A test of the market’s mispricing of domestic and foreign earnings

A test of the market’s mispricing of domestic and foreign earnings Wayne B Thomas School of Accounting, University of Utah, Salt Lake City, UT 84112, USA Received 13 May 1999; received in revised form 17 March 2000 Abstract This study investigates whether abnormal returns can be earned using public information about firms' domestic and foreign earnings The results indicate that the market understates foreign earnings’ persistence As a result, it is possible to construct a zero-investment hedge portfolio that consistently earns positive returns across years A disproportionate fraction of the positive abnormal returns to the long position is concentrated in the few days surrounding the subsequent year's quarterly earnings announcement dates Furthermore, the abnormal returns not appear to persist beyond the subsequent year The results are consistent with market mispricing, and not mis-estimated risk JEL classification: F23; G14; M41 Key words: Capital markets; Market efficiency; Valuation; Multinational firms; Foreign earnings *Corresponding author Tel: (801) 581-8790; fax: (801) 581-7214; e-mail: actwbt@business utah.edu I wish to thank Neil Bhattacharya, Dan Collins, Peter Easton, Don Herrmann, Marlene Plumlee, J Riley Shaw, James Wahlen and seminar participants at Arizona State University, Oklahoma State University, and the University of Utah for helpful comments relating to the paper I am especially thankful for the comments provided by S.P Kothari (the editor) and Art Kraft (the referee) that greatly improved this research Eugene Fama and Mark Carhart generously provided factor model data Introduction This study investigates whether abnormal returns can be earned using public information about firms’ domestic and foreign earnings Specifically, I test whether the market accurately incorporates the pricing effects of the persistence of the domestic and foreign earnings components of total earnings reported by a firm The tests in this study add to the existing literature on post-earnings-announcement drift, the pricing of accruals, and the pricing of domestic and foreign earnings components The results indicate that the market understates foreign earnings’ persistence and that positive abnormal returns can be earned using a trading strategy based on changes in foreign earnings Further analysis indicates that the abnormal returns not appear to be the result of risk mis-estimation SEC Regulation §210.4-08(h), General Notes to Financial Statements – Income Tax Expense, requires firms to disclose components of income (loss) before income tax expense (benefit) as either domestic or foreign While domestic income refers to a single country (i.e., the United States), foreign income encompasses countries from around the world differing drastically in terms of economic conditions, political stability, competitive forces, growth opportunities, governmental regulations, etc Therefore, Rule 4-08(h) may provide only limited information regarding the risks and opportunities of the firm’s foreign earnings Guidelines set forth in Statement of Financial Accounting Standards No 14, Financial Reporting for Segments of a Business Enterprise (FASB 1978) (SFAS 14) require firms to go beyond a simple breakdown of earnings into foreign and domestic categories SFAS 14 requires that firms disclose earnings by geographic area (e.g., Canada, Europe, Asia/Pacific), potentially providing information beyond that required by Rule 4-08(h) Many complain, however, that geographic segment earnings disclosures are not useful because of (1) the lack of comparability and consistency in segment definition both across firms and over time for the same firm, (2) insufficient disaggregation, (3) failure to group foreign operations according to similar risk and return characteristics, and (4) management manipulation through transfer pricing policies and common cost allocations These criticisms come from both the financial community (e.g., Association of the Institute for Management Research 1992 and American Institute of Certified Public Accountants 1994) and the academic community (Bavishi and Wyman 1980, Arnold et al 1980, Roberts 1989, Balakrishnan et al 1990, Boatsman et al 1993, and Herrmann 1996).1, If the market fails to understand the time-series properties of domestic or foreign earnings, then stock prices will systematically understate/overstate the value of the firm in a predictable manner That is, if the market perceives the persistence of domestic or foreign earnings to be different than their historical time-series patterns, then stock prices will move in a predictable manner in the subsequent year A growing body of literature questions the market’s efficiency with respect to earnings and other accounting information (for reviews see Ball 1992, Bernard et al 1993, and Bernard et al 1997) Most of this research centers on the premise that the market does not fully understand the time-series behavior of earnings or its components For example, Bernard and Thomas (1989, 1990) show that the well-documented post-earnings-announcement drift is characteristic of a market that expects (naively) seasonal changes in quarterly earnings to follow a random walk process, even though the time-series pattern over the past several decades shows that this is not the case When subsequent earnings are released, the market acts “surprised” and stock prices move in a predictable direction and magnitude See Pacter (1993) for a thorough discussion of the alleged shortcomings of segment reporting practices The FASB recently issued SFAS 131, Disclosures about Segments of an Enterprise and Related Information, which supersedes SFAS 14 However, the new statement appears to have reduced the quantity and quality of disclosure of foreign operations compared to that provided under SFAS 14 (Herrmann and Thomas 2000) In related work, Sloan (1996) investigates the accrual and cash flow components of earnings Sloan (1996) finds that even though the cash flow component of earnings persists into future earnings more heavily than the accrual component, stock prices act as if the opposite were true In the subsequent period, the market appears to revise its prior (incorrect) belief in a predictable manner Furthermore, these adjustments are concentrated around future earnings announcements Abarbanell and Bushee (1997, 1998) examine nine of the twelve fundamentals signals identified in Lev and Thiagarajan (1993) Abarbanell and Bushee (1997) find that (some of) these fundamentals are significantly associated with future earnings but analysts tend to underreact to the fundamental signals (i.e., analysts not fully understand the impact that these fundamental signals have on future earnings) Abarbanell and Bushee (1998) devise an investment strategy based on these fundamental signals that earns significant abnormal returns in the following period The market tends to underreact to fundamental signals about future earnings and in the subsequent period when earnings are different than expectations, the market corrects its apparent mispricing in a predictable manner This study adds to the existing literature by testing whether the market correctly incorporates the pricing effects of the persistence of domestic and foreign earnings components of total earnings reported by a firm The results indicate the market understates foreign earnings' persistence, causing a positive relation between current changes in foreign earnings and future abnormal stock returns As with any study in this area, conclusions should be made with the caveat that the apparent abnormal returns could be the result of the researcher’s inability to adequately measure and control for underlying risk factors The change in foreign earnings may be a proxy for (or source of) risk, and the positive relation with abnormal returns is the result of unidentified risk premia and not market mispricing To help disentangle these two competing hypotheses, I employ three additional tests First, Bernard et al (1997) suggest that any risky hedge portfolio that requires zero-investment should produce positive returns in some years and negative returns in other years A zeroinvestment hedge portfolio that consistently produces positive returns is more likely to be the result of market mispricing and not unidentified risk Using the relation between changes in total earnings and foreign earnings, a zero-investment hedge portfolio consisting of firms expecting to well (poorly) is constructed This hedge portfolio produces positive abnormal returns in nine out of ten years, which supports the conclusion of market mispricing and not omitted risk factors The second test suggested by Bernard et al (1997) involves observing market reactions to future earnings announcements If abnormal returns are the result of a market that does not fully understand the persistence of current earnings (or its components), then market corrections are most likely to occur when future earnings are announced As such, abnormal returns should be concentrated in the few days surrounding subsequent earnings announcements I find that the abnormal returns to the long position of the hedge portfolio are concentrated in the few days surrounding the subsequent year’s earnings announcements For firms that experience a large, positive increase in foreign earnings in year t (holding the change in total earnings constant), a disproportionately large, positive reaction occurs in the few days surrounding the quarterly earnings announcements in year t+1 This is characteristic of a market that underestimates the persistence of foreign earnings and corrects for this mispricing in the subsequent year when earnings are announced higher than expected The final test involves estimating the relation between long-term stock returns and current changes in foreign earnings Long-term stock returns are defined as stock returns two or three years in the future If the change in foreign earnings is a proxy for (or source of) risk, then one might expect abnormal returns to persist beyond the subsequent year A