Many established investment strategies have their origins in the world of academia. What is popularly known as value investing, momentum, low-risk anomaly, or smart beta styles - they were all once the research projects of finance professors and their graduate students. They started out as theories which were then tested and backtested, deployed in the live markets, and refined over years. Not surprisingly, the academic world continues to remain at the forefront of unearthing new & innovative investing strategies.
One of the coolest such theories that I’ve come across is known as the Post Earnings Announcement Drift (aka PEAD), which I learnt while studying the MSc. in Financial Economics course at the University of Oxford. Originally researched in the mid 1980s in the US, this theory has gained widespread acceptance and support since then and is implemented by many investors & traders across the world.
The PEAD theory states that when stocks experience an earnings surprise, they have a tendency to drift in the direction of the surprise for several weeks upto 3 months. Let’s say analysts expected Infosys to post an EPS of 15 - but instead when the results came out, Infosys pleasantly surprised the market by posting an EPS that’s 40% higher at 21. As a result of this great news, let’s assume the stock shoots up 25% on the day of the results. Now, PEAD says that over the next few weeks, the stock is going to “drift” by, say, another +5%. The same would be true if the surprise would’ve been negative instead of positive - and the greater the surprise, the larger the drift.
In fact, the seminal 1989 paper
on this theory, published in the prestigious Journal of Accounting Research, found that the average drift of the top & bottom 10 percentile of companies (i.e. the companies with the largest positive and negative earnings surprise) was 6.31% over 60 trading days - or about 25% on an annualised basis. This finding was based on quarterly data covering 12 years for all firms then listed on the NYSE and AMEX.
At that time, or even for years after, it wasn’t clear why the PEAD phenomenon existed - until behavioural finance gained prominence and provided answers. PEAD happens because investors have a tendency to under-react to such unexpected news - when a stock has a positive surprise & rises by a large amount in a few hours, many existing investors start selling & booking profits without really studying all the new positive developments. As such, this selling prevents the stock from rising to its new & improved fundamental value based on the new information presented in the earnings surprise - this tends to correct itself over the next few weeks as professional investors step-in, thus leading to the drift.
Similarly, when a stock has a negative earnings surprise, many investors start buying that stock because it now looks attractive to them, and this buying prevents the stock from reaching its updated & lowered inherent value on the first few days of the surprise. But as and when this new information has been analysed and processed, professional investors step in and short-sell the stock, again resulting in the drift.
So, why should you care? Well, this theory has 2 practical implications:
- If you simply buy (short) the shares experiencing a positive (negative) earnings surprise on the day of the surprise, you can make a cool return without really doing any work, i.e. without having done any fundamental research and/or technical analysis
- Equally importantly, if you’re an investor who’s already holding a stock experiencing an earnings surprise, you can earn additional returns by holding-on to that stock for a few more weeks - or save yourself some additional damage by selling it immediately in case of a negative earnings surprise.
Does this always work? Of course not. Personally speaking, I’ve experienced this as an investor when I owned a stock that experienced an approx. +35% move due to better-than-expected earnings - I would’ve sold the stock that day had I not know this theory, due to which I ended up earning another ~13% over the next few weeks. But this will certainly not always be the case. A good indicator is that. the stronger the earnings surprise, the higher the odds of a drift. However, you should certainly do your own due-diligence before making any investment or testing any strategy or theory.