Financial marketsHow African Investors can exploit the PEAD Hypothesis to make Positive Returns

adminMarch 28, 202357617 min

 Johannesburg Stock Exchange (JSE) trading floor; Photo Courtesy: John Lamb, Capital Markets in Africa.

Everyone wants to make money, but how? When one grows vegetables and sells them, they earn a profit from their sale. Securing a job guarantees one an income through a salary. Buying shares in the financial markets positions one to earn dividends if the company makes profits. The latter has been termed as ‘making money work for you’ in the financial world. However, how can one maximise this? The path eventually leads us to the Post Earnings Announcement Drift (PEAD) hypothesis.

 The PEAD hypothesis stipulates that security prices will drift upwards when companies release “good news” and drift downwards when firms release “bad news.” Simply put, if Safaricom announces the launch of 5G network in East Africa, its share price will go up. Similarly, when an electricity distribution company releases news about lower water levels in power-generating dams, its share price will go up. Why is this so? News, by design, makes humans (investors) peek into the future of their returns. The Safaricom investor knows all too well how 5G will be transformative to East Africa, the same way it has already began (and is expected to) revolutionize the entire globe. This may lead to Safaricom’s growth, consequently translating to an enhanced valuation of the company and its share price.

Investors will take long positions when a company announces billions of dollars of profits and short positions when it announces losses. The PEAD strategy has been widely used since its documentation by Ray Ball and Phillip R. Brown in 1968.  Their discovery was that share prices tend to react positively (upwards) to positive news and react negatively to negative news. For instance, a positive earnings report will drive the stock price up. These scholars of PEAD found evidence supporting this hypothesis especially relating to security prices. It could also be that the companies are each informing the investors about how they performed in the previous quarter or financial year. This gives quite the perspective on how they might perform in the next, and consequently, how the share prices will move. This is the true picture that the PEAD hypothesis brings forward to investors.

While agreeing with Brown and Ball (1968), interest in this market anomaly resurged after Thomas and Bernard (1989) developed a strategy based on the PEAD that produced an 18% return on an annualized basis, during the preceding quarter after the earnings announcement. Their strategy was based on buying stocks with positive earnings report and selling stocks with negative earnings report. Essentially, an investor would reap an 18% return on their investment at the end of the year. Their strategy was grounded on the idea of taking contrarian positions on the stocks with the highest negative surprises of the unexpected earnings and going short on stocks with highest positive surprises.

Why are we talking about such an old strategy? The PEAD has resurged recently due to introduction of algorithmic trading (buying and selling shares using programs) and evidence from various quant firms (companies that use this cool trading innovation) has shown that the strategy can be exploited to generate positive alphas. The graph below shows a 5-year back-test of the PEAD alpha with cumulative returns of 436% against S&P 500. This is just an illustration of how the strategy would have performed if it had been applied during that period against what was actually achieved.

Asset prices are driven towards fundamental values only through costly information, search and arbitrage trading. Historical samples have shown that classical trading strategies, that is, trading strategies based on methods developed over along period of time and considered to be of lasting value are no longer profitable. Thus, classical trading strategies, as per research, have been seen to actually not have lasting value. They fail, if to say, after some time. Whilst most studies are consistent with the efficient market hypothesis (EMH) and that profitable opportunities are exploited by arbitrageurs to the extent that they are no longer profitable, it remains unclear whether there have been attempts to generate abnormal profits from a well-documented cross sectional anomaly that focuses on fundamental values. EMH dictates that no investor can profit since all information is incorporated into the security price. EMH hypothesis dictates that asset prices reflect all publicly available information and that it is difficult to generate abnormal returns.  

According to Bloomberg, most of the trading strategies have been unprofitable because of focusing on relative values (those that compare one firm and another, e.g. ratios) as opposed to fundamental values (the true and inherent values, independent of the market). It, therefore, becomes difficult to know the extent of mispricing (under or over-pricing) in any given security. It is important to mention that when there is too much arbitrage trading (taking advantage of mispricing), a reversal pattern is formed in turn that leads to the formation of a V-shaped consolidation pattern. That is to imply that the share price will always attempt to go back to its original value.

Investors ought to consider the fact there is usually a surprise level that is created once companies release earnings reports. Surprises are generally the difference between the projected earnings and the predicted earnings. A positive surprise implies that the actual data is larger than the forecasted. Past empirical literature has demonstrated that after an extreme earnings surprise; the PEAD manifests itself in the days after each of the next two earnings announcements of a company. Conferring to Bernard and Thomas (1989), following the drift, there is normally a significant reversal that follows the fourth subsequent announcement. It is important to mention that naïve and sophisticated investors differ in their assessment of the fundamental value of a financial asset. For instance, after receiving good news, a sophisticated investor would believe that the price is too low and that their action to buy the asset would drive prices higher. Here, we consider the asset as being the stock/share of a particular company. On the other hand, naïve traders would believe that the prices have moved too much and therefore, their action to sell the asset would bring back the asset price back to normal. 

Preceding theoretical work has been able to prove that the PEAD represents market inefficiency (where not all available information is reflected in the stock price). In this respect, investors who are sophisticated and have the necessary trading knowledge are able to exploit this reversal pattern near the subsequent earnings date by employing dynamic contrarian strategies. Is this a good thing? Definitely, because it typically means that these investors know that the market is inefficient and they are able to trade intelligently, if to say. They can evade making the mistakes of the crowd and trade on the right solitary path (contrarian strategy). Research has shown that after a positive surprise, investors place buys positions which leads to overcrowding. Therefore, as a smart investor, it would be prudent to place a short position (sell) a day after the announcement so as to profit from the correction of prices. The trading strategy offers a favourable balance between risk and expected return. The table below shows an illustrative representation of the strategy.

Asset Ticker Date Estimate EPS Actual EPS Surprise (%) Action
Equity Bank Equity [0001 [EQTY]) 2019-01-07     95.56   98.76   3.3%   SHORT (SELL)
Citi Bank Equity [0002 [C] 2019-01-07     21.80   19.90   (8.7%)   LONG (BUY)
Apple Equity [0003 [AAPL] 2019-01-07     36.52   40.56   11.1%   SHORT (SELL)
JPMorgan Equity [0004 [JPM] 2013-01-07     101.80   95.80   (5.8%)   LONG  (BUY)

The rhythm of financial markets has changed given that algorithms have now caused a disruption in the financial markets. Sophisticated traders are now competing with alphas (trading codes) that are able to capture accurate price points of entry and exit. With emergence of Machine Learning and Artificial Intelligence, electronic trading is set to undergo a phase of transformation. It is, therefore, important for investment professionals to always consider the fundamental aspects of a company before developing and using trading strategies.  This is because the worst case scenario is not that the strategy will not work but that the strategy will constantly fail and yield losses.

Written by Kennedy Muturi


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