The Incremental Information Content of Tone Change in Management Discussion and Analysis

This study explores whether the Management Discussion and Analysis (MD&A) section of Form 10-Q and 10-K has incremental information content beyond financial measures such as earnings surprises, accruals and operating cash flows (OCF). It uses a well-established classification scheme of words into positive and negative categories to measure the tone change in a specific MD&A section as compared to those of the prior four filings. Our results indicate that short window market reactions around the SEC filing are significantly associated with the tone of the MD&A section, even after controlling for accruals, OCF and earnings surprises. We also show that the tone of the MD&A section adds significantly to portfolio drift returns in the window of two days after the SEC filing date through one day after the subsequent quarter’s preliminary earnings announcement, beyond financial information conveyed by accruals, OCF and earnings surprises. The incremental information of tone change is larger the weaker is the firm’s information environment. The Incremental Information Content of Tone Change in Management Discussion and Analysis There is a substantial body of literature in financial economics and accounting that examines the value relevance and information content of quantitative factors in the pricing of stocks. While economic and statistical modeling has become more sophisticated over the years, the somewhat disconcerting conclusion that seems to have emerged is that these quantitative factors inadequately explain movement of stock prices. Persuasive evidence of this is provided by Shiller (1981), Roll (1988), and Cutler et al. (1989), and others in the finance literature, who demonstrate that stock prices do not respond to change in quantitative measures of firm fundamentals as would be expected from models incorporating only quantitative variables of firm performance. In the accounting literature, Lev and Thiagarajan (1993), and Amir and Lev (1996), are two examples of research that have shown the inadequacy of conventional quantitative financial measures in pricing a firm’s stock. All in all, there is a growing realization that to develop a “good” stock pricing model, one has to incorporate not only the conventional quantitative measures of firm performance, but also include nonconventional measures such as potential market share (Amir and Lev, 1996), and even verbal, non-quantitative, difficult to quantify, kinds of measures. This is not totally surprising from a theoretical perspective. After all, stock prices are set by investors who, by definition, compute prices as the discounted present value of future cash payoffs conditional on the current information set available to them. It seems natural then to expect that the investor information set should include not only quantifiable information, but also non-quantifiable, verbal information, such as news articles. Indeed, Tetlock (2007) examines whether the general negative or pessimistic flavor of a particular daily news column from the Wall Street Journal (WSJ) (titled “Abreast of the Market”) covering the stock market activity on the previous day influences prices of market indices of stocks. The depth of article pessimism is defined as the proportion of negative words used in this column. After controlling for other variables, he finds that the depth of pessimism in this column does put a significant downward (temporary) pressure on prices of the stock indices. Tetlock et al. (2008) further examines the ability of negative words used in WSJ and the Dow Jones News Service (DJNS) columns about S&P 500 firms to predict future earnings and stock returns on the day after the publication of these news articles. They find that the proportion of negative words in these news stories (especially, negative words about a firm’s fundamentals) do provide information about future earnings even after controlling for other factors; the higher the proportion of negative words the larger are the negative shocks to future earnings. In addition, they provide persuasive evidence that potential profits could be made by trading on negative words from DJNS, a timely news service (but not from the one day old information published in the WSJ). The two Tetlock papers remain among the first of their kind to assess the predictive content of non-quantitative verbal information and are the main motivators of our work. By focusing on news stories in media, their work is more concerned with 1 Following the initial impact on stock prices due to the media pessimism factor, the prices of indexes of smaller stocks reverse more slowly than those of large firms. In addition, he also provides persuasive evidence to show that pessimism is not a proxy for risk. As an additional feature, he also finds that unusually high or low pessimism among investors leads to temporarily high trading volume. 2 The authors acknowledge that these profits could be wiped out by transactions costs from high frequency trading. 3 We note that Abrahamson and Amir (1996) perform a content analysis of over 1,300 President’s Letters to shareholders for firms trading in the NYSE and written between 1986 and 1988. They show that while