Post-Earnings Announcement Drift and Corporate Insider Trading

Post-earnings announcement drift (PEAD) is a well-documented and puzzlingly persistent market anomaly. Companies that report earnings higher than expected typically experience an upward drift in their stock prices while those that report earnings below what was anticipated see a downward drift.

In a recent paper, we offer a new explanation for this anomaly based on the trading behavior of corporate executives and directors in the days after an earnings announcement. We distinguish between contrarian and confirmatory corporate insider trades after the earnings announcement. Contrarian trades occur in the opposite direction to the response of share prices after a surprise in an earnings announcement: purchases after bad earnings news and sales after good news. Confirmatory insider trades occur in the same direction as the response of share prices after the earnings surprise: sales after bad news and purchases after good news. Our study then shows that contrarian trades by corporate insiders mitigate the post-earnings announcement stock price drift, and in contrast, confirmatory trades instigate further stock price movements in the same direction as the earnings surprise.

These results are consistent with the notion that insider trading provides relevant information about the underlying earnings process, and more specifically about transitory or permanent changes to the earnings process, allowing the market to make appropriate inferences about the nature of the earnings surprise. Regulations in the U.S. and UK require that corporate insider trades are fully disclosed to the market. In the case of confirmatory buys, the market infers that if corporate insiders are buying after good news, then the stock price has potential to go higher. In the case of contrarian transactions, if insiders sell after good earnings news, the market infers that there was initially an overreaction to the earnings surprise. Our research goes on to show that contrarian insider trades alleviate the PEAD anomaly even for hard-to-value firms (those companies with low earnings precision), where previous research has shown that the anomaly is most prevalent.

The evidence for the role of corporate insiders in explaining the PEAD is based on a sample of 7,980 annual earnings announcements for 1,373 UK companies listed on the London Stock Exchange over the period 1995-2013. First, we report evidence of the PEAD phenomenon, in terms of the spread in returns between the top and bottom quintiles of companies formed on the basis of unexpected earnings. This spread in the performance represents the post-earnings announcement drift: prices drift up for the stock of firms with good news, and the price of stock of firms with bad news firms drifts down. The results of this exercise confirm the presence of a statistically significant 3.4 percent spread for a strategy of taking a position 11 days after the earnings announcement and ending six months later[1]. However, under the influence of contrarian insider trades after an earnings announcement (insider sales after good news or insider purchases after bad news), the quintile spread disappears, as the market infers that the earnings surprise reflects only a transitory change. Further, because of confirmatory insider trades (insider purchases after good earnings news, and sales after bad news), the spread between top and bottom quintiles increases to a highly significant 7.3 percent, suggesting the market believes that insiders have information that the earnings surprise reflects a permanent change in the earnings process.

These results are robust to alternative measures of corporate insider trades and alternative time horizons as well as starting points after the earnings announcement. In all cases the results are consistent with the main findings on the effect of contrarian and confirmatory directors trading on the PEAD.

ENDNOTE

[1] Note that in the UK semi-annual corporate reporting is most common.

REFERENCE

Dargenidou, C., I. Tonks, and F. Tsoligkas (2018). Insider trading and the post‐earnings announcement drift. Journal of Business Finance & Accounting, vol. 45, issue 3-4, pages 482-508.

This post comes to us from Christina Dargenidou, a senior lecturer at the University of Exeter Business School, Professor Ian Tonks at the University of Bath School of Management, and Fanis Tsoligkas, a lecturer in accounting at the University of Bath School of Management. It is based on their recent paper, “Insider Trading and the Post-Earnings Announcement Drift,” available here.

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