permanent shift in the firm’s systematic risk will be related to higher returns in subsequent years If, however, the market does not fully understand the persistence of foreign earnings, then abnormal returns should exist in the immediate subsequent year only and should not continue It is not likely that mispricing could occur for several subsequent years The market will correct for its (incorrect) prior belief when earnings are realized above or below expectations in the subsequent year The results in this study show no relation between long-term stock returns and current changes in foreign earnings The market appears to correct fully for its mispricing in the subsequent year so that abnormal returns not persist for more than one year All three tests support the notion that the abnormal returns are the result of market pricing, and not mis-estimated risk The paper proceeds as follows The research design is outlined in section The sample selection is discussed in section The results of the primary and supplemental tests are reported in section and the paper concludes in section Research Design The primary focus of this paper is to test whether the market correctly prices multinational firms’ securities relative to the persistence of the domestic and foreign earnings components To test this, I use the Mishkin (1983) framework Mishkin (1983) devises a test to determine whether the market rationally prices information In the context of this study, the test for market rationality would involve simultaneously estimating the following equations.3 For a more extensive, generalized discussion of this test, see Mishkin (1983) or Sloan (1996) TOTX t 1    D DOMX t   F FORX t   t 1 ARETt 1     ( TOTX t 1     D* DOMX t   F* FORX t )   t 1 (1) (2) where TOTXt+1 = the change in total earnings in year t+1, DOMXt = the change in domestic earnings in year t, FORXt = the change in foreign earnings in year t, and ARETt+1 = the abnormal return in year t+1 Equation (1) represents the actual time-series relation of changes in domestic and foreign earnings to future changes in total earnings (i.e., the extent to which changes in domestic and foreign earnings persist into changes in total earnings in the subsequent year) D represents a measure of the persistence of changes in domestic earnings and F represents a measure of the persistence of changes in foreign earnings, controlling for one another A slope coefficient equal to -1 would suggest that earnings are purely transitory whereas a slope coefficient equal to would suggest that earnings follow a random walk A slope coefficient greater than would indicate growth in earnings If F is greater than D, then foreign earnings are considered to be more persistent than domestic earnings Equation (2) estimates the relation between unexpected movements in stock prices and the unexpected portion of the change in total earnings The expected change in total earnings is based on last year’s change in domestic and foreign earnings Mishkin (1983) suggests that the second equation provides an estimate of the market’s perceived time-series behavior of domestic and foreign earnings The notion is that unexpected movements in stock prices in the current period are related only to unexpected information received that same period Therefore, the second equation can be used to estimate the market’s perception of the unexpected change in total earnings based on the change in domestic and foreign earnings in the previous year *is an estimate of the extent to which the market perceives changes in domestic earnings to persist into future years Likewise, * is an estimate of the extent to which the market perceives changes in foreign earnings to persist into future years Since domestic and foreign earnings are public information, market efficiency requires that D = * and F = * If either equality does not hold, then the market’s perception of earnings persistence differs from the historical time-series pattern The two equations are estimated simultaneously using non-linear least squares Nonlinear least squares is required because of equation (2) The equality of the coefficients across equations is tested using the likelihood ratio statistic suggested by Mishkin (1983) 2n log(SSR C / SSR U ) ~  ( q) (3) where n = the number of observations, SSRC = the sum of squared residuals from the constrained weighted system, SSRU = the sum of squared residuals from the unconstrained weighted system, and q = the number of constraints imposed by market efficiency A significant Chi-square statistic would suggest that the coefficients are not equal across equations and market efficiency would be rejected Sample Selection, Variable Measurement, and Descriptive Statistics The sample consists of all firms that have the necessary data available in the intersection of the 1998 versions of the Compustat annual industrial and research files and the CRSP monthly stock returns file Compustat contains data on firms’ foreign and domestic earnings back to 1984 Since the tests require the change in foreign earnings, 1985 is the