Post-earnings drift is a phenomenon where stocks move in the direction of earnings surprises for months on average. Investors can use this strategy to buy stocks that recently posted better-than-expected earnings, but it can also lead to volatility in investment portfolios. The effectiveness of this strategy is inconclusive due to many variables.
Publicly traded companies report quarterly and annual earnings. This is a financial report that reveals profitability and sales over a period. Prior to the announcement, financial analysts and company executives often make forecasts of what those results will be, and investors tend to respond to the results based on the barometer that’s been established. In some cases, the investor reaction is delayed, and once it sets in, it seems to develop over a period of weeks or more. This phenomenon is known as post-earnings drift, and it explains some of the gains made and losses made in the stock market.
In the post-earnings drift, the stock moves in the direction of the earnings surprise for months on average. If the earnings results are better than expected, for example, the stock will continue to advance over time in response. Conversely, in the event of an earnings disappointment, the stock will lose ground for the duration of the drift. Some researchers suggest that the drift theory, also known as the standardized windfall effect (SUE), indicates that investors are not responding appropriately to the details of notable gains.
There is an undercurrent to this market theory that investors are naive when responding to a company’s earnings report. In its simplest form, this strategy should allow investors to buy stocks that recently posted better-than-expected earnings. If the investment is held for several months, investors should make a profit.
Professional investment managers, including mutual fund managers and hedge funds, could also use the post-earnings drift instance to try to capitalize on stock movement. Some mutual fund managers even tout the theory as the primary investment portfolio strategy. However, the downside to doing so is a lot of volatility in the fund, which is a risky proposition. The composition of a mutual fund is unlikely to reflect diversification because the goal is to track earnings surprises, not traditional exposures. The unpredictable nature of post-earnings announcement drift also leads to volatility in the rate at which funds move in and out of investment portfolios into the hands of investors.
Researchers, analysts, and other financial professionals often track the performance of various investment strategies and derive average monthly or yearly returns earned through these styles. Market participants have attempted to use this approach with investors applying the post-earnings announcement drift style. However, the results appear inconclusive as the attempt to track investment performance is blurred by many variables. Certain research studies suggest that the cost of completing transactions in financial markets strongly influences the returns offered by this opaque investment strategy.
Smart Asset.
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