We examine whether the application of basic concepts of fundamental analysis can yield significant abnormal returns. Using a collection of signals that reflect traditional rules of fundamental analysis related to contemporaneous changes in inventories, accounts receivables, gross margins, selling expenses, capital expenditures, effective tax rates, inventory methods, audit qualifications, and labor force sales productivity, we form portfolios that earn an average 12 month cumulative size-adjusted abnormal return of 13.2 percent. We find evidence that the fundamental signals provide information about future returns that is generated around subsequent earnings announcements. These findings are consistent with the underlying focus of fundamental analysis on the prediction of earnings. Significant abnormal returns to the fundamental strategy are not earned after the end of one year of return cumulation, indicating little support for the idea that the signals capture information about multiple-year-ahead earnings not immediately impounded in price or long-term shifts in firm risk.

We investigate whether the direction and magnitude of earnings management by a firm is affected by analysts' current perception of its equity investment potential (i.e., its perceived ability to generate positive abnormal returns). We argue that firms whose investment potential is perceived to be high (low) by analysts have strong (weak) incentives to meet earnings expectations. Accordingly, firms whose investment potential is perceived to be high are expected to manage earnings towards expectations (to ratify analysts beliefs), whereas firms whose investment potential is perceived to be low are expected to manage earnings away from expectations (to create the greatest possible amount of accounting slack for the future). Relying on analysts' Buy, Hold and Sell recommendations as proxies for firms' perceived investment potential and analysts' earnings forecasts to measure earnings expectations, we find evidence that strongly supports these hypotheses. Specifically, we find that after being rated a Sell, firms engage more frequently in extreme income-decreasing earnings management than other firms, indicating strong incentives to take earnings baths to create accounting slack. This earnings management behavior is associated with extreme bad news earnings surprises. In contrast, after being rated a Buy, firms engage in more frequent (but not more extreme) income-increasing earnings management than other firms. This behavior is associated with a high incidence of reported earnings that meet or slightly exceed the target of analysts' earnings forecasts. Our findings provide evidence of widespread earnings management in response to equity market incentives. They also suggest that some portion of apparent quot;optimismquot; in analysts' forecasts previously documented may be attributable to actions taken by managers subsequent to the issuance of forecasts rather than incentives to bias forecasts often ascribed to analysts.

This paper studies the information links that connect detailed financial statement data and security prices. We establish empirically the underlying relations between rules of fundamental analysis and: 1) analysts' earnings forecast revisions, 2) actual future earnings changes and 3) security returns. We find evidence that some but not all of the fundamental signals are related to subsequent earnings changes and analysts' revisions as hypothesized. Paradoxically, contemporaneous security returns reveal that, in the eyes of investors, the set of fundamental signals contain information orthogonal to analysts' revisions. Additional evidence suggests one explanation for this result is that analysts' forecast revisions are inefficient with respect to the future earnings information contained in some of the fundamental signals. One practical implication of our findings is that if analysts were to process efficiently the information in the fundamental signals, it would be sufficient to eliminate the well-documented phenomenon of analyst underreaction to prior earnings news.

Several influential studies have concluded that earnings surprises just to the right or to the left of a hypothesized bright line produce distinct price reactions compared to the surrounding earnings surprises because they convey special meaning. In this study, we examine whether previous inferences of asymmetric stock price reactions to bright-line surprises are observed when empirical tests are designed to be consistent with a rational expectations equilibrium. Focusing on a small range of earnings surprises around hypothesized bright lines, we find no evidence of asymmetric price reactions once investors' ex ante expectation of bias in earnings surprises is controlled. Results from additional tests yield support for the external validity of the theoretical framework underlying our bright-line pricing tests. Our findings suggest simple refinements to traditional bins-comparison and regression tests for asymmetric price reactions to bright-line earnings surprises, which account for necessary conditions implied by a rational expectations equilibrium.

Because spin-offs create new firms with characteristics markedly different from the original firm, institutional investors pre-committed to certain investment styles and/or subject to fiduciary restrictions have incentives to rebalance their portfolios at the time of the spin-off. Prior articles in the business press and academic journals claim that the large volume of trading related to this rebalancing creates short-term price pressure in stocks of the entities emerging from the spin-off. In this paper, we examine whether corporate spin-offs lead to significant changes in the holdings of institutional investors and whether these changes do create temporary price pressure. We find strong evidence that investment strategy and fiduciary restrictions affect institutional investor demand for the stocks after spin-offs. However, our results indicate that matching of institutional buying and selling is sufficiently complete in most cases to allow for large volumes of shares to change hands without prices deviating from fundamentals.

Prominent properties of distributions of differences in earnings reported by forecast data providers (FDPs), i.e., I/B/E/S, Zacks, and First Call, and Compustat drive statistical inferences drawn in extant research concerning the relative information content and value relevance of alternative reported earnings numbers (e.g., quot;Streetquot; or pro forma versus GAAP earnings). These properties include, 1) the existence of an extreme negative tail in such distributions (representing cases in which Compustat earnings is below FDPs' earnings by extreme amounts), 2) a higher frequency of cases in which Compustat earnings exceed FDP earnings by small amounts than cases in which FDP earnings exceed Compustat earnings by small amounts accompanied by a high concentration of zero earnings differences, 3) systematic changes in the shape of such distributions over time attributable to the application of stable formulae for excluding items from reported earnings by the FDPs while recognition of these items by firms in the cross-section changes. Relying on knowledge of these properties we show that many statistical inferences and interpretations concerning market reliance/fixation on FDP (Street or pro forma) earnings versus Compustat (GAAP) earnings in the cross section and over time are driven by a small number of extreme negative tail observations and a regime shift in the mean earnings differences in 1990, respectively. These properties have similar impacts on inferences in the value relevance literature. Our findings highlight the value of understanding the properties of distributions of earnings differences and the composition of earnings related to these properties for identifying potential factors that can confound inferences, and for uncovering evidence that generates new lines of investigation and improves test designs.