Journal of Financial Economics 10 (1982) 2699287.

North-Holland Publishing Company

EMPIRICAL ANOMALIES BASED ON UNEXPECTED EARNINGS

AND THE IMPORTANCE OF RISK ADJUSTMENTS*

Richard J. RENDLEMAN, Jr.

Duke Unirwsitp, Durhm~, NC 27706. US.4

Charles P. JONES
North Carolina State University, Raleigh, NC 27607, USA

Henry A. LATANE
Unioersity oj North Carolina, Chapel Ifill, NC .?7514. USA

Received January 1982, final verston recetved June 1982

The purpose of this paper is to reexamine Reinganumi study which indicates that abnormal
returns could not be earned using unexpected quarterly earnings mformation, and to document
precisely the response of stock prices to earmngs announcements. This study, using a very large
sample of stocks and daily returns, represents the most complete and detailed analysis of
quarterly earnings reports that has been performed to date. Our results are contrary to those of
Reinganum and show that abnormal returns could have been earned almost any time during the
1970s. Our analysis also indtcates that risk adJustments matter httle in this type of work.
Fmally, we find that roughly SO,; of the adjustment of stock returns to unexpected quarterly
earnings occurs over a 90-day period after the earnings are announced.

1. Introduction
Over the years a number of papers have appeared which analyze the issue
of market efficiency with respect to earnings reports. As discussed in Joy and
Jones (1979), while some of the earlier work may have had shortcomings,
later studies were more rigorous and dealt with the objections that were
raised concerning data limitations and risk adjustments. For example, Joy,
Litzenberger and McEnally (1977) took explicit cognizance of possible
biases in prior studies and concluded that price adjustments to the
information . . contained in unexpected highly favorable quarterly earnings
reports are gradual over time rather than instantaneous.
Recently, Ball (1978) surveyed the literature and found that it reveals
consistent excess returns after public announcements of firms earnings. And

*The tinancial support of the Chicago Mercantile Exchange and the North Carolina Institute
for Investments Research ts gratefully acknowledged.

0304405x/82/00 /$02.75 0 1982 North-Holland

270 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

Watts (1978), examining the abnormal returns following quarterly earnings

announcements, found that significant abnormal returns are observed after
the earnings announcement. Thus, there is ample evidence to support the
possibility of a significant relationship between quarterly earnings and stock
prices.
Several papers by LatanC and Jones (1974, 1977, 1979) have identified a
specific relationship between unexpected quarterly earnings and subsequent
excess holding period returns from common stocks. This relationship, based
on a concept called Standardized Unexpected Earnings (SUE), has been
supported by other researchers, for example Bidwell (1979) and Cole (1981).
Nevertheless, no study has yet appeared documenting the precise SUE
relationship for a large sample of stocks over a long period of time, which
would provide strong support for the work that has been performed in this
area. And, recently, Reinganum (1981) has presented results concerning the
effectiveness of SUE that are in marked contrast to the Latank and Jones
findings.
This paper has three basic purposes: (1) to reexamine Reinganums findings
which appear to refute the SUE phenomenon altogether; (2) to document
precisely the returns response of stocks to unexpected quarterly earnings
both before and after the announcement date of earnings; and (3) to assess
the importance of risk adjustments in this analysis. The question of SUEs
effectiveness in predicting stock performance is important because of its
implications for market efficiency. And if, contrary to Reinganum, there is a
significant SUE effect, it is desirable to document precisely what that effect is.
Because of data limitations, previous studies have failed to do this.
Section 2 of the paper outlines the SUE concept and describes the large
data base used in the analysis. In section 3, we discuss Reinganums results
and replicate his analysis on a larger sample of stocks. We find results
contrary to those of Reinganum, and we offer an explanation for the results
that he found.
Section 4 examines the impacts of various risk adjustments using
alternative beta calculations, and the differences that result from making no
explicit risk adjustment. This is particularly interesting given the overriding
emphasis on risk adjustments in the literature. In section 5 we document the
response of a large sample of stocks to unexpected earnings. This is done by
separating the responses into pre- and post-announcement day movements as
well as those on the day of the earnings announcement. Finally, section 6
provides a summary and offers some concluding comments.

