CFOs who like to watch the stock markets might be interested to know that investors and analysts consistently miss a profit-making opportunity related to companies’ fourth-quarter earnings.
During 35 years from 1989 through 2023, U.S. public companies reported fiscal fourth-quarter profits that were an average of 49.6% lower than the average of the three interim quarters, according to a new, so-far unpublished paper.
The effect was shown to be strongly present in every year tracked in the study, which was performed by Oliver Binz and Martin Kapons, assistant professors at European universities ESMT Berlin and INSEAD, respectively.
Virtually all of the Q4 earnings falloff was attributed to inaccurately low accrual expense estimates for the interim quarters, particularly for the cost of goods sold and sales, general and administrative expenses. That caused a shift in such expenses to the fourth quarter.
Tentatively titled “The Fourth-Quarter Earnings Effect,” the study normalized earnings across the spectrum of company sizes by using a standard method of computing return on assets — income before extraordinary items, divided by total assets — as the measurement of earnings. The study included all U.S. companies with publicly traded equity or debt.
Despite the regularity of lower Q4 earnings, analysts repeatedly reacted negatively to the annual earnings announcements that include Q4 results, and investors followed, thus ignoring a profit opportunity hiding in plain sight.
Additionally, the research found, negative reactions to 4Q announcements typically washed out of the market within two months, while negative reactions to interim-quarter announcements generally didn’t reverse at all.
“This pattern is so clear that it would be relatively easy to come up with a trading strategy that would generate abnormal returns,” Binz said.
Specifically, a hedging portfolio created by buying the stocks of companies reporting Q4 earnings that negatively surprised analysts, and selling the stocks of companies that did so for interim-quarter earnings, would have earned an alpha averaging 0.6% per month, or 7.2% annually, during the study period.
But if the market pattern that creates this profit opportunity is clear, why have analysts and investors not leveraged it more? It’s particularly curious behavior because, as Binz told CFO.com, research documented decades ago that analysts’ Q4 forecasts were systematically optimistic.
To be sure, market reactions to the Q4 earnings misses are less negative than for earnings surprises in the other quarters, indicating that analysts and investors “may get it to a certain degree,” said Binz. “But they don’t get it fully.”
Binz said that to his knowledge, the paper would be the first to document the fourth-quarter earnings effect, although some prior research hinted at it, such as one study concluding that loss-making firms tend to have high special charges in the fourth quarter.
Consider, though, that (1) U.S. public companies are not required to break out Q4 results separately from the full-year results presented in annual reports; (2) full-fledged audits are not required for the interim quarters; and (3) most profit-forecasting frameworks rely on annual data, while quarterly data is relatively little-used.
Consequently, Binz suggested, “there might be more pressure from auditors, investors, and other stakeholders to get the numbers right for the full fiscal year than there is for the interim quarters.” While Q4 data has always been easily calculable, “it’s not like it’s straight in sight.”
In fact, the SEC has come under fire for continuing to mandate quarterly reporting. Warren Buffett, for one, is not a fan.
CFOs, for their part, don’t tend to be much concerned with short-term fluctuations in their company’s stock price. And they likely don’t care enough about the annual dips in Q4 income to warrant investment in making sensible accrual estimates in the interim quarters, since the dips are caused merely by a shift of accrual expenses to the fourth quarter and don’t impact annual results.
But is that lack of attention wise?
“From prior research, we have some indication that managers actually rely on these accrual estimates when making decisions,” Binz said. “So if the financial reporting is systematically off, they might make worse decisions. That is speculation, but it’s the next natural question to ask.”
Binz and Kapons are currently seeking input to fine-tune the paper in preparation for shopping it to investment journals.
