Management’s Tone Change, Post Earnings Announcement Drift and Accruals

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 and accruals. 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 relative to prior periodic SEC 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 and earnings surprises. We also show that management’s tone change 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 and earnings surprises. We find that the incremental information of management’s tone change is higher when the firm’s information environment is weaker. Management’s Tone Change, Post Earnings Announcement Drift and Accruals 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 in order 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 1 Though not directly connected to the research questions in our paper, we note that Boukus and Rosenberg (2006), and Hanley and Hoberg (2008), make a strong case for incorporating verbal and textual information in asset pricing models. While qualitative studies to date (including ours) make additional contribution to the explanatory power of stock return volatility, they do not completely fill the void left after one considers the financial quantitative measures. 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 is correlated with 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 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). 2 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 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. 3 The authors acknowledge that these profits could be wiped out by transactions costs from high frequency trading.