2. Background, methodology and data

Unexpected earnings for company j in quarter q is the differ-encc between
the actual earnings for the quarter and the corresponding expected earnings,
 R.J. Rendleman, Jr. el al., Unexpected earnings and abnormal stock returns 271

where the latter has been forecast using a simple time series model.
Standardized Unexpected Earnings (SUE), in turn, is defined as unexpected
earnings statistically deflated for standardization purposes. It is important
to note that the earnings forecasting model is designed to capture investors
expectations and not the mathematical time series nature of the reported
earnings.2
Unexpected information should lead to a revision of probability beliefs
and, hence, a change in stock prices. Empirical evidence has indicated that
the adjustment in stock prices to the unexpected earnings is relatively slow,
occurring over a period of weeks. This adjustment usually has been measured
using either 3-month holding period returns (HPRs), (expressed in excess
form as the HPR for the individual stock minus the corresponding market
HPR), or abnormal returns (i.e., observed returns in excess of those predicted
by an equilibrium model). In those studies using the former, for example
Latant- and Jones (1977, 1979). this response has been measured beginning
either two or three months after the end of the fiscal quarter. Thus, the
performance from companies reporting soon after the close of the quarter is
mingled with the performance from those reporting later. In those studies
using abnormal returns, for example Joy. Litzenberger and McEnally (1977)
and Watts (1978), a relatively small sample of companies has been used (102
and 73 respectively).
This study uses daily returns from the CRSP tape to assess the response of
stock prices to quarterly earnings announcements before, on. and after the
announcement date. It uses a fresh source of quarterly earnings and
announcement dates (a customized PDE tape) and programs completely
independent of those used in previously published studies. Specifically, the
customized PDE tape was produced at the end of May, 1981 by Standard
and Poors Corporation, and provides quarterly earnings data and earnings
announcement dates for all companies on the Compustat PDE Tape.
Earnings announced after 3:30 p.m. by the wire services are recorded on the
tape as being announced the next day. Although we have not checked
specifically each earnings announcement, we have no evidence that this data
recording procedure significantly affected our results. Since few earnings
announcement dates are provided prior to the third quarter of 1971, our
study begins that quarter. The study is limited to companies with fiscal year

The exact procedure for calculating SUE can be found in Latank and Jones (1977, p. 1457) or
Reinganum (1981, pp. 22-23).
This point has been misunderstood by some researchers. See Joy and Jones (1979, pp. 60-61)
for a complete discussion of this model misspecdication criticism.
3Reinganum (1981) provides a distribution of quarterly earnings announcements by month of
release. For the 1st. 2nd, and 3rd quarters. roughly 4 times as many companies report within
one month of the fiscal quarter close compared to the second month following the quarters
close. For the 4th quarter, roughly 607; report in the second month and roughly 20% report in
the 1st and 3rd months following the close.
 212 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

ends of March, June, September and December. The CRSP tape included
returns data through December, 1980, which required that our analysis end
with the earnings reports for the second quarter of 1980.
As shown in table 1, the sample size ranges from a minimum of 618
companies in the third quarter of 1971 to a maximum of 1496 companies in
the first quarter of 1980.4 The merger of the Compustat and CRSP tape
provides the largest sample of companies with daily returns that has been
used to date in a study of quarterly earnings announcements. We believe
that, within the confines of any large-scale computer study based on the
widely known and used data bases, this study represents the most complete
and detailed analysis of quarterly unexpected earnings that reasonably can be
performed.5 The magnitude by which the size and time span of this study
exceeds others will be apparent as we examine a recently published study by
Reinganum, and it is to the contrary evidence of his study that we now turn.

