Download Insider Trading & Analyst Forecasts: Insights on Information Trading and more Slides Investment Management and Portfolio Theory in PDF only on Docsity! Aswath Damodaran! 1! Trade on the news?
Information Trading" Aswath Damodaran Aswath Damodaran! 2! Information and Value" Investors attempt to assess the value of an asset based upon the information that they have about that asset at that point in time. At the same time, different investors will arrive at different assessments of value for the same asset • Because the information they have is different • Because they have different ways of processing the same information The price is determined by demand and supply. Aswath Damodaran! 5! An Overreacting Market" Time New information is revealed Asset price Figure 10.3: An Overreacting Market The price increases too much on the good news announcement, and then decreases in the period after. Aswath Damodaran! 6! Trading on Private Information" Insiders are managers, directors or major stockholders in firms. While they are constrained from trading ahead of information releases, they can still legally buy or sell stock in their companies. Analysts operate at the nexus of private and public information. To the extent that they “know” something about the company that the rest of us do not, their recommendations should convey information to the market. One way to examine whether private information can be used to earn excess returns is to look at whether insiders and analysts earn excess returns. Aswath Damodaran! 7! Insider Trading as a Leading Indicator of Stock prices.." Aswath Damodaran! 10! Can you follow insiders and make money?" 1% 0% -1% -2% 2% 3% 4% Insider Reporting Date Official Summary Date Days around event date -200 +300 Aswath Damodaran! 11! Are some insiders more inside than others?" Not all insiders have equal access to information. Top managers and members of the board should be privy to much more important information and thus their trades should be more revealing. A study by Bettis, Vickrey and Vickery finds that investors who focus only on large trades made by top executives, rather than total insider trading may, in fact, be able to earn excess returns. As investment alternatives to trading on common stock have multiplied, insiders have also become more sophisticated about using these alternatives. As an outside investor, you may be able to add more value by tracking these alternative investments. Knowledge about insider trading is more useful in some companies than in others. Insider buying or selling is likely to contain less information (and thus be less useful to investors) in companies where information is plentiful (both because of disclosure by the company and analysts following the company) and easy to assess. Aswath Damodaran! 12! Illegal Insider Trading: Is it profitable? " When insiders are caught trading illegally, they almost invariably have made a killing on their investment. Clearly, some insiders made significant returns off their privileged positions. Almost all major news announcements made by firms are preceded by a price run-up (if it is good news) or a price drop (if it is bad news). While this may indicate a very prescient market, it is much more likely that someone with access to the privileged information (either at the firm or the intermediaries helping the firm) is using the information to trade ahead of the news. In fact, the other indicator of insider trading is the surge in trading volume in both the stock itself and derivatives prior to big news announcements. In addition to having access to information, insiders are often in a position to time the release of relevant information to financial markets. One study find that insiders sell stock between 3 and 9 quarters before their firms report a break in consecutive earnings increases. They also find, for instance, that insider selling increases at growth firms prior to periods of declining earnings. Aswath Damodaran! 15! Determinants of analyst following…" Market Capitalization: The larger the market capitalization of a firm, the more likely it is to be followed by analysts. Institutional Holding: The greater the percent of a firm’s stock that is held by institutions, the more likely it is to be followed by analysts. The open question, though, is whether analysts follow institutions or whether institutions follow analysts. Given that institutional investors are the biggest clients of equity research analysts, the causality probably runs both ways. Trading Volume: Analysts are more likely to follow liquid stocks. Here again, though, it is worth noting that the presence of analysts and buy (or sell) recommendations on a stock may play a role in increasing trading volume. Aswath Damodaran! 16! I. Earnings Forecasts" Analysts spend a considerable amount of time estimating the earnings per share that companies will report in the next quarter. They also provide forecasts of earnings further out - up to 5 years. Analysts also constantly update these forecasts as new information comes out. To the extent that there is information in these revisions, stock prices should react. Aswath Damodaran! 17! Information in Earnings Forecasts" 1. Firm-specific information that has been made public since the last earnings report: Analysts can use information that has come out about the firm since the last earnings report, to make predictions about future growth. 2. Macro-economic information that may impact future growth : Analysts can update their projections of future growth as new information comes out about the overall economy and about changes in fiscal and monetary policy. 3. Information revealed by competitors on future prospects: Analysts can also condition their growth estimates for a firm on information revealed by competitors on pricing policy and future growth. 