first year of usable observations The sample is restricted to U.S multinational firms so that domestic and foreign earnings are reported for each firm and have the same meaning across sample firms To control for influential observations, any observation that has a change in total earnings, change in domestic earnings, or change in foreign earnings (scaled by average total assets) in year t greater than 25 is deleted This criterion resulted in approximately 4% of the observations being deleted The final sample consists of 8,051 firm-year observations over the 1985-1995 period No control for extreme observations of returns or earnings in t+1 is made since this would introduce hindsight bias in the results Compustat reports both domestic and foreign earnings on a pretax basis (Compustat data item #272 and data item #273, respectively) To be consistent, total earnings is defined as pretax income (data item #122) To control for differences in size across firms and over time, all earnings variables are scaled by average total assets (data item #7) Average total assets are defined as total assets in year t plus total assets in year t-1, divided by 2.4 The Mishkin (1983) test requires the use of abnormal returns As in Daniel, Grinblatt, Titman, and Wermers (1997), I calculate abnormal returns using a comparison portfolio approach This approach entails matching a firm’s security return with the value-weighted return of a portfolio consisting of firms that are similar in size, book-to-market-ratio, and prior year return The comparison portfolios are created by first selecting all stocks that have year end capitalization values available on CRSP and book value data available on COMPUSTAT Only firms with positive book values are included These stocks are then sorted into quintiles based on their capitalization values at the beginning of the year of portfolio formation NYSE breakpoints are used so that there are an equal number of NYSE stocks in each quintile Next, For some firms, domestic earnings plus foreign earnings does not equal total earnings To test the sensitivity of the results to this inequality, observations were eliminated if domestic earnings and foreign earnings did not sum to within 1% of total earnings (scaled by average total assets) This resulted in approximately 2.2% of the sample observations being eliminated The results for this reduced sample are similar to those reported The effect of this inequality was also tested by including the difference between total earnings and domestic plus foreign earnings (i.e., “nonallocated” earnings) as an additional explanatory variable Inclusion of this additional explanatory variable has no qualitative effect on the reported results within each of the size quintiles, stocks are sorted into quintiles based on their industry-adjusted book-to-market ratios The book-to-market ratio is defined as the book value at the end of the fiscal year prior to the year of portfolio formation divided by capitalization value at the beginning of the calendar year of portfolio formation The book-to-market ratio is industryadjusted by subtracting the mean industry book-to-market ratio over the sample period from the individual stock's book-to-market ratio, where industries are defined along two-digit SIC codes Finally, within the 25 size/book-to-market portfolios, stocks are sorted based on their prior twelve-month return ending one month prior to portfolio formation Excluding the month just prior to the portfolio formation date avoids problems associated with the bid-ask spread bounce and monthly return reversals (Jegadeesh 1990) Thus, there are 125 size/book-to-market/prior year return portfolios for each fiscal year Abnormal returns are calculated as the stock’s twelve-month buy-and-hold return beginning three months after the fiscal year-end minus the buy-and-hold value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period Extending the return interval three months beyond the fiscal year end helps to ensure that information related to domestic versus foreign earnings is publicly available by the beginning of the return interval Table reports descriptive statistics for the variables in this study The average annual abnormal return for the firms in the sample is 92% The average change in domestic earnings is 46% while the average change in total foreign earnings is 31% (both scaled by average total assets) Total earnings has an average change of 77%.5 The rank correlation between the change in domestic earnings and the change in foreign earnings is 15 [insert table about here] Average domestic earnings is 5.13% and average foreign earnings 2.36% 10 4.3 Incremental Explanatory Power beyond the Accrual Anomaly As a final test, the market anomaly documented in this study is tested in the presence of the accrual anomaly documented in Sloan (1996) Sloan (1996) finds that the market overvalues (undervalues) firms with large positive (negative) accruals If the change in foreign earnings (holding the change in total earnings constant) is negatively correlated with