3. Reinganum and SUE

Reinganum (1981), in studying empirical anomalies, analyzed the use of
SUE as a portfolio selection technique. Using a sample of 566 New York
and American Exchange stocks available as of December 1975, Reinganum
studied the SUE effect over rhe eight quarters of his sample period, which
ended with the third quarter of 1977.j Focusing only on those companies
that reported within one month of the close of the fiscal quarter
(Reinganums sample size by quarter is shown in table l), he examined daily
portfolio returns for four different 3-month holding periods ~ the periods
begin at the end of one, two, three, and four months following the fiscal
quarter close. In reporting the results of our tests which replicate

4The only reasons for excluding a company from the analysis in a given quarter were a lack
of 20 quarters of earnings (which are needed to calculate SUE), a lack of sufficient returns data
(which are needed to calculate beta), or a lack of a recorded earnings announcement date. Our
sample size is increasing for two reasons. First, in the mid-1970s Compustat significantly
expanded the number of companies covered. Second, Compustat has not gone back to a
common date for reporting earnings announcement dates; thus, Compustat did not necessarily
go back to 1971 in picking up all the earnings announcements. We found, for example, that in
the quarter preceding our starting date, there were only approximately 250 compantes available
with reported announcement dates that met our other criteria.
Possible biases in studies of thts type, such as the survivorship bias, have been dealt with in
earher papers. See Latani and Jones (1979, footnote 2). As dtscussrd tn footnote 13, we do not
believe that any signiticant survivorship bias exists in our data.
In correspondence with the authors, Reinganum points out that the 566 stock sample came
from a sample of 577 stocks provided to him by Latane and Jones. Eleven of the original
companies were eliminated because of missing data. Reinganum started with 566 companies, and
535 were left at the end of eight quarters. Thus he directly controlled for survivorship bias. Our
analysis is limtted to companies in business m May of 1981, and therefore does not control for
survivorship bias. However, as explained in footnote 13, we do not beheve that this bias poses a
significant problem.
For example, for a company reporting fourth quarter results in January of the next year,
portfolio returns would be examined for February-MarchhApril, MarchhAp&May, April-
May-June. and May-June-July.
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns 213

Table 1
Number of companies analyzed by quarter

Number of Reinganums
companies sample Size
Number of reporting of companies
companies in earnings within reporting within
the sample I month of the 1 month of the
by quarter quarters close quarters closeb

1971.3 618 400

4 636 170
1972.1 659 449
2 694 434
3 704 489
4 720 222
1973.1 788 546
2 847 558
3 873 606
4 1037 349
1914.1 1076 744
2 1124 741
3 1132 762
4 1197 373
1975.1 1219 809
2 1258 822
3 1262 841
4 1283 378 124
1976.1 1302 839 455
2 1343 809 453
3 1346 802 424
4 1368 418 124
1977.1 1385 825 441
2 1392 804 427
3 1402 870 426
4 1411 450
1978.1 1426 834
2 1428 828
3 1430 912
4 1438 470
1979.1 1449 892
2 1458 898
3 1463 957
4 1470 509
1980.1 1496 972
2 1420 946

Earnings announcement dates are provided by Compustat. Compustat

employs the date that the announcement is reported over the wire services,
as long as the announcement occurs before 3:30 p.m. Those reported after
3:30 p.m. are assigned the next calendar day.
bReinganum collected his announcement dates from the Wall Street
Journal.
274 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

