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...Reproduced with permission of the copyright owner Further reproduction prohibited without permission COMPARING THE ASSOCIATION BETWEEN CUMULATIVE ABNORMAL RETURNS AND UNEXPECTED EARNINGS FOR FIRMS WITH. .. differences in the association between cumulative abnormal stock returns and unexpected earnings around the time of earnings announcements between firms held by institutional investors and firms with non-institutional... f the copyright owner Further reproduction prohibited w itho ut perm ission COMPARING THE ASSOCIATION BETWEEN CUMULATIVE ABNORMAL RETURNS AND UNEXPECTED EARNINGS FOR FIRMS WITH DIFFERENT TYPES
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Further reproduction prohibited w itho ut perm ission UMI Number: 3051934 Copyright 2001 by Njoroge, Joyce W All rights reserved _ _ ® UMI UMI Microform 3051934 Copyright 2002 by ProQuest Information and Learning Company All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code ProQuest Information and Learning Company 300 North Zeeb Road P.O Box 1346 Ann Arbor, Ml 48106-1346 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission ©Copyright by JOYCE W NJOROGE, 2001 All Rights Reserved R eproduced with perm ission o f the copyright owner F urther reproduction prohibited w itho ut perm ission To the Faculty o f Washington State University: The members of the Committee appointed to examine the dissertation of JOYCE W NJOROGE find it satisfactory and recommend that it be accepted Chair ii R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission ACKNOWLEDGMENTS I wish to extend my sincerest thanks to the Chair o f my committee, Dr Susan Gill, for her unwavering patience and support throughout this project I have learned a lot from her throughout this process I would also like to thank the other members of my committee, Dr Robert Greenberg and Dr Tom Nunamaker for their helpful comments I wish to thank my family for being with me throughout this process Special thanks go to my husband Samuel for his patience, encouragement and unconditional love Special thanks also go to my lovely daughters Irene and Crystal for their sacrifice and patience I would also like to especially thank my father, John Njoroge and my mother, Virginia Njoroge for instilling in me the importance of knowledge and hard work To my brothers and sister, thank you for your love Lastly, I would like to acknowledge my friends Fatuma Yusuf for being a true friend and for standing by me whenever I needed her, Dr Jimmy Sentenza for his encouragement And to all my friends in Pullman, thank you for making my stay there enjoyable and quite memorable iii R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission COMPARING THE ASSOCIATION BETWEEN CUMULATIVE ABNORMAL RETURNS AND UNEXPECTED EARNINGS FOR FIRMS WITH DIFFERENT TYPES OF INVESTORS Abstract by Joyce W Njoroge, Ph.D Washington State University December 2001 Chair: Susan Gill The goal of this dissertation is to compare the association between cumulative abnormal returns (CAR) and unexpected earnings (UE) o f firms held by different classes of investors around earnings announcement dates A recent ruling by the Securities and Exchange Commission (SEC) expresses concern firms may make selective disclosure of important information to some investors prior to fully disclosing the same information to the general public As such, those investors are likely to benefit from that information Thus, this study compares the CA R / UE association o f firms held by institutional investors (informed investors) to that o f firms held by non-institutional investors (uninformed investors) around earnings announcement dates It is expected that firms with institutional investors will exhibit a high CAR / \ UE association prior to the public announcements o f earnings due to availability of predisclosure information Conversely, firms with non-institutional investors will demonstrate a higher association after earnings announcements have been issued iv R eproduced w ith perm ission o f the copyright owner F urther reproduction prohibited w itho ut perm ission The results o f this study show that prior to earnings announcements, firms with institutional investors exhibit a higher CAR / UE association than firms with noninstitutional investors Also, consistent with expectations, the post-earnings announcement CAR / UE association for firms with non-institutional investors was found to be significantly greater than for firms with institutional investors Contrary to expectations, there is no significant difference between the pre-earnings announcement CAR / UE association and the post-earnings announcement association for firms with institutional investors These results indicate that while it appears that actual earnings announcements are considered important in decision-making, predisclosure information as suggested by the SEC, appears to provide an advantage to institutional investors Further analyses, which involve examining at CAR / UE association for firms with only one type o f institutional investor, demonstrate the heterogeneity of institutional investors themselves Finally, an examination o f the association between firms' earnings persistence and levels of institutional investors confirm that institutional investors are attracted to firms with high earnings persistence v R eproduced with perm ission o f the copyright owner F urther reproduction prohibited w itho ut perm ission TABLE OF CONTENTS Page ACKNOWLEDGMENTS iii ABSTRACT iv LIST OF TABLES ix DEDICATION xi Chapter INTRODUCTION 1.1 Purpose of the stu d y 1.2 Implications of the stu d y 12 BACKGROUND AND LITERATURE REVIEW 15 Institutional Investors 15 2.2 Institutional investors and Earnings Announcements 18 2.3 Institutional Investors and Predisclosure Information 20 2.4 Institutional Investors and Time H orizon 22 2.5 Institutional Investors and Earnings Persistence 26 2.6 Different Types of Institutional Investors 28 2.7 Summary of the Literature re v ie w 31 DATA AND METHODOLOGY 33 3.1 D a ta 35 vi R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission Table 14 Results of the Regression Analysis of Pre-Earnings Announcement CAR and UE and LOGCAP for Firms with Only One