What Is Acquired Earnings Drift?
Acquired Earnings Drift refers to the observable tendency of a company's stock price to continue moving in the direction of an earnings surprise for an extended period, often several weeks or months, following the official earnings announcement. This phenomenon is a well-documented market anomaly within the field of behavioral finance. It suggests that market participants do not immediately and fully incorporate all new information released during earnings announcements into a stock's price, leading to a gradual "drift" rather than an instantaneous adjustment.77, 78
The acquired earnings drift contradicts the premise of the efficient market hypothesis, which posits that all available information is instantly reflected in asset prices. Instead, it indicates a form of market inefficiency where investors may underreact or be slow to process new information, particularly unexpected earnings.75, 76
History and Origin
The concept of acquired earnings drift, also widely known as Post-Earnings Announcement Drift (PEAD), was first empirically documented by researchers Ray Ball and Philip Brown in their seminal 1968 paper, "An Empirical Evaluation of Accounting Income Numbers."73, 74 Their study observed that after an earnings announcement, stock prices continued to drift in the direction of the earnings surprise, challenging the prevailing notion of perfectly efficient markets where new information should be rapidly reflected in stock prices.
Subsequent research, particularly by Victor Bernard and Jacob Thomas in their 1989 and 1990 studies, provided more comprehensive analysis and confirmed the persistence of the phenomenon.69, 70, 71, 72 Bernard and Thomas showed that portfolios constructed based on earnings surprises could generate significant abnormal returns over subsequent quarters, further solidifying the acquired earnings drift as a robust anomaly in financial markets.68 This extensive body of academic work has investigated various drivers of the drift, including investor underreaction and market frictions.67
Key Takeaways
- Acquired Earnings Drift (also known as Post-Earnings Announcement Drift or PEAD) describes the tendency of a stock price to continue moving in the direction of an earnings surprise after the initial announcement.65, 66
- This phenomenon challenges the efficient market hypothesis by suggesting that markets do not immediately and fully process new earnings information.64
- It was first documented by Ball and Brown in 1968 and further solidified by Bernard and Thomas in the late 1980s.63
- The drift can persist for several weeks or even months, leading to potential arbitrage opportunities for traders who identify and act on these delayed price adjustments.62
- Explanations for acquired earnings drift often involve behavioral biases and limits to arbitrage.60, 61
Formula and Calculation
The acquired earnings drift itself is not calculated by a single, universally applied formula but rather is observed through the sustained movement of abnormal returns following an earnings announcement. The core concept behind measuring the potential for acquired earnings drift relies on quantifying the "earnings surprise."
One common method for defining earnings surprise is through Standardized Unexpected Earnings (SUE). SUE aims to capture how much actual earnings deviate from what the market or analysts expected, adjusted for variability.
The formula for Standardized Unexpected Earnings (SUE) is generally expressed as:
Where:
- Actual Earnings Per Share (EPS) represents the company's reported earnings for the period.59
- Expected EPS is typically derived from analyst consensus estimates or a time-series model of past earnings.
- Standard Deviation of Unexpected EPS measures the historical volatility of earnings surprises, acting as a scaling factor to standardize the surprise.
A positive SUE indicates that actual earnings exceeded expectations, while a negative SUE suggests they fell short. The subsequent drift in stock price is then observed in relation to this SUE.57, 58 Another measure used is Earnings Announcement Return (EAR), which is the abnormal return over a short window around the announcement date.56
Interpreting the Acquired Earnings Drift
Interpreting the acquired earnings drift involves understanding that a stock's price may not fully reflect new earnings information immediately. If a company announces positive earnings that surpass expectations (a positive earnings surprise), the theory of acquired earnings drift suggests that its stock price will continue to rise gradually over the subsequent weeks or months.54, 55 Conversely, if a company reports negative earnings that fall short of expectations, its stock price is likely to continue declining for some time.52, 53
This delayed reaction suggests that investors may initially underreact to the full implications of the earnings news.50, 51 The magnitude and persistence of the acquired earnings drift can vary, influenced by factors such as the size of the company, its liquidity, and the extent of analyst coverage. Smaller firms and those with less institutional ownership or analyst coverage may exhibit a more pronounced drift due to greater information asymmetry and limits to arbitrage.48, 49 Recognizing this drift can inform investment strategies, as it implies that opportunities may exist even after the initial earnings announcement has passed.46, 47
Hypothetical Example
Imagine "GreenTech Innovations Inc." (GTI), a publicly traded company known for its renewable energy solutions. For the past several quarters, GTI's earnings per share (EPS) have consistently been around $0.50. Analysts, however, have been expecting a breakthrough due to a new product line.
On July 15th, GTI announces its Q2 earnings, reporting an EPS of $0.75, significantly above the analyst consensus of $0.55. On the announcement day, the stock jumps 8%. However, according to the principle of acquired earnings drift, the market has not fully incorporated all the positive implications of this surprise.
Over the next two months, GTI's stock price continues to slowly but steadily climb. Investors and analysts gradually digest the implications of the strong earnings, such as potential for increased market share and future profitability. By September 15th, GTI's stock has risen another 12%, totaling a 20% gain since the earnings announcement. This sustained upward movement, beyond the initial announcement day jump, is an example of acquired earnings drift in action, as the stock price continues to "drift" in the direction of the positive earnings surprise. This gradual adjustment can be contrasted with the immediate price movements often associated with the efficient market hypothesis.
Practical Applications
Acquired earnings drift, or Post-Earnings Announcement Drift (PEAD), has several practical applications for investors and financial analysts, primarily stemming from its nature as a market anomaly.