accruals, then the anomaly documented in this study may simply be the accrual anomaly in disguise Sloan (1996, 293) estimates accruals using the following equation: Accruals ( CA  Cash)  ( CL  STD  TP )  Dep (5) where CA = current assets, CL = current liabilities, STD = short-term debt, TP = income taxes payable, Dep = depreciation and amortization expense, and  denotes a change (all scaled by average total assets) Collins and Hribar (1999) suggest that this estimation of accruals can lead to serious errors, especially when the firm has been involved in mergers, acquisitions, and divestitures Instead, Collins and Hribar (1999) estimate accruals as the difference between earnings and operating cash flows as reported on the statement of cash flows They find that the accrual anomaly is more robust when using reported accruals rather than estimated accruals as in Sloan (1996) Limiting the estimation of accruals in this manner, however, limits the test period to 1988 and beyond since most firms did not begin reporting operating cash flows until Statement of Financial Accounting Standards No 95 (SFAS 95) became effective To test for the incremental explanatory power of the foreign earnings anomaly beyond the accrual anomaly, the following regression models are estimated First, using data over the 19881995 period, the existence of the accrual anomaly is tested for the sample of US multinational firms in this study in a regression of abnormal returns in year t+1 on accruals in year t Consistent with previous research, the coefficient on accruals should be negative Since the test 23 period has changed to coincide with the SFAS 95 reporting period, the results reported in Table are replicated for this slightly different time period The coefficient on the change in foreign earnings is expected to remain positive and significant Results consistent with expectations in the first two regressions would separately support both anomalies To test whether the anomalies are incremental to one another, the final regression includes both accruals and the change in foreign earnings This allows the testing of one anomaly while controlling for the other The results are reported in Table As expected and consistent with prior research, the first regression shows a significant negative relation between accruals in year t and abnormal returns in year t+1 This result essentially replicates the anomaly documented in Sloan (1996) and Collins and Hribar (1999) for this sample of multinational firms The second regression documents the existence of the foreign earnings anomaly in the SFAS 95 reporting period The results are similar to those reported in Table Finally, the third regression reveals that the coefficients on both accruals and the change in foreign earnings remain significant and have the predicted sign, controlling for each other This result demonstrates that these anomalies are incremental to one another and additional abnormal returns could be earned using a combined strategy For example, creating a hedge portfolio that consists of a long position in firms with large negative accruals and (holding total earnings constant) large positive changes in foreign earnings and a short position in firms with large positive accruals and (holding total earnings constant) large negative changes in foreign earnings should provide greater abnormal returns than those documented in the previous section In fact, it does Intersecting the long (short) position of the hedge portfolio created in Table and Figure with firms in the lowest (highest) accrual quintile results in an average annual abnormal return of 12.8%.16 This compares to the 16 The average abnormal return of the long position is 5.0% and the average abnormal return of the short position is –7.8% 24 average annual abnormal return of 6.8% when using the foreign earnings strategy alone, as reported in Table [insert table about here] Conclusion Prior research has shown that in certain contexts the market does not fully understand the extent to which current earnings persist to future earnings [e.g., Bernard and Thomas (1989, 1990) for the quarterly earnings series, Sloan (1996) for the cash flow versus accrual component of earnings, and Abarbanell and Bushee (1998) for various fundamental signals] As a result, stock prices predictably overstate/understate the value of the firm This study builds on this line of research by investigating whether abnormal returns can be earned using public information about firms’ domestic and foreign earnings The results suggest that foreign earnings tend to be more persistent than domestic earnings The market, however, underestimates the persistence of foreign earnings As a result, there is a positive relation between current changes in foreign earnings and future abnormal stock returns, controlling for current changes in total earnings A zero-investment hedge portfolio is constructed using the relation between changes in total earnings and changes in foreign earnings This portfolio earns positive abnormal returns in nine out of ten years and the