Type of Institutional Investor CARjt_i= bo + bi (UEjt) + bj (LOGCAP)jt + £jt Type Type Type Type Type 0.39 0.49 0.48 Intercept 0.73 0.72 16.75*** 8.87*** 13.24*** 15.62*** 5.08*** t-stat UE t-stat 0.005 0.81 0.022 3.38*** 0.016 2.92** 0.001 0.19 0.005 0.26 Logcap t-stat 0.031 0.015 0.019 0.017 0.03 13.24*** 6.56*** 9.85*** 12.07*** 3.35*** R2 11.12% 12.71% 9.29% 7.37% 3.19% F-value 88.02*** 25.14*** 50.95*** 72.93*** 5.66*** ***Significant at a=0.01 ** Significant at ot=0.05 UE = LOGCAP = CARjt-i = Type = Type = Type = Type = Type = Seasonal difference in quarterly EPS before extraordinary items and discontinued operations Log o f monthly capitalization Cumulative abnormal returns before earnings announcements for each type o f institutional owner minus the CRSP value-weighted market return Banks Insurance Companies Mutual funds Independent investment advisors (mostly pension funds) All other large institutional investors (e.g endowments) 81 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission Table 15 Results of the Regression Analysis of Post-Earnings Announcement CAR and UE and LOGCAP for Firms with Only One Type of Institutional Investor CARjt+i—bo + bi (UEjt) +■b2 (LOGCAP)jt + £jt Type Type Type Type Type 0.396 0.51 0.65 Intercept 0.75 17 28*** 8.57*** 13.59*** 16.63*** 5.85*** t-stat UE t-stat Logcap t-stat R2 0.0003 0.53 0.033 13.78*** 12 12 % 0.0204 0.0042 3.03*** 5.79*** 0.0026 0.0455 2.05** 0.015 0 0.027 0.038 *** 10.03*** 13.43*** 4.48*** 7 8.61% 12.78% 9.15% F-value 95.03*** 22.61*** 11.65*** 90.13*** 6.70% 12 *** ^^Significant at a=0.01 * Significant at a=0.05 UE= LOGCAP= CAR jt+i= Type = Type = Type = Type = Type = Seasonal difference in quarterly EPS before extraordinary items and discontinued operations Log of monthly capitalization Cumulative abnormal returns after earnings announcements for each type of institutional owner minus the CRSP value-weighted market return Banks Insurance Companies Mutual funds Independent investment advisors (mostly pension funds) All other large institutional investors (e.g endowments) 82 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission earnings announcements to make decisions, the insignificant coefficients for the pre announcement unexpected earnings variable is not illogical The lack of significance for the unexpected earnings coefficient for firms with Types 1,4 and institutional investors prior to earnings announcements and Types I and following earnings announcements show that, only firms with Types and institutional investors reveal an association between CAR and UE around earnings announcements Overall, these results confirm the heterogeneous nature of different institutional investors and point to it as a possible reason for some o f the inconsistent results found earlier These results should however be used cautiously due to the size of the sample used in the tests As expected, there are a few firms with only one type o f institutional investors Thus it is possible that the small sample size is driving the results in this case and more research is warranted in this area 18 See conclusion on how this problem can be mitigated in a future study 83 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission 18 CHAPTER FIVE SUMMARY AND CONCLUSIONS 5.1 Conclusions The efficient market hypothesis is the basis for most capital markets studies This hypothesis states that investors and other decision-makers use all available information to make decisions 19 The question is therefore raised regarding what information is available to the investors and more specifically, whether there are differences in the information available to different classes of investors The Securities and Exchange Commission (SEC) issued a ruling on "Selective Disclosure and Insider Trading" (2000) that resulted from the concern that firms were selectively issuing information to certain investors The premise of this ruling was to ensure that all classes of investors have equal access to material information Specifically, the SEC’s ruling requires that information made available to one or a select group o f investors be made public to all investors While evidence exists that certain groups of investors have access to predisclosure information, the extent to which they are able to use this information to their advantage is unknown Therefore, this study compares the association between cumulative abnormal returns and unexpected earnings for firms with different classes of investors around earnings announcements To so, firms are first classified as being owned by either institutional (informed) investors or non-institutional (uninformed) investors A likelihood ratio test is used to compare the correlation coefficients of the association between cumulative abnormal returns and unexpected earnings around earnings announcements for firms with institutional investors to that of firms with non- 10 This definition of efficient market hypothesis refers to the strong form 84 R eproduced with perm ission o f the copyright owner F urther reproduction prohibited w itho ut perm ission institutional investors Regressions involving institutional investors are estimated first using all firms with institutional investors, followed by confirmatory tests using only those firms with greater than 30% and greater than 50% o f their ownership held by institutional investors After first determining that a pre-eamings announcement association exists between cumulative abnormal returns and unexpected earnings for firms owned by institutional investors, this association is then compared with the post-eamings announcement association for these firms The purpose of this test is to determine whether institutional investors trade more on earnings prior to firms’ formal earnings announcements than after The expectation is that the pre-eamings announcement association is greater than the post-eamings announcement association due to institutional investors’ selective predisclosure information The results o f this test indicate no difference in the pre- and post-eamings announcement associations Repeating the tests using different levels (percentages) o f institutional ownership (greater than 30% and greater than 50%) also fail to corroborate this expectation