationship between underwhelming-to-negative commentary and forecasts from management (in spite of a real-time corporate sales indicator suggesting robust activity) and a positive return in the period starting a few days after earnings were reported is stronger and more reliable when insiders are purchasing shares during this period. "This implies that insiders understate their private information to purchase undervalued stocks prior to the price increase," they write.
"Unfortunately, we do not see any coherent alternative hypothesis — other than managerial manipulation for personal gain — to explain our particular rejection of the Timely Disclosure Hypothesis," the team concludes.