positive abnormal returns to the long position are concentrated in the few days surrounding the subsequent year’s earnings announcement dates Furthermore, the abnormal returns not persist beyond the subsequent year While it is not possible to observe directly whether the positive abnormal returns are the results of market mispricing or compensation for risk, the results of this study support the notion that market mispricing is more likely However, the risk-based explanation 25 cannot be ruled out It could be that the abnormal returns are a combination of market mispricing and compensation for risk It is also possible that risk factors other than those controlled for are the reason for the results One potential explanation for the existence of market mispricing is that it is difficult for investors to understand fully the origin of firms’ foreign earnings As discussed in the introduction, the investment and academic communities have heavily criticized firms’ disclosures of foreign earnings As a result of the low-quality disclosures, investors may not fully understand the implications of foreign earnings on the value of the firm When facing considerable uncertainty, investors may cautiously underestimate the persistence of foreign earnings Noise in disclosures alone, however, should not explain why investors underestimate the persistence of foreign earnings Noise (or uncertainty) does not suggest a bias in either direction in setting security prices (Houlthausen and Verrecchia 1988) Future research is needed to investigate further why the market appears to underestimate the persistence of foreign earnings as the results of this study suggest Additional research could investigate the source of foreign earnings or the type of disclosure that is associated with the market apparently underestimating the persistence of foreign earnings For example, are earnings from riskier geographic areas such as South America or Asia more closely related to the foreign earnings anomaly? Is the level of disaggregation of geographic segment disclosures related to the foreign earnings anomaly? Unfortunately, given the high level of aggregation of foreign operations by many firms and the wide range of reporting practices across firms, it may be difficult to make any generalizations about the relation between geographic segment disclosures and the foreign earnings anomaly documented in this paper 26 REFERENCES Abarbanell, J., Bushee, B., 1997 Fundamental analysis, future earnings, and stock prices Journal of Accounting Research 34, 1-24 Abarbanell, J., Bushee, B., 1998 Abnormal returns to a fundamental analysis strategy The Accounting Review 73, 19-45 American Institute of Certified Public Accountants, 1994 The Information Needs of Investors and Creditors AICPA, New York Association for Investment Management and Research, Financial Accounting Policy Committee, 1992 Financial Reporting in the 1990's and Beyond: A Position Paper of the Association for Investment Management and Research, prepared by Peter H Knutson, Charlottesville, Va., October Arnold, J., Holder, W., Mann, M., 1980 International reporting aspects of segment disclosures International Journal of Accounting 15, 125-135 Ball, R., 1992 The earnings-price anomaly Journal of Accounting and Economics 15, 319-346 Ball, R., Kothari, S., Watts, R., 1993 Economic determinants of the relation between earnings changes and stock returns The Accounting Review 68, 622-638 Bavishi, V., Wyman, H., 1980 Foreign operations disclosures by US-based multinational corporations: Are they adequate? 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The Accounting Review 71, 289-315 Stober, T., 1992 Summary financial statement measures and analysts’ forecasts of earnings Journal of Accounting and Economics 15, 347-372 29 Table Descriptive statistics during the period 1985-1995 (n=8,051) Standard Variables Mean Deviation Min Q1 Median Q3 Max ARETt+1 92% 47.03% -159.56% -23.31% -3.51% 17.13% 980.32% TOTXt+1 43% 9.99% -187.74% -2.52% 1.13% 4.06% 123.69% TOTXt 77% 7.16% -24.95% -2.29% 1.12% 4.09% 24.99% DOMXt 46% 6.31% -24.97% -2.11% 69% 3.26% 24.91% FORXt 31% 2.75% -24.97% -.53% 17% 1.05% 24.76% ARET = twelve-month buy-and-hold security return beginning three months after the fiscal year end minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period The comparison portfolios are created by first sorting stocks into quintiles based on their capitalization values at the beginning of the year of portfolio formation NYSE breakpoints are used so that there are an equal number of NYSE stocks in each quintile Next, within each of the size quintiles, stocks are sorted into quintiles based on their industry-adjusted book-to-market ratios The book-to-market ratio is defined as the book value at the end of the fiscal year prior to the year of portfolio formation divided by capitalization value at the beginning of the calendar year of portfolio formation The book-tomarket ratio is industry-adjusted by subtracting the mean industry book-to-market ratio over the sample period from the individual