Therefore, even though a preeamings association for firms with institutional investors was significant, this association is not significantly greater than the post-eamings association There are at least two possible implications that can be derived from these results First, institutional investors may not be trading on selective predisclosure information and secondly, actual earnings announcements may still be considered a more reliable source o f information for all investors in decision-making As such, it is logical that there exists trading both before and after earnings are announced Since the pre-eamings announcement association for institutionally owned firms was found significant, implying the existence (and use) of 85 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission predisclosure information by institutional investors, the first explanation is unlikely Therefore, a test examining pre-announcement differences between institutionally owned and non-institutionally owned firms is performed Differences between the groups may provide additional evidence regarding the existence and use o f selectively disclosed information by institutional investors This test compares the pre-earnings announcement association between cumulative abnormal returns and unexpected earnings for firms with institutional investors to the association for firms with non-institutional investors The expectation is that the association will be greater for firms with institutional investors than for firms with non-institutional investors due to the former’s access to predisclosure information The test results support the expectation at all levels of institutional ownership The results of this second test imply that prior to earnings announcements institutional investors trade more on earnings information than non-institutional investors This offers support for the SEC's argument that the existence of selective disclosure of information provides advantages to some types of investors To complete the analysis, the post-earnings announcement association between cumulative abnormal returns and unexpected earnings for firms with institutional investors is compared to that of firms with non-institutional investors The argument behind this test is that firms with non-institutional investors will show a higher postearnings announcement association since the absence of predisclosure information requires these investors to wait for the public announcement of earnings in order to trade on unexpected earnings At the same time, firms with institutional investors are expected to exhibit a lower post-earnings announcement association since predisclosure 86 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission information enables them to trade prior to actual earnings announcements The results of this test are consistent with the prediction only at high levels of institutional ownership i.e institutional ownership greater than 30% and greater than 50% Thus, whether or not firms with non-institutional investors have a higher post-earnings announcement association than firms with high levels of institutional ownership is dependent on the operationalization of institutional ownership The implication of this test is that, compared to institutional investors, more of the non-institutional investors' trading takes place after earnings announcements This may be due to the lack of predisclosure information, available to institutional investors In summary, the following results were obtained First, there is no difference in the association between cumulative abnormal returns and unexpected earnings for firms with institutional investors prior to and after earnings announcements Secondly, prior to earnings announcements, the association between cumulative abnormal returns and unexpected earnings for firms with institutional investors is higher than the association between cumulative abnormal returns and unexpected earnings reaction for firms with non-institutional investors Thirdly, the post-eamings announcement association between cumulative abnormal returns and unexpected earnings is higher for firms with noninstitutional investors than for firms with high levels of institutional investors Overall, it appears that institutional investors trade both prior to and after earnings announcements while non-institutional investors tend to trade more after earnings announcements Thus, it appears that while actual earnings announcements are considered important in decision-making, consistent with the SEC's contention, predisclosure information provides an advantage to institutional investors 87 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission This study further explores the pre- and post-earnings announcement associations by analyzing firms based upon the type of institutional investors that hold them Types o f institutional investors consist of the following five categories; banks, mutual funds, insurance companies, independent investment advisors (mostly pension funds) and all other large institutional investors (e.g endowments) The purpose of this test is to explore whether there are differences among the different types of institutional investors If so, these differences can be used to further document the heterogeneous nature of institutional investors and also indicate areas for which future research is needed The pre- and post-eamings announcement associations between cumulative abnormal returns and unexpected earnings are examined for firms in each of the categories of institutional investor The results showed no significance for the unexpected earnings coefficient for firms with Types 1, and institutional investors prior to earnings announcements and Types I and following earnings announcements Thus, only firms with Types and institutional investors reveal an association between CAR and UE around earnings announcements Although more research is need in this area, results of this test offered additional support to' the hypothesis and more importantly, indicated heterogeneous nature of different institutional investors Thus, it appears there is a need to separate firms according to their type of investors when conducting tests for which heterogeneity of ownership is likely to