4. Private information about the firm: Analysts sometimes have access to private information about the firms they follow which may be relevant in forecasting future growth. 5. Public information other than earnings: It has been shown, for instance, that other financial variables such as earnings retention, profit margins and asset turnover are useful in predicting future growth. Analysts can incorporate information from these variables into their forecasts. Aswath Damodaran! 20! How about long term forecasts?" There is little evidence to suggest that analysts provide superior forecasts of earnings when the forecasts are over three or five years. An early study by Cragg and Malkiel compared long-term forecasts by five investment management firms in 1962 and 1963 with actual growth over the following three years to conclude that analysts were poor long term forecasters. This view was contested in 1988 by Vander Weide and Carleton who found that the consensus prediction of five-year growth in the I/B/E/S was superior to historically oriented growth measures in predicting future growth. Aswath Damodaran! 21! Market Reaction to Earnings Revisions…" In one of the earliest studies of this phenomenon, Givoly and Lakonishok created portfolios of 49 stocks in three sectors, based upon earnings revisions, and reported earning an excess return on 4.7% over the following four months on the stocks with the most positive revisions. Hawkins, in 1983, reported that a portfolio of stocks with the 20 largest upward revisions in earnings on the I/B/E/S database would have earned an annualized return of 14% as opposed to the index return of only 7%. In another study, Cooper, Day and Lewis report that much of the excess returns is concentrated in the weeks around the revision – 1.27% in the week before the forecast revision, and 1.12% in the week after, and that analysts that they categorize as leaders (based upon timeliness, impact and accuracy) have a much greater impact on both trading volume and prices. In 2001, Capstaff, Paudyal and Rees expanded the research to look at earnings forecasts in other countries and concluded that you could have earned excess returns of 4.7% in the U.K, 2% in France and 3.3% in Germany from buying stocks with the most positive revisions. Aswath Damodaran! 22! Potential Pitfalls and possible use…" The limitation of an earnings momentum strategy is its dependence on two of the weakest links in financial markets –earnings reports that come from firms (where accounting games skew earnings)and analyst forecasts of these earnings (which are often biased). To the extent that analysts influence trades made by their clients, they are likely to affect prices when they revise earnings. The more influential they are, the greater the effect they will have on prices, but the question is whether the effect is lasting. It is a short-term strategy that yields fairly small excess returns over investment horizons ranging from a few weeks to a few months. One way you may be able to earn higher returns from this strategy is to identify key analysts and build an investment strategy around forecast revisions made by them, rather than looking at consensus estimates made by all analysts. While forecast revisions and earnings surprises by themselves are unlikely to generate lucrative portfolios, they can augment other more long- term screening strategies. Tempered by fears of bias...
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Performance Comparison for Companies Receiving New Buy
Recommendations within One Year of IPO, 1990-91
Cumulative Mean Size-
Adjusted Return (%)
0.20
ba acetate ey
Ma Eas ee 6s 6 Y 8 8: 8-2 2S
Months before/after Buy Recommendation
‘Source: Based on data from Michaely and Womack (1999).
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Aswath Damodaran! 26! Using Analyst Recommendations…" Can you make money off analyst recommendations? • Stock prices should go up on recommendations, even if there is no new information in them, because there is a self fulfilling prophecy. • If this is the only reason for the stock price reaction, though, the returns are not only likely to be small but could very quickly dissipate. A four step process to getting the most out of analysts: • Identify the analysts who are not only the most influential but also have the most content (private information. Recommendations backed up by numbers and a solid story have more heft to them. • Screen out analysts where the potential conflicts of interest are too large for the recommendations to be unbiased. • You should invest based upon the recommendations, preferably at the time the recommendations are made. • Assuming that you still attach credence to the views of the recommending analysts, you should watch analysts for signals that they have changed or are changing their minds. Aswath Damodaran! 27! Trading on Public Information" There is substantial information that comes out about stocks. Some of the information comes from the firm - earnings and dividend announcements, acquisitions and other news - and some comes from competitors. Prices generally react to this information.
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The post-announcement drift?
4.00%
-3.00%
Figure 10.11; Post-Announcement Drift after Unexpected Quarterly Earnings Surprises: US
Companies from 1988-2002
ues
—vE9
"Most positive
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By day of the week..
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Figure 10.12: Earnings and Dividend Reports by Day of the Week
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The Consequence of Delays...
