Investors Miss Performance Signals

Research found that investors only price in negative changes once they have occurred, even if they were preceded by a predictable pattern of updated financial reports.

In an efficient market, investors price a stock according to a company’s material value, outlined in its comprehensive financial reports. As such, returns should be in line with the market’s return, given some volatility.

However, a study of 10-K and 10-Q reports found that companies making significant and frequent changes to these regulatory filings underperformed the market by up to 5.12% per year, usually marking negative business shifts in their changes.

In the analysis, researchers found that “changers” are more likely to issue negative reports both in the current and following period, release more business updates and exhibit lower operating margins, return on capital and interest coverage.

Most firms reuse their financial reports year after year with minor adjustments, according to the study. Companies keep their “risk factors” section timely and relevant, even when using the same text.

If companies have negative information about their business, they disclose it to avoid being sued. Positive news is announced for obvious reasons. Therefore, the most significant changes to financial reports are negative business changes.

Companies that did not significantly alter their 10-Ks and 10-Qs were found to neither underperform nor outperform the market.

There are many arguments for whether or not investors benefit from the amount of financial information companies disclose. The sheer number of companies precludes investors from analyzing the entire market.

The study found that while companies predictably underperformed after updating financial reports, investors were not reading reports closely enough to ascertain material changes and price them into stocks. The pattern of “changers” underperforming the market held even when looking at the S&P 500 index constituents, which are some of the most closely tracked stocks worldwide.

What does this mean for individual investors? There seems to be a gap between investors reading available information and that information’s predictive ability. There may also be an over-emphasis on year-over-year trends that occludes consecutive changes to reports.

Going forward, the author expects more computer-based textual analysis of financial reports to address this gap in the market’s efficiency.

Source: “Copy-Paste Outperformance: Lazy Investors and Copied Reports,” by Sven-Philip Sadlo; SSRN, 2020.