The observed prices of financial assets are a function of the information available to investors regarding the assets. The revelation of new information regarding the future prospects of a firm affects the price of the firm’s financial securities. The news of a corporate merger, the announcement of a CEO resignation, or the announcement of the development of a new product all provide investors with new information regarding the economic prospects of the firm, and thus affect the valuation of outstanding financial claims on the firm’s assets. In our study, we examine one such source of new information. Specifically, we examine the market response to updates to risk factor disclosures required in mandatory, quarterly corporate filings.
Risk factors have been required to be disclosed in annual reports and updated in quarterly reports (if necessary) since 2005. Since then, questions have arisen regarding the usefulness of the information being disclosed. Academic studies have found that such information is valuable. However, the requirements for risk factor disclosure are not necessarily perfect, and the market may not necessarily fully understand the information disclosed.
Our recent study, available here, focuses on quarterly updates to annual risk factor disclosures and addresses two basic questions. First, can quarterly risk factor updates predict future returns? If so, this implies that the market does not fully incorporate the informational value of the update at the time of disclosure. Second, are there certain disclosures that are more or less predictive of future returns? In other words, are some disclosures more likely to be fully incorporated, i.e., priced, by the market at the time of disclosure?
We find multiple forms of evidence consistent with risk factor updates predicting future negative returns. In one of our tests we form a simple risk factor update trading strategy that is long in firms without a quarterly risk factor update, and short in firms with a quarterly risk factor update. This strategy yields a positive annualized alpha of 3.53 percent. The results are very similar regardless of the asset-pricing model used. Next, we classify firms with risk factor updates into two groups based on the concentration of language in the update that relates to firm fundamentals. The intuition for this classification system is that we expect that when firms use more language that describes the effect of the risk factor update on firm fundamentals, the market will be able to more clearly understand the impact on the firm. We use the term “strong updater” for firms with updates that contain more words relating to firm fundamentals (such as revenue, expense, operations, liquidity, etc.). Our premise is that quarterly risk factor updates containing more of these types of words are more likely to better describe the potential effects of the risk factor’s effect on firm fundamentals. All other quarterly risk factor updates are termed “weak updates,” which are the remaining updates in the sample that by definition contain fewer words relating to firm fundamentals. Our findings suggest that future return predictability is strongest for weak updaters, i.e. those firms that do not appear to do as good a job at describing the effect of the risk factor update on firm fundamentals. Updating our trading strategy to be short in firms with “weak” updates and long in firms without a quarterly risk factor update yields a larger positive annualized alpha of 5.28 percent.
The results of our study are timely from a regulatory perspective. The SEC has recently closed a comment period related to a concept release regarding disclosure required by Regulation S-K. This concept release includes discussion of regulation covering risk factor disclosure. In this concept release, the SEC expressed interest in understanding how the content and readability of risk factor disclosure can be improved. Our study provides evidence that is directly relevant to this discussion. First, we show that, on average, information in risk factor updates is not being efficiently incorporated into prices. To the extent that updated regulations could improve the situation, modifying the disclosure requirement may be warranted. Second, our results suggest that the language used in the disclosure affects the completeness of the market reaction at the time of initial disclosure. This points to one potential dimension of the disclosure that could make the disclosure more useful to investors. We encourage investors to pay attention to these disclosures given their predictive ability, and look forward to more research in this area.
 Campbell, J. L., Chen, H., Dhaliwal, D.S., Lu, H., & Steele, L.B. (2014). The information content of mandatory risk factor disclosures in corporate filings. Review of Accounting Studies, 19 (1): 396-455. Filzen, J.J. (2015). The information content of risk factor disclosures in quarterly reports. Accounting Horizons, 29 (4): 887-916.
 Securities and Exchange Commission (SEC). 2016. Business and financial disclosure required by Regulation S-K. Release Nos. 33-10064, 34-77599. Washington, D.C.: Government Printing Office. https://www.sec.gov/rules/concept/2016/33-10064.pdf. Accessed 16 November 2016.
This post comes to us from Professor Joshua J. Filzen and Professor Garrett A. McBrayer at Boise State University’s College of Business and Economics and from Kyle Shannon, a senior software engineer at the university’s Office of Information Technology, Research Computing. It is based on their recent paper, “Risk Factor Disclosures: Do Managers and Markets Speak the Same Language?, available here.