stock's book-to-market ratio, where industries are defined along two-digit SIC codes Finally, within the 25 size/book-to-market portfolios, stocks are sorted based on their prior twelve-month return ending one month prior to portfolio formation TOTX = change in total earnings scaled by average total assets DOMX = change in domestic earnings scaled by average total assets FORX = change in foreign earnings scaled by average total assets 30 Table Nonlinear least squares regression of the relation between future abnormal stock returns and information in current changes in total earnings (or domestic and foreign earnings) about future total earnings changes (n=8,051) Panel A: Total Earnings TOTX t 1    T TOTX t   t 1 ARETt 1    1 (TOTX t 1     T* TOTX t )   t 1 Pooleda Cross-sectionalb 0 006 (.001) 005 (.220) T -.209 (.001) -.230 (.001) * -.194 (.001) -.226 (.001) 0 009 (.077) 008 (.380) 1 1.48 (.001) 1.46 (.001) 162 (.687) 073 (.943) Test of Market Efficiency:c H0: T = * ARET = twelve-month buy-and-hold security return beginning three months after the fiscal year end minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period (see Table for a description of the comparable portfolio construction) TOTX = change in total earnings scaled by average total assets a Amounts reported are coefficients from the pooled regression with the p-value of the Chi-square likelihood ratio statistic that the coefficient equals zero in parentheses b Amounts reported are mean coefficients from annual cross-sectional regressions with the pvalue of the two-tailed t-test that the mean coefficient equals zero in parentheses c Amounts reported for the pooled model are the Chi-square likelihood ratio statistic that the coefficients are equal across equations and the corresponding p-value in parentheses Amounts reported for the cross-sectional model are the t-statistic for the two-tailed difference of means test that the mean coefficients are equal and the corresponding p-value in parentheses 31 Table (continued) Nonlinear least squares regression of the relation between future abnormal stock returns and information in current changes in total earnings (or domestic and foreign earnings) about future total earnings changes (n=8,051) Panel B: Domestic and Foreign Earnings Pooleda TOTX t 1    D DOMX t   F FORX t   t 1 Cross-sectionalb ARETt 1     1( TOTX t 1     *D DOMX t   *F FORX t )   t 1 0 006 (.001) 005 (.223) D -.233 (.001) -.254 (.001) * -.168 (.002) -.199 (.002) F -.096 (.017) -.111 (.153) * -.338 (.006) -.367 (.004) 0 009 (.109) 008 (.388) 1 1.47 (.001) 1.45 (.001) 1.71 (.191) 859 (.401) Test of Market Efficiency: c H0: D =* H0: F = * 5.62 2.09 (.018) (.049) ARET = twelve-month buy-and-hold security return beginning three months after the fiscal year end minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period (see Table for a description of the comparable portfolio construction) TOTX = change in total earnings scaled by average total assets DOMX = change in domestic earnings scaled by average total assets FORX = change in foreign earnings scaled by average total assets 32 a Amounts reported are coefficients from the pooled regression with the p-value of the Chi-square likelihood ratio statistic that the coefficient equals zero in parentheses b Amounts reported are mean coefficients from cross-sectional regressions with the p-value of the two-tailed t-test that the mean coefficient equals zero in parentheses c Amounts reported for the pooled model are the Chi-square likelihood ratio statistic that the coefficients are equal across equations and the corresponding p-value in parentheses Amounts reported for the cross-sectional model are the t-statistic for the two-tailed difference of means test that the mean coefficients are equal and the corresponding p-value in parentheses 33 Table Average abnormal returns during the announcement and nonannouncement periods for the long and short positions of the hedge portfolio.a Return Interval Announcement Periodc Nonannouncement Periodd e Total Period Average Abnormal Returnb Average Number of Trading Days Average Hedge Portfolio Abnormal Return Long Position Short Position Long Position Short Position 12 12 1.21% (.011) 71% (.304) 50% (.347) 240.7 240.7 2.19% (.034) -4.44% (.061) 6.63% (.010) 3.21% (.006) -3.61% (.071) 6.82% (.010) 252.7 252.7 a Firms are first ranked on the magnitude of the change in total earnings and assigned in equal numbers to twenty portfolios each year Next, within each of the twenty portfolios, firms are sorted evenly into quintiles based on the change in foreign earnings The long position consists of observations in the highest quintile of the change in foreign earnings and the short position consists of observations in the lowest quintile of the change in foreign earnings b Abnormal returns are calculated as the compounded daily return over the given interval minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same interval (see Table for a description of the comparable portfolio construction) Average abnormal returns are shown with the