0.006
Cumulative Abnormal Returns
0.014
Figure 10.13: Cumulated Abnormal Returns around Earnings Reports: Day 0 is Earnings
Announcement Date
Early>6 days
Earnings Annoui
Date
+30
Delay>6 days
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Aswath Damodaran! 35! Can you make money of earnings announcements?" One strategy is to buy stocks that report large positive earnings surprises, hoping to benefit from the drift. The evidence indicates that across all stocks, the potential for excess returns from buying after earnings announcements is very small. You can concentrate only on earnings announcements made by smaller, less liquid companies where the drift is more pronounced. In addition, you can try to direct your money towards companies with higher quality earnings surprises by avoiding firms with large accruals. Your biggest payoff is in investing in companies before large positive earnings surprises. You may be able to use a combination of quantitative techniques (time series models that forecast next quarter’s earnings based upon historical earnings) and trading volume (insiders do create blips in the volume) to try to detect these firms. Even if you are right only 55% of the time, you should be able to post high excess returns. I]. Acquisitions
25.00%
20.00%
15.00%
Very slight drift in stock price after announcement
Target
Bidder
Cumulative Abnormal Return
Ss
‘The stock price drifts
up before the news
hits the market
‘The acquistion is announced at this point in
time.
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Aswath Damodaran! 37! Across different types of acquisitions…" 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% C um ul at iv e A bn or m al R et ur n (2 d ay s) Tender offer(A) vs Mergers (B) Cash (A) vs Stock (B) Hostile (A) vs Friendly (B) Categorization of Acquisitions Target Firm Premiums in Acquisitions A: Tender, Cash, Hostile B: Merger, Stock, Friendly Aswath Damodaran! 40! After the acquisition… Divestitures" The most damaging piece of evidence on the outcome of acquisitions is the large number of acquisitions that are reversed within fairly short time periods. Mitchell and Lehn note that 20.2% of the acquisitions made between 1982 and 1986 were divested by 1988. In a study published in1992, Kaplan and Weisbach found that 44% of the mergers they studied were reversed, largely because the acquirer paid too much or because the operations of the two firms did not mesh. Studies that have tracked acquisitions for longer time periods (ten years or more) have found the divestiture rate of acquisitions rises to almost 50%, suggesting that few firms enjoy the promised benefits from acquisitions do not occur. In another study, Aswath Damodaran! 41! Takeover based investment strategies" The first and most lucrative, if you can pull it off, is to find a way (legally) to invest in a target firm before the acquisition is announced. The second is to wait until after the takeover is announced and then try to take advantage of the price drift between the announcement date and the day the deal is consummated. This is often called risk arbitrage. The third is also a post-announcement strategy, but it is a long-term strategy where you invest in firms that you believe have the pieces in place to deliver the promised synergy or value creation. Aswath Damodaran! 42! Preannouncement Trading" Research indicates that the typical target firm in a hostile takeover has the following characteristics: • It has under performed other stocks in its industry and the overall market, in terms of returns to its stockholders in the years preceding the takeover. • It has been less profitable than firms in its industry in the years preceding the takeover. • It has a much lower stock holding by insiders than do firms in its peer groups. • It has a low price to book ratio & a low ratio of value to replacement cost. There are two ways in which we can use the findings of these studies to identify potential target firms. • Develop a set of screens that incorporate the variables mentioned above. You could, for instance, invest in firms with market capitalizations below $ 5 billion, with low insider holdings, depressed valuations (low price to book ratios) and low returns on equity. • The second and slightly more sophisticated variant is to estimate the probability of being taken over for every firm in the market using statistical techniques
IV. Dividend Changes
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CAR (%)
-0.15
-0.37
-0.90
-1.43
-1.96
-2.49
-3.02
-3.55
-4.08
i 4 us Lv
-0.13
461
-10-8 -3 AD2 7.10
Oavs relative to the announcement cate
of dividends
{a) Dividend decrease
dt a 1. iJ
7
~10-8 -3 AD2 10
Oays relative to the announcernent cate
of dividends
(b) Dividend increase
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Have dividends become less informative?
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Figure 10.19: Market Reaction to Dividend Changes over time: US companies
® Dividend Increases
® Dividend Decreases
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Aswath Damodaran! 47! Implementing an Information Based Strategy: Determinants of Success" n Identify the information around which your strategy will be built: Since you have to trade on the announcement, it is critical that you determine in advance the information that will trigger a trade. n Invest in an information system that will deliver the information to you instantaneous: Many individual investors receive information with a time lag – 15 to 20 minutes after it reaches the trading floor and institutional investors. While this may not seem like a lot of time, the biggest price changes after information announcements occur during these periods. Execute quickly: Getting an earnings report or an acquisition announcement in real time is of little use if it takes you 20 minutes to trade. Immediate execution of trades is essential to succeeding with this strategy. Keep a tight lid on transactions costs: Speedy execution of trades usually goes with higher transactions costs, but these transactions costs can very easily wipe out any potential you may see for excess returns). Know when to sell: Almost as critical as knowing when to buy is knowing when to sell, since the price effects of news releases may begin to fade or even reverse after a while.