Reinganums methodology, these portfolio formation dates will be labelled in

the text and tables as + 1, + 2, + 3, etc.
As in the Latane-Jones study, Reinganum analyzed two portfolios each
quarter, one containing the stocks with the highest 20 SUES and the other
containing the lowest 20 SUES. However, he went a step further by
constructing each of these two portfolios to have an estimated beta equal to
one. This was done by dividing each 20 stock portfolio into two equally
weighted portfolios of ten securities, with weights selected to balance the
portfolio beta to one; that is, both the high and low SUE portfolios are
constructed to have a beta risk of one.8 Reinganum argues that the difference
in the expected returns between these portfolios should be zero under the
null hypothesis that the CAPM describes asset pricing.
Although portfolios of 20 stocks were used to replicate the portfolio
selection procedure employed in earlier work by Latane and Jones, their two
20 stock portfolios were selected from a much larger universe of 975 stocks.
As a result, the stocks in Reinganums portfolios represent a substantially
higher percentage of the original sample. Thus, the portfolio selection
procedure devised by Reinganum is less likely to find SUE to be an effective
discriminator among over and under-performing stocks.
Reinganum found that abnormal returns (based on means of the
differences in daily returns between the high and low SUE portfolios) were
not statistically different from zero. He concluded that abnormal returns
cannot be earned over the period studied by constructing portfolios on the
basis of firms standardized unexpected earnings as defined by Latane and
Jones.
Within the confines of our much larger analysis, we have reconstructed the
Reinganum test in order to validate (or not) the SUE effect. The period from
1971.3 through 1980.2 is analyzed, which includes Reinganums period of
1975.4 through 1977.3. Following him, in this section of the paper we
concentrate only on those companies reporting within one month of the
close of the fiscal quarter; therefore, the number of observations is reduced
and now ranges from a minimum of 170 companies in 1971.4 to a maximum
of 972 in 1980.1. (This reduced number of companies per quarter is shown in
table 1 along with the number used by Reinganum in his study.) The test
focuses on the differences in three month returns between the high and low
20 stock portfolios of identical beta risk.

This technique was borrowed from Watts (1978). Reinganums weights on individual
securities are based upon betas estimated using 60 days of daily data over the period
immediately preceding the first three month holding period. The index is an equally wetghted
NYSE-AMEX market index.
Like Reinganum, we have calculated the results for those companies releasing earnings in the
second month after the close, but do not report them. The results are similar to those reported
here, as is the case m Reinganums study.
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns 275

We have replicated Reinganums risk-adjusting procedure for the high and

low SUE 20 stock portfolios. In addition, we have also reestimated the betas
using the Scholes and Williams (1977) technique. Their technique attempts
to adjust for the finding in some empirical studies that market model (OLS)
beta estimates vary systematically with measurement length. Scholes and
Williams found an errors-in-variables type bias occurring in observed betas
as a result of the last transactions for some securities occurring earlier in the
measurement interval.
Finally, we have recalculated the results of this SUE analysis with no
adjustments made for risk. This will allow us to assess the importance of the
risk adjustment for strategies such as SUE.
Table 2, based on the OLS betas, shows the complete three month returns
constructed as differences between the high SUE and low SUE 20 stock
portfolios. Since the beta risk of each portfolio has been constructed to be
one, these differences should equal zero. Portfolio positions are taken at the
end of 1, 2, 3, 4, and 5 months following the fiscal quarter close (again, only
for companies releasing quarterly earnings in the month immediately
following the quarter close). Reinganums analysis covered only the eight
quarters 1975.4 through 1977.3; therefore, this analysis is able to examine
both the 17 quarters preceding his sample period and the 11 quarters
following his sample period.
The first observation to be noted from table 2 is that, unlike Reinganum,
we find a significant SUE effect. The mean abnormal returns are quite large,
ranging (for all 36 quarters) from almost 60/d,for the first portfolio starting
position (+ 1) to about 3.4% for the position starting five months (+ 5) after
the close of the fiscal quarter. Almost all of the mean abnormal returns
are statistically signficant, as shown by the t-statistics at the bottom of the
table. The mean abnormal returns for all 36 quarters compare quite

Like Reinganum, we compute betas based on the 60 trading days prior to the lirst holding
period over which performance is assessed using the CRSP NYSE-AMEX equally weighted
index. In calculating Scholes+Williams betas, 62 days of stock and market returns are required.
The Ordinary Least Squares (OLS) beta, which is obtained from the Scholes~Williams
calculations, is the OLS beta that we employ in our analysis of Reinganums work. This beta is
actually measured over days 2-61. while Reinganums would be measured over days 3~62. This
difference of one day should not affect the results.
The abnormal returns reported in table I are three month returns, starting at the end of
one month after the close of the quarter (+ I), two months after the close of the quarter ( + 2),
etc. Reinganum, in his table 2, reports mean differences m daily returns. We have converted his
overall mean returns for eight quarters to a quarterly basis by assuming 63 trading days per
quarter. They are, for starting periods + I through +4, 0.0176, 0.0100, 0.0258, and - 0.0036.
t-statistics are calculated as follows: let p. denote the average portfolio return difference for
n quarters for the returns shown in a given column of table 2. and S,: the %lmple variance of
return differences over the same n quarters. Then, the r-statistic is calculated a\ I ~ pnL2 S,. I-tnr
calculation parallels that of Reinganum and implicitly assumes that there 1s no serial correlation
in the return differences. r-statistics shown in table 3 are also calculated accordmg to this
procedure.
276 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

