Abstract
We examine whether investors can exploit financial statement information to identify companies with a greater likelihood of future earnings increases and whether stocks of those companies generate 1-year abnormal returns that exceed the abnormal returns from following analysts’ consensus recommendations. Our approach summarizes financial statement information into a ‘‘predicted earnings increase score,’’ which captures the likelihood of 1-year-ahead earnings increases. We find that, within our sample of consensus recommendations, stocks with high scores are much more likely to experience future earnings increases than stocks with low scores. A hedge portfolio strategy that utilizes our approach within each consensus recommendation level generates average annual abnormal returns of 10.9 percent over our 12-year sample period, after controlling for previously identified risk factors. These abnormal returns exceed those available from following analysts’ consensus recommendations. Our results show that share prices and consensus recommendations fail to impound financial statement information that helps predict future earnings changes.
1 Introduction
We investigate whether share prices and analysts’ consensus recommendations fully reflect available financial statement information. Specifically, we test whether investors can use financial statement information ex ante to predict future earnings changes and then use those predictions to execute a trading strategy that will outperform sell-side analysts’ consensus recommendations (strong buy, buy, hold, underperform, or sell).
4 Conclusion
This study investigates consensus recommendations from a financial statement users’ perspective. Specifically, we test whether one can use financial statement information ex ante to predict future earnings changes and then use those earnings change predictions to execute a trading strategy to pick winners and losers among consensus analysts’ recommendations. Our tests essentially ask whether analysts’ consensus recommendations and share prices fully reflect the earnings prediction information in financial statements.
