Study details ‘cheat season’ where companies attempt to exceed analysts' expectations

It won’t surprise any market-watcher to learn that in the run-up to earnings season, companies tend to lower the bar for top and bottom line performance, thereby giving themselves better odds of exceeding analysts’ expectations.

However, a new working paper suggests that the sins of omission that occur during the corporate “cheating” season, as it was dubbed by Societe Generale global head of quantitative strategy Andrew Lapthorne, are far more insidious.

Authors Kenneth Froot, Namho Kang, Gideon Ozik, and Ronnie Sadka conclude that managers mislead analysts and shareholders during earnings reports, and that their penchant for massaging expectations downwards may be employed in order to open up a window to buy their stock on the cheap in the near future.

The analysis starts from the premise that when company officials are discussing the quarter’s results on a conference call, they’re already well into the next reporting period — and have a much better idea of how the firm’s been faring than the average investor.

The researchers then drew on data from around 350 million electronic consumer devices to track when individuals professed an intent to visit the physical location of a given store.

The sample size was significant enough to develop a real-time corporate sales indicator for 50 publicly-traded US retailers.

Their findings suggest that guidance or “bundled forecasts” provided by managers and the tone of the conference call “point toward rejection of ‘timely disclosure’ in favour of the ‘leaning against the wind’ alternative.”

Now, why would managers do this? A charitable explanation offered by the team is the executives try to avoid litigation by ensuring that investors don’t get too bullish on the company’s near-term prospects.

The evidence is with the cynics. The team found that the relationship between underwhelming-to-negative commentary and forecasts from management — in spite of a real-time corporate sales indicator suggesting robust activity — and a positive return in the period starting a few days after earnings were reported is stronger and more reliable when insiders are purchasing shares during this period.

“This implies that insiders understate their private information to purchase undervalued stocks prior to the price increase,” they write.