- Trading Strategies: One of the most direct applications is in developing event-driven trading strategies. Traders might establish long positions in stocks that have reported significant positive earnings surprises, anticipating that the price will continue to drift upwards. Conversely, they might short-sell stocks with large negative earnings surprises, expecting further price declines.45 These strategies aim to capitalize on the market's slow absorption of information.43, 44
- Portfolio Management: For portfolio managers, understanding PEAD can lead to adjustments in portfolio composition. By systematically identifying stocks exhibiting earnings surprises, managers may rebalance portfolios to overweight those with positive drift potential and underweight those with negative drift. This can involve analyzing quarterly earnings reports and the subsequent market reaction.41, 42
- Fundamental Analysis Refinement: While PEAD highlights market inefficiency, it also underscores the importance of thorough fundamental analysis. Investors can use earnings surprise as a signal to delve deeper into a company's financial health, scrutinizing income statements and other financial statements to confirm the underlying strength or weakness indicated by the earnings surprise.38, 39, 40
- Risk Management: Investors can also use the concept of acquired earnings drift to refine their risk management approaches. For instance, being aware of the potential for continued downward drift after negative earnings can inform decisions to reduce exposure or implement hedging strategies more promptly.
The existence of acquired earnings drift has been consistently documented across various markets globally, suggesting its robust nature as a capital market anomaly.35, 36, 37
Limitations and Criticisms
Despite its widespread documentation, acquired earnings drift faces several limitations and criticisms, particularly concerning its exploitability and implications for the efficient market hypothesis.
One significant criticism centers on the concept of "limits to arbitrage." Even if the drift represents a genuine mispricing, transaction costs, such as brokerage fees and bid-ask spreads, and the illiquidity of certain stocks can make it difficult for arbitrageurs to profit from the anomaly after accounting for these expenses.34 The effect is often more pronounced in smaller, less liquid stocks, where trading costs are higher.33 This raises questions about whether the observed drift is a true market inefficiency or merely a reflection of the costs involved in correcting mispricings.
Another point of contention is the methodology used to measure earnings surprise and abnormal returns. Different models for calculating expected earnings can lead to varying degrees of observed drift.31, 32 Critics argue that the drift might be a statistical artifact of the models used rather than a genuine market phenomenon. Some research suggests that the drift might be partially explained by factors related to arbitrage risk.29, 30
Furthermore, the behavioral explanations for acquired earnings drift, such as investor underreaction or limited attention, are not universally accepted. While behavioral finance provides compelling narratives, the precise psychological mechanisms and their consistent impact on market prices can be challenging to isolate and measure.25, 26, 27, 28 Over time, as more investors become aware of such anomalies, the opportunities to profit from them may diminish due to increased competition and market adaptation, a concept known as "anomaly decay."24 This suggests that while acquired earnings drift has historically been a robust phenomenon, its future profitability for active traders may decline as markets become increasingly sophisticated.
Acquired Earnings Drift vs. Price Momentum
Acquired Earnings Drift (PEAD) and Price Momentum are both widely studied market anomalies that describe persistent movements in asset prices, but they originate from different underlying drivers.
Acquired Earnings Drift specifically refers to the tendency of a stock's price to continue moving in the direction of an earnings surprise (positive or negative) for several weeks or months following an earnings announcement.22, 23 The primary cause attributed to PEAD is the market's delayed or underreaction to the fundamental information contained in the earnings report.20, 21 It suggests that the full implications of a company's financial performance are not immediately priced into the stock.
In contrast, Price Momentum describes the tendency for stocks that have performed well in the recent past (e.g., over the last 3 to 12 months) to continue performing well in the near future, and similarly for poorly performing stocks to continue their decline.19 Price momentum is generally attributed to psychological biases such as investor herding, anchoring, or underreaction to a broad range of information, not just earnings news. It is a broader phenomenon that reflects trends in market sentiment and trading behavior, rather than being tied to a specific corporate event like an earnings release.17, 18
While there can be an overlap (strong earnings can contribute to positive price momentum), PEAD is a more targeted anomaly linked to the informational inefficiency around earnings announcements, whereas price momentum is a more general market trend based on past price performance.
FAQs
What causes acquired earnings drift?
Acquired earnings drift is primarily attributed to investors' delayed reaction or "underreaction" to new information contained in a company's earnings announcement.15, 16 This behavioral bias suggests that market participants do not fully process the implications of an earnings surprise immediately, leading to a gradual price adjustment over time.13, 14 Other contributing factors can include trading frictions, such as transaction costs, and limits to arbitrage.
How long does acquired earnings drift typically last?
The acquired earnings drift can persist for several weeks, or even several months, following the earnings announcement.11, 12 Research has indicated that the abnormal returns associated with the drift can continue to accrue for up to 60 days or longer.10
Is acquired earnings drift consistent with the efficient market hypothesis?
No, acquired earnings drift is considered a significant challenge to the efficient market hypothesis.9 The efficient market hypothesis posits that all available information is immediately and fully reflected in stock prices, meaning there should be no predictable patterns of abnormal returns after a public announcement like earnings. The existence of acquired earnings drift suggests that markets are not perfectly efficient in processing information.6, 7, 8
Can investors profit from acquired earnings drift?
Acquired earnings drift presents a potential opportunity for investors who can identify and act on these delayed price reactions.3, 4, 5 Strategies often involve buying stocks with strong positive earnings surprises and short-selling those with significant negative surprises. However, profitability can be affected by transaction costs, market liquidity, and the diminishing size of the anomaly as more participants attempt to exploit it.1, 2