closely to the mean for Reinganums sample period of eight quarters (0.059
vs 0.056) for the first three month holding period (+ 1). And, interestingly, the
results over Reinganums sample period for the first holding period (+ 1) are
more significant (i.e., a t-value of 6.10) than the corresponding means for the
other subperiods or the overall period.

Table 2
Differences in three month returns between the high and low standardized unexpected earnings
portfolios of 20 stocks of identical beta risk for companies reporting earnings in the month
following the liscal quarter close.

Number of months after quarter close

that portfolio position is taken

Quarter +1 +2 +3 +4 +5

1971.3 - 0.00743 0.05679 0.06588 0.14963 0.08135

-0.07523 - 0.06624 - 0.05424 0.01062 0.057 I2
1972.1 0.05400 0.03844 0.03891 -0.07535 - 0.02854
0.02216 o.oooo2 0.0045 1 -0.01467 0.01640
0.0359 1 0.06614 0.075 11 0.13267 0.12597
-0.01051 - 0.06639 -0.11480 - 0.09942 0.02249
1973.1 0.11073 0.07521 0.07548 0.15564 0.15150
0.15371 0.09763 0. I5972 0.02784 0.02156
0.17207 0.15593 -0.03449 0.07202 0.0 1463
0.01881 0.06696 0.06771 0.08902 0.06226
1974.1 0.02674 0.08810 0.20512 0.19146
0.17413 0.11836 0.18477 - 0.09980 -0.16723
0.05207 - 0.02840 -0.10083 0.073 18 0.02496
- 0.02589 - 0.06580 0.045 18 0.06799 0.11286
1975.1 0.16169 0.08383 0.05954 0.02341 0.07626
0.04657 0.07327 0.03674 0.05323 0.05465
-0.00092 0.00320 0.01447 0.07026 - 0.05746
0.08283 0.00406 - 0.05303 - 0.07862 -0.02556
1976.1 0.05706 0.07080 0.16358 0.06352 0.0773 1
0.04752 0.03636 -0.03162 ~ 0.02705 -0.03117
0.04406 -0.03909 -0.06122 - 0.07058 0.00652
0.04583 0.08870 0.05769 0.06143
1977.1 0.10580 0.03122 -0.00418 -0.00988 -0.04537
0.03888 0.00182 0.00036 - 0.04066 0.07672
0.02985 0.07225 0.05234 0.07083 0.00237

0.03664 0.09686 0.06067 0.05788 0.04353

1978.1 0.05000 0.05488 0.05400 0.02110 0.05687
0.10027 0.07194 0.04060 0.03562 -0.03461
0.02656 0.06030 -0.03330 0.00292 0.01161
0.07639 0.05049 0.06732 0.01407 0.01519
1979.1 - 0.02839 -0.01696 0.00737 0.05483 0.07857
0.09194 0.16517 0.11533 0.073 15 0.01020
0.27339 0.22875 0.11923 0.14215 0.06854
0.01427 0.00620 0.09015 0.10337 0.12299
1980.1 - 0.03093 0.04882 0.09954 0.10445 0.10054
0.16301 0.28045 0.19138 _b _b
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns 277

Table 2 (continued)

Number of months after quarter close

that portfolio position is taken

+I +2 +3 +4 +5

Mean
1st 17 quarters 0.05345 0.0403 1 0.03599 0.04949 0.04472
Reinganums period 0.05568 0.02791 0.02 162 -0.00434 ~ 0.00390
Last 11 quarters 0.07029 0.09517 0.07384 0.06095 0.04735
All 36 quarters 0.05909 0.05432 0.04436 0.04046 0.03436

t-statistic
1st 17 quarters 2.92942 2.48438 I .8603 1 2.33054 2.21438
Reinganums period 6.10068 2.09372 0.80486 ~0.20210 -0.21032
Last 11 quarters 2.64233 3.42195 4.074 18 4.27755 3.13832
All 36 quarters 5.01311 4.37837 3.58234 3.21516 2.91011

