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Understanding the “Ricochet Effect” of Bad News

Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

 

Bottom Line: Profit warnings not only hurt a company’s domestic rivals, but also international competitors, and can cause industry-wide investor skittishness.

Firms are under increasing pressure to release financial statements that give analysts, stockholders, and regulators insight into past performance and future prospects. One of the more common types of these disclosures is a voluntary profit warning, which cautions investors that a company is set to post financial results that will fall short of expectations.

In general, when a firm announces bad news, its stock price tends to fall. Bad news travels fast, as they say, and it can also have a ripple effect on the stock prices of other companies within the same industry, because investors know that companies in a sector tend to share a common business landscape, use similar technology, face the same macroeconomic conditions, and have comparable growth opportunities.

But most of the evidence for the ripple effect is based on earnings announcements, which are essentially after-the-fact summations of a firm’s performance during the past quarter. Profit warnings, on the other hand, are forward-looking projections, disclosed voluntarily, that are meant to soften the blow when the actual numbers are released.

So do profit warnings rub off on other firms in the same industry the way earnings announcements do? And given the increasingly global nature of business, does the bad news that ricochets off a particular firm affect its domestic and international competitors differently?

To answer these questions, the authors of a new study examined the market impact of voluntary profit warnings issued by U.S. firms on their domestic and foreign rivals in the same industry, who had not made any sort of announcement. To validate the so-called “ricochet effect,” the authors tested whether the negative impact of profit warnings was larger for a firm’s domestic competitors than it was for international rivals.  

The authors analyzed the ricochet effect of 1,045 profit warnings made by 486 U.S. companies listed on the New York Stock Exchange, NASDAQ, and the American Stock Exchange from 1995 through 2009. For each of these announcements, the authors selected up to five of the largest domestic and international companies, in terms of revenue, that operated in the same industry but didn’t issue a warning. As a result, the authors were able to examine the ricochet effect of bad news on 4,431 domestic and 4,139 international companies.

Although previous research has pointed to dramatic market overreactions within European markets to European companies’ profit warnings, the authors of this study found a more modest impact of announcements made by U.S.-based firms. Still, there was a decided and significant ricochet effect. The authors estimate that when a company issues a profit warning, about 10 percent of domestic rivals’ negative abnormal returns — a drop in stock price that deviated from the expected rate of return — could be attributed to the announcement. The effect was about 4 percent for a company’s international rivals.

Further, the authors found that about 70 percent of companies operating within the same domestic industries showed similar, and significant, movements in their patterns of abnormal returns. This suggests that U.S.-based firms share the brunt of bad news among themselves. Nevertheless, some impact does ricochet on to foreign companies — most significantly in the chemicals and petroleum, computer equipment, electronics, transportation, and communication sectors. That would seem to indicate that international investors in these industries are particularly jittery and sensitive to any hint of a segment-wide downturn that might spread from the U.S., or that shareholders believe the economics of these sectors are especially interwoven, regardless of geographic distance.

Using data from the National Bureau of Economic Research — which draws on macroeconomic indicators such as GDP, real income, employment rate, and industrial production to classify different business cycles — the authors also analyzed whether the effects of bad news differed during periods of industry growth or contraction.

They found that the industry-wide trend toward negative abnormal returns in reaction to profit warnings was far more marked during an expansion stage than during one of retrenchment. The authors posit that because investor confidence typically soars during periods of growth, when shareholders readily extrapolate good news for one company to mean good news for the whole industry, the release of ominous tidings during what should be a positive time is a jarring (and unexpected) red flag, which makes them rethink the sector’s prospects.

Profit-warning fallout is rarely isolated and can spread uneasiness at home and, to a lesser extent, overseas.

On the other hand, the release of very bad news during periods of contraction did not spread nearly as much to firms that didn’t issue their own profit warning. That’s probably because the prospect of extremely negative performance during an industry-wide slowdown is somewhat to be expected, and merely signals that one firm is doing a bit worse than the others.

Profit-warning fallout is rarely isolated and can spread uneasiness throughout an industry’s investors at home and, to a lesser extent, overseas. As a result, the authors suggest, executives should have a greater understanding of the ramifications of disclosing financial projections, and how they are affected by business-cycle phases.

“Firms must consider how the market will react to the information transfer of their voluntary disclosure of profit warnings to non-announcing peer firms and how peer firms’ profit warnings will impact their own firm,” the authors write.

Source:The Ricochet Effect of Bad News,” Raymond A.K. Cox (Thompson Rivers University), Ajit Dayanandan (University of Alaska Anchorage), and Han Donker (University of Alaska Anchorage), The International Journal of Accounting, Sept. 2016, vol. 51, no. 3

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Understanding the “Ricochet Effect” of Bad News