p-value of the corresponding two-tailed t-test that the mean abnormal return is zero in parentheses c The announcement period consists of the four three-day periods surrounding the subsequent year’s quarterly earnings announcements Each quarterly announcement period begins two days before the earnings announcement date and ends on the day of announcement d The nonannouncement period begins on the first trading day in April in year t+1 and ends on the last trading day in March in year t+2 Announcement period days are excluded e The total return period is the announcement period plus the nonannouncement period 34 Table Mean coefficients (p-values) of cross-sectional regressions of abnormal returns in year t+ on the change in total earnings and the change in foreign earnings in year t.a ARETt      TOTX t   FORX t   t  =1 (n = 8,051) =2 (n = 7,137) =3 (n = 6,273) 0 008 (.380) 008 (.385) 003 (.757) 005 (.634) 010 (.273) 010 (.266) 1 -.044 (.600) -.140 (.185) 083 (.447) 134 (.284) -.219 (.170) 128 (.443) 2 495 (.045) -.374 (.345) -.478 (.316) R2 01 00 00 ARET = twelve-month buy-and-hold security return beginning three months after the fiscal year end minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period (see Table for a description of the comparable portfolio construction) TOTX = change in total earnings scaled by average total assets FORX = change in foreign earnings scaled by average total assets a Amounts reported represent mean coefficients of cross-sectional regressions Amounts in parentheses are p-values of two-tailed t-tests that the mean coefficient is equal to zero tstatistics are calculated using the time-series standard errors of the cross-sectional coefficients 35 Table Mean coefficients (p-values) of cross-sectional regressions of abnormal returns in year t+1 on the change in total earnings, change in foreign earnings, and accruals in year t over the 1988-1995 period (n=6,111).a ARETt 1    TOTX t   FORX t   ACCRUALS t   t 1 0 004 (.691) -.021 (.036) 1 -.204 (.156) -.038 (.781) 2 632 (.052) 607 (.048) 3 -.019 (.055) -.540 (.003) -.544 (.004) R2 01 01 02 ARET = twelve-month buy-and-hold security return beginning three months after the fiscal year end minus the value-weighted return of the comparable size/book-to-market/prior year return portfolio over the same twelve-month period (see Table for a description of the comparable portfolio construction) TOTX = change in total earnings scaled by average total assets FORX = change in foreign earnings scaled by average total assets ACCRUALS = earnings before extraordinary items minus reported operating cash flows, divided by average total assets a Amounts reported represent mean coefficients of cross-sectional regressions Amounts in parentheses are p-values of two-tailed t-tests that the mean coefficient is equal to zero tstatistics are calculated using the time-series standard errors of the cross-sectional coefficients 36 Figure Abnormal returns by calendar year to a hedge portfolio taking a long position in firms with large positive changes in foreign earnings and taking a short position in firms with a large negative changes in foreign earnings, controlling for changes in total earnings a The short and long positions have approximately an equal number of firms in each year Abnormal returns are defined as the twelve-month buy-and-hold security return beginning April and ending March 31 minus the value-weighted return of a comparable size/book-to-market/prior year return portfolio over the same period (see Table for a description of the comparable portfolio construction) The calendar year is the year in which the portfolio was formed (e.g., for 1986, changes in total and foreign earnings in 1986 are used to form the long and short position of the hedge portfolio and abnormal returns are then measured for the twelve-month period beginning April 1, 1987 and ending March 31, 1988) 25% Average 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 15% Hedge Portfolio Abnormal Returns 5% -5% Year a Firms are first ranked on the magnitude of the change in total earnings and assigned in equal numbers to twenty portfolios each year Next, within each of the twenty portfolios, firms are sorted evenly into quintiles based on the change in foreign earnings The long position consists of observations in the highest quintile of the change in foreign earnings and the short position consists of observations in the lowest quintile of the change in foreign earnings 37 ... scaled by average total assets) Total earnings has an average change of 77%.5 The rank correlation between the change in domestic earnings and the change in foreign earnings is 15 [insert table... Lev and Thiagarajan (1993) Abarbanell and Bushee (1997) find that (some of) these fundamentals are significantly associated with future earnings but analysts tend to underreact to the fundamental... Statistics The sample consists of all firms that have the necessary data available in the intersection of the 1998 versions of the Compustat annual industrial and research files and the CRSP monthly