In this table beta calculations and portfolio formation parallels that of Reinganum (1981) in
which OLS betas are calculated using daily data 60 days prior to the earnings announcement.
The + 1 etc. refers to taking a posrtion one month, two months, etc. after the fiscal quarter close
and holding for three months. The returns for each quarter are calculated on a three month
basis, regardless of whether the three-month period begins at the end of the + 1, +2, +3, +4,
or +5 month.
Insufficient data prohibited us from computmg returns in the last quarter for the +4 and + 5
starting positions.
Not significant at the 0.05 level.

The second observation to be made is that for each of the four holding
periods beginning two months after the close of the fiscal quarter (+2, + 3,
+ 4, and + 5), the results for the Reinganum period are decidely inferior to
the periods before or after his analysis. Compare to the overall results, the
Reinganum-period abnormal returns are about 50% less for the 2nd and 3rd
holding periods, and drop to about 0.0 for the 4th and 5th holding periods.
In fact, the only three returns in this table that are not significant, at the 0.05
level or better, are those for Reinganums period for the + 3, + 4, and + 5
starting times. Thus, Reinganum may have chosen for his analysis the one
subperiod out of almost an entire decade that would lead him to his
conclusion that SUE cannot discriminate among over and under performing
stocks. (However, it is important to note that we find significant abnormal
returns for Reinganums period for the first and second portfolio starting
times, + 1 and +2.) Also, the small size of his sample does not allow for as
much variance in SUE as does ours. On average, our stock portfolios should
include more companies with extreme SUES, and therefore would be more
likely to show superior abnormal performance.
The vast majority of the other returns in table 2 are clear evidence that
SUE has been an effective discriminator over a long period of time. Also note
that the very high abnormal returns in the last 11 quarters after Reinganums
278 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

period are the largest means in table 2. Not only have SUE effects persisted,
they seem to have become stronger.13
Overall, these results strongly indicate the presence of a SUE effect. SUE
does discriminate among over and under performing stocks, and subsequent
positive and negative abnormal returns continue for a considerable amount
of time after the close of the fiscal quarter. Testing the hypothesis that the
difference in the expected returns between the high and low 20 stock
portfolios should equal zero (because of the beta risk being constructed to
equal one), the return differences shown in table 2 are, in almost all cases,
significantly different from zero. Thus, contrary to Reinganums conclusion,
we find that abnormal (i.e., risk-adjusted) returns typically could have been
earned on the basis of properly indentifying firms standardized unexpected
earnings during the very long period of nine years analyzed in this study. It
is worthwhile to note from the data in table 2 that signlicant abnormal
returns could also have been earned during Reinganums period for the first
two portfolio formation dates (+ 1 and + 2).

4. Dues the risk adjustment matter?

As noted, we recalculated betas and risk-adjusted return differences using
the alternative Scholes-Williams methodology, and we also calculated return
differences using no risk adjustment. The first point to be considered in this
section is that the Scholes-Williams methodology, being a different and
presumably superior technique compared to OLS calculations, may produce
quite different results. The second point considered is the possibility that the
betas are not the crucial consideration in this analysis, and that the omission
of specific risk (beta) adjustments will have little effect on the overall results.
This is a worthwhile consideration, because in section 5 we want to examine
the precise response of stock returns to unexpected earnings, and it will
simplify matters considerably if risk adjustments are not made.
Table 3 presents the results of running our replication of the Reinganum
test three ways: using the Watts-Reinganum risk adjustment technique based
on OLS betas, using the same technique with Scholes-Williams betas, and
making no risk adjustment at all. We present only the mean returns and t-
statistics for each of the subperiods and the overall period for the three
alternatives. In the case of the first alternative using Reinganums OLS betas,
the summary data is repeated from table 2. Again, there are five consecutive

laThis provides some
selection of firms employed
exist near the end of the
have been removed from
near the end of the sample
problem.
indirect evidence on the possibility of a survivorship bias in the
in the analysis. If such a bias exists, the least amount of bias should
sample period since very few firms that existed near the end would
the PDE tape. Given the fact that the most favorable results occur
period, we do not feel that the survivorship bias presents a signiticant
 R.J. Rendleman. Jr. et al., Unexpected earnings and abnormal stock returns 219

