Surprise is a fact of life. Do stock markets like it?

Who doesn’t like a surprise? I do and, I am sure, you do too. Positive surprises are pleasant and negative surprises are sad. Ever feel confused about what to make of a surprise? Probably not, but well, as ridiculous as it may sound, this is how the Q1 FY20 earnings season was.

In an efficient financial market where information is symmetric and flows smoothly, uniformly, and simultaneously across all sections of investors, any new information should be incorporated into the price immediately after it is publicly disseminated. If we look at quarterly earnings results, prior to the result announcement, the entire investor community should have rational and uniform expectations. And if a company beats the estimates, it should come as a positive surprise, and be immediately incorporated into the price with a single positive move. Similarly, if it falls short of the expectations, the price should immediately correct downwards.

But, in reality, this is hardly how it plays out. To begin with, only a small section of the investor population forms its expectations based on analysis and logic. The rest are driven by rumors, pigeonhole perception of the company or its management, views of high-profile investors, and recall value – recent positive news and advertisements tend to heighten their expectations, while negative news pushes expectations down. The most recent example of negative recall value was how all banks were punished for a single piece of negative news in a small co-operative bank, regardless of how unconnected they were with the actual crisis.

Even post the announcement, the effect can be muddled either due to confusing management commentary, slow assimilation because of mixed signals from performance of different aspects of the business, or just basic over/under-reaction to the announcement.

In effect, because of irrational expectations and poor understanding of the results announced, a stock’s price may exhibit extended periods of slow reaction to the results announced. This phenomenon, called post-earnings-announcement drift, has even come to be considered as a consistent source of return globally. The slow or muted reaction allows the small fraction of rational sophisticated investors to make money off a positive surprise, which wouldn’t have been possible in an efficient market where price immediately and accurately incorporates all news.

However, in India, this effect remains relatively under-researched as well as frequently contradictory with no clear winner anywhere in sight. Let us look at some of the data ourselves to try and make sense of how Indian markets react to news.

If we consider the first quarter of this financial year (Q1-FY20) and look at stocks in the Nifty 50 index, we find that most stocks missed the street estimates. Let’s consider three stocks which presented the largest positive surprises – Asian Paints, Indian Oil, and HDFC, and three stocks at the other extreme with the largest negative surprises – Vedanta, Dr Reddy’s, and Wipro.

We can see that negative earnings surprises have resulted in price corrections for all three stocks considered, although over many days at a stretch. This is nothing but post-earnings-announcement drift.

The story with positive earnings surprises, however, is befuddling. Asian Paints posted one of the biggest earnings surprises, but its price had already appreciated in “anticipation of the surprise” and saw almost no market-reaction post the actual surprise. HDFC came out with promising earnings in an environment that hasn’t been kind to Financials, and the market didn’t even blink an eye. Indian Oil’s numbers were negative, but not as negative as the Street expected. Notwithstanding this, the stock corrected post announcement, making one wonder about the quantum of misalignment between expectations of the investor community and analyst estimates.

All in all, based on recent reactions to earnings, it is safe to say that one would probably be better off by selling a stock that misses its estimates. But, buying one that beats estimates may not always pay off. It is advisable to bear in mind the company’s long-term business outlook and stick with the strong companies as long as their results do not indicate any erosion in their competitive positioning.
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