Finance & Accounting Dec 1, 2009

Explain­ing Stock Price Drift

Trad­ing costs lead the way

Based on the research of

Jeffrey Ng

Tjomme O. Rusticus

Rodrigo Verdi

Buy low, sell high seems sage enough invest­ment advice, but it does not explain why stock prices con­tin­ue to climb if earn­ings are good — or fall if earn­ings are bad — months after com­pa­ny earn­ings announcements.

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If you knew the stock price was going to go up, then you’d buy more now so you would prof­it from it,” says Tjomme Rus­ti­cus, (Assis­tant Pro­fes­sor of Account­ing Infor­ma­tion and Man­age­ment at the Kel­logg School of Management).

So how to explain the well-doc­u­ment­ed drift in stock prices that dog earn­ings reports?

Researchers sus­pect­ed the drift might be due to trans­ac­tion costs — fees paid to mar­ket mak­ers that stand ready to buy and sell a par­tic­u­lar stock at a pub­licly quot­ed price on a reg­u­lar and con­tin­u­ous basis. An analy­sis of earn­ings reports eigh­teen years of quar­ter­ly trad­ing data shows this is exact­ly the case, reports Rus­ti­cus and his co-authors Jeff Ng and Rodri­go Ver­di (Assis­tant Pro­fes­sors of Account­ing at MIT Sloan School of Management).

In the long dis­tance past — that’s about forty years ago — the first large-scale data on company’s earn­ings and stock prices became avail­able. That’s when account­ing researchers could start inves­ti­gat­ing how the stock mar­ket uses earn­ings infor­ma­tion,” Rus­ti­cus says.

The first thing they looked at was a rather basic ques­tion: If we have good earn­ings — high­er than expect­ed — is that some­thing that investors val­ue? If you think about it, you would say yes: If a com­pa­ny makes a lot of mon­ey and has high­er earn­ings, then the stock price should go up.”

An Account­ing Puz­zle
Unsur­pris­ing­ly, bet­ter earn­ings were fol­lowed by a boost in a company’s stock price. Con­verse­ly, low­er earn­ings trig­gered a decline. How­ev­er, the analy­sis showed some­thing else as well: Stock prices not only went up or down after earn­ings announce­ments, but they con­tin­ued to do so for months after­ward. That was the start of a puz­zle in account­ing research,” Rus­ti­cus says.

Rus­ti­cus and his col­leagues mea­sured the trans­ac­tion costs by look­ing at the dif­fer­ence between the price traders were charg­ing to sell a stock and the price they were charg­ing to buy.

More research fol­lowed using dif­fer­ent data, time peri­ods, and mea­sures in an attempt to explain the phe­nom­e­na. Researchers inves­ti­gat­ed whether the result could be due to risk, or whether some­how investors did not pay enough atten­tion to or did not under­stand earn­ings reports. Some won­dered whether the returns in the data were real­ly attain­able giv­en that investors incur costs when trad­ing stocks.

One of the expla­na­tions was that there are costs involved with trad­ing,” Rus­ti­cus says. The returns that you see in the data­base as the change in price are not exact­ly the mon­ey that you would make. When you buy a stock, you tend not to get the best price avail­able. You tend to trade with a mar­ket mak­er, for exam­ple, who will sell you a stock for a lit­tle more than he or she bought it for. There’s an inter­me­di­ary who takes some prof­it every time they sell a share, so the prof­it that the trad­er makes is less than the prof­it observed in the database.”

Rus­ti­cus and his col­leagues mea­sured the trans­ac­tion costs by look­ing at the dif­fer­ence between the price traders were charg­ing to sell a stock and the price they were charg­ing to buy. That dif­fer­ence between the ask price and the bid price was their prof­it — a cost that was nor­mal­ly hid­den in day-to-day trad­ing, but one that could explain the drift in stock prices months after earn­ings reports.

For exam­ple, sup­pose there is an investor who knows that the true val­ue of a stock is $100 a share. A favor­able earn­ings report comes out and each share of the company’s stock is now worth $105. If buy­ing will cost $1 and there will be anoth­er $1 fee to sell at some point in the future, then the savvy investor knows that he or she can keep buy­ing until the share price reach­es $103. If you pay more than that, you would lose mon­ey in the trade. Pay less and you would gain.

The Bid-Ask Spread Fac­tor
To show that trans­ac­tion costs were sys­tem­at­i­cal­ly affect­ing stock prices over time, Rus­ti­cus grouped stocks based on the spread in their bid and ask prices, the prof­it a trad­er stood to make in the trans­ac­tion. The idea was that stocks with a small­er spread, which are cheap­er to trade, would have a greater ini­tial bump in price fol­low­ing earn­ings reports and less change in the price months lat­er. In con­trast, stocks with a big­ger bid-ask spread would still show the impact of the trans­ac­tion fees months later.

To com­pute the dai­ly per­cent com­mis­sion rate, the researchers first obtained the aver­age trade size for each stock by aver­ag­ing the dol­lar vol­ume of the trades with­in each day. They then took the aver­age trade size and com­bined it with a com­mis­sion sched­ule from CIGNA Finan­cial Ser­vices to esti­mate the com­mis­sion for an aver­age trade. Dai­ly per­cent­age com­mis­sion rates were deter­mined by divid­ing the com­mis­sion by the aver­age trade size. The last step in the process was to aggre­gate the dai­ly spread (the dif­fer­ence between the ask­ing price and the sell­ing price) and the com­mis­sion rate dur­ing the month of earn­ings announce­ments to esti­mate the aver­age trans­ac­tion cost.

The researchers looked at earn­ings from 126,386 announce­ments culled from the quar­ter­ly trad­ing data. They matched this with stock returns and trans­ac­tion cost data between 1988 and 2005.

We first looked at how big a response there was at the earn­ings announce­ment,” Rus­ti­cus said. For com­pa­nies with low trans­ac­tion costs, there should be a big response at the earn­ings announce­ment because it’s cheap to trade, so the whole response should come then. For com­pa­nies where trans­ac­tion costs are high, that’s where we would expect a small response at the earn­ings announce­ment and more returns in the sub­se­quent months. That’s exact­ly what we found.”

The research does not rule out oth­er fac­tors that may be trig­ger­ing the stock price drift, but it is well sup­port­ed by the data.

Our the­o­ry and empir­i­cal results do a good job at cap­tur­ing pat­terns in the data. It doesn’t mean that our the­o­ry is the only expla­na­tion,” Rus­ti­cus adds. Just as in physics there are all kinds of forces that work on things. In eco­nom­ics, the same thing applies.”

Featured Faculty

Tjomme O. Rusticus

Member of the Department of Accounting Information & Management faculty from 2006 to 2013

About the Writer

Irene Klotz is a freelance writer based in Florida.

About the Research

Ng, Jeffrey, Tjomme O. Rusticus, Rodrigo S. Verdi. 2008. Implications of transaction costs for the post-earnings-announcement drift. Journal of Accounting Research 46(3): 661-696.

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