confound results Finally, the association between institutional ownership and firms’ earnings persistence was examined The assumption is that institutional investors have a better interpretation of information, can accurately predict earnings persistence, and are attracted to firms with high earnings persistence The results indicate a significant 38 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission association between earnings persistence and institutional ownership at different levels of institutional ownership Assuming that earnings persistence is a trait considered favorable by institutional investors, these results act as a confirmation that institutional investors are better able to interpret and act on firms' information Overall, the support of the hypotheses in this study this may lend additional support to the SEC’s concerns on selective disclosure o f material information by issuers of information That is, institutional investors not only appear to benefit from access to selective predisclosure information, but also possibly have superior abilities to interpret information both o f which give them an advantage over non-institutional investors This study also demonstrates the heterogeneity o f institutional investors, thus indicating a need for future research as described below 5.2 Limitations and Suggestions for Future Research This study has a few limitations First, it is assumed that firms' association between cumulative abnormal returns and unexpected earnings is an indicator of investors' trading behavior A more precise test would involve a comparison of the actual trades undertaken by different types of investors This was not done in this study due to data constraints However, it is logical that looking at the association between cumulative abnormal returns and unexpected earnings of firms can proxy for investors' use of information, which in turn may imply trading behavior A second limitation of the study is the lack of other controlling variables such as analysts' following Prior studies have shown a relationship between institutional ownership and analysts following This 89 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission problem is, however, mitigated by controlling for firm size through market capitalization, a variable highly correlated to analysts’ following Other limitations have to with the data itself The data used in this study range between the years 1988-1997 As previously indicated (see Table 2) considerably fewer observations were available in earlier years than in later As such, the years used in this study are ones with the highest level of institutional ownership To the extent to which the smaller number o f observations reported in the early years is due to incomplete data, rather than lesser institutional ownership, noise is added to the tests Additionally, the partitioning of the sample into firms with greater than 30% and greater than 50% of outstanding shares owned by institutional investors was ad hoc While these levels appear logical (greater than 30% ownership corresponds to the mean of institutional ownership for all firms, while greater than 50% institutional ownership approximates the three uppermost deciles of institutional ownership (Table and Table 3)) the levels are not theoretically determined Finally, when performing the exploratory analysis, the inclusion of firms with only one type o f institutional investors considerably reduced the sample size While this insures a 'clean' sample, it may adversely affect the results and/or the ability to draw conclusive decisions based on the results The limitations noted above identify possible areas of future research The use of a richer data set that includes the size of trades, the frequency of trades, etc, by different investors could be used to compare the actual trading behavior of institutional and noninstitutional investors around earnings announcements Additionally, since this study compares the association between cumulative abnormal returns and unexpected earnings prior to the SEC’s ruling, future studies can examine the post-ruling association That is, 90 R eproduced with perm ission o f the copyright owner F urther reproduction prohibited w itho ut perm ission this study can act as a point of reference for determining the effectiveness of the SEC's ruling For example, the test that found a significantly greater pre-earnings association for firms with institutional investors than for firms with non-institutional investors could be repeated in the future to determine whether this has changed This would offer some assurance to the SEC as to the improvement of issuer's disclosure practices Additionally, a more comprehensive test of firms with different types of institutional investors can be done to better understand firms' trading behavior Such a study could involve identifying and analyzing firms based upon the characteristics of their specific institutional investors For example, analyses of firms with institutions that have a short time investing horizon e.g banks and mutual funds, versus those with long time investing horizon e.g pension funds Also, different types o f partitioning, such as firms with a majority of shares held by one type of institutional investor, rather than firms with only one type of institutional investors could be examined These results could be compared to the results for firms with only one type of institutional investor to offer more insight into the trading behavior of different types of institutional investors Also, more theoretically driven criteria could be used to determine the appropriate levels of institutional ownership at which influence on management is expected to occur 91 R eproduced w ith perm ission o f the copyright owner Further reproduction prohibited w itho ut perm ission REFERENCES Alexander, J C 1991 Earnings expectations and the Market Reaction to Earnings surprise Dissertation Florida State University Alexander, J.C., P P Peterson and D Goff 1989 Profitability o f Trading a Strategy Based on Unexpected Earnings Financial Analysts Journal (45): 65-72 Ali, A., and P Zarowin 1992a Permanent Versus transitory Components of Annual Earnings 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