Table 3
Mean values and f-statistics for differences between the returns of the 20 high and low
standardized unexpected earnings portfolios wtth alternative rusk adjustments.

Number of months after quarter close

that portfolio position is taken

+1 +2 +3 f4 +5

OLS beta?
Mean
1st 17 periods 0.05345 0.0403 I 0.03599 0.04949 0.04472
Reinganums periods 0.05568 0.0279 1 0.02162 - 0.00434 0.00390
Last 11periods 0.07029 0.095 17 0.07384 0.06095 0.04735
All 0.05909 0.05432 0.04436 0.04046 0.03436
r-statistic
1st 17 periods 2.92942 2.48438 I .8603 I 2.33054 2.21438
Reinganums periods 6.10068 2.09372 0.80486 -0.20210 0.21032
Last 11 periods 2.64233 3.42195 4.074 18 4.27755 3.13832
All 501311 4.37837 3.58234 3.21516 2.9101 I
Scholes- Williums betas

Mean
1st 17 periods 0.05529 0.03389 0.02875 0.04580 0.04568
Reinganums periods 0.05234 0.02355 0.01760 - 0.00762 0.00290
Last 11 periods 0.06892 0.09 120 0.06939 0.06199 0.048 13
All 0.05880 0.049 10 0.03869 0.03822 0.03528
f-statistic
1st 17 periods 2.83274 2.00533 1.41480 2.10248 2.26077
Reinganums periods 3.18797 1.82950 0.82263 - 0.34095 0.14300
Last 11 periods 2.56404 3.40749 3.86703 4.32643 3.18813
All 4.66862 3.95307 3.15928 2.95540 2.953 15
No risk adjustment

Mean
1st 17 periods 0.05940 0.04993 0.04267 0.05367 0.04 197
Reinganums periods 0.05469 0.02898 0.01723 - 0.00086 0.00156
Last 11 periods 0.06934 0.08995 0.07107 0.06300 0.05080
Ah 0.06 I39 0.05750 0.04569 0.04387 0.03526
r-statistic
1st 17 pertods 3.85911 3.55644 1.96148 2.3500 2.11942
Reinganums periods 4.24423 2.96254 1.00323 -0.04641 0.07999
Last 11 periods 2.49892 3.15201 3.53486 4.29123 3.61005
All 5.45542 4.98550 3.59622 3.36720 3.05836

Within the OLS and ScholessWilliams panels of the table, portfolios are constructed to have
a beta of 1.0. In the no risk adjustment panel, return differences are calculated as unweighted
differences without risk adjustment.
%sed in the Reinganum (1981) analysis.
Not significant at the 0.05 level.
280 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

starting points after the close of the quarter for assuming a portfolio position
(+ 1 through + 5).
The results of this analysis are striking. Most of the corresponding means
are quite close together. The c-statistics are almost all significant, with the
only nonsignificant numbers (with one exception) occuring for Reinganums
period in the + 3, + 4, and + 5 starting times.
Comparing the two methods for calculating betas, it can be seen that for
the various subperiods the abnormal returns using ScholessWilliams betas
are typically somewhat lower than those which employ OLS betas. The
differences arc not very pronounced, however, and for the entire 36 periods
there is little overall difference. Thus, the gains from using the more
sophisticated Scholes-Williams methodology would seem to be small in the
sense that the abnormal returns are not affected to any large extent.
The bottom two panels of table 3 show the results of making no risk
adjustments. It is not surprising that some of these means are slightly larger
than the corresponding means under the two forms of risk adjustment for
some of the subperiods and portfolio position starting points. However, what
is surprising is that the differences are again slight, and on an overall basis
there is very little difference between them and the corresponding returns
using OLS betas. On average, adjusting these portfolio returns for risk, using
the Watts-Reinganum weighting scheme, does not make any significant
difference. SUE clearly demonstrates an ability to discriminate among over
and under performing stocks, with or without risk adjustments.
The early papers showing the value of quarterly earnings in stock selection
techniques were criticized for failing to make explicit adjustments for risk.
Later papers, such as Latane and Jones (1979) demonstrated the stability of
the excess returns over different types of markets, suggesting the beta effect
was not an important part of the explanation of the SUE effect. These results
show the small differences that occur in risk adjusted and non-risk adjusted
analyses. We will use this finding as a justification for examining the exact
pattern of SUE effects over time without recourse to detailed adjustment for
the risk factor.

5. The SUE effect

In this section we examine the ability of SIJE to identify stocks providing
excess returns, using the entire sample available in any quarter. Using daily
returns, we measure the performance of stocks before and after, as well as on
the earnings announcement dates. This analysis will indicate the effectiveness
of SUE for all stocks in the sample rather than only the 20 stocks with the
highest and lowest SUES. It will also document how much of the response in
stock prices occurs after the announcement of quarterly earnings. In efftcient
markets, stock price changes associated with the information contained in
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns 281

quarterly earnings should be concurrent with the public announcement of

those earnings.
For each of the 36 quarters, all stocks in the sample are classified into one
of 10 SUE categories: all stocks with a SUE 5 -4.0 (category # l), all
between -4.0 and - 3.0 (# 2), all between - 3.0 and -2.0 (f 3) etc. up to
the tenth category, all stocks with SUES > 4.0 (# 10).
In each quarter, daily excess and cumulative excess returns are calculated
for each stock for days -20 to +90 surrounding the announcement date of
earnings. The excess returns are calculated as the difference between the
individual stocks daily returns and the corresponding market returns, using
an equally-weighted NYSE-AMEX index. (Phus, we do not make an
adjustment for systematic risk. However. as demonstrated in the previous
analysis as well as in work which we will describe later, the lack of an
explicit risk adjustment should not significantly affect the conclusions of the
study.) Next, these excess returns are aggregated for all stocks within each
SUE category over days -20 to +90 relative to the various earnings
announcement dates during the quarter, and cumulated over days -20 to
+90. Finally, we construct a 36 quarter summary of the cumulative excess
returns for each of the ten SUE categories. It is this data we report.
The cumulative excess return calculations can be quantified as follows:
denote the excess return for stock j on day r relative to the announcement
date of earnings in quarter 4 as ER,,. Let M, denote the number of stocks
in a given SUE category in quarter q. Then, the average excess return for
stocks in that category for day r in quarter q is

AER,, =$ ,$ ERj,,.
qJ

These average excess returns are averaged across all 36 quarters of the
sample period to produce an aggregate average excess return for day r,

AAER,=& c AER,,.
4 1

The aggregate average excess returns are then added from days 71 to TV to
produce a cumulative aggregate average excess return,

CAAER,,,,, = 2 AAER,.

To test for the significance of the CAAERs, an estimate of the variance of

the CAAERs must be made. Following Ruback (1982), we estimate the
variance by assuming that there may be first-order serial correlation in the
282 R.J. Rendlemnn, Jr. et al., Unexpected earnings and abnormal stock returns

AAERs. (We ignore all higher order serial correlation.) The variance of the
cumulative aggregate average excess return is calculated as follows:

var(CAAER,,,,J= T.var(AAER,)+2(T- l)cov(AAER,, AAER,+l), (4)

where

AAER=; g AAER,,
c 11

var(AAER,)=- T! 1 $ (AAER,- Ax)*,

T II

cov(AAER,, AAER,, ,)= &$ (AAER,- AAER)(AAER,+I - AAER).

r [I

To test whether the CAAER is significantly different from zero, the

following r-statistic is calculated:

t=CAAER,, .=2/ var(CAAER,,q,J. (9

In addition, we test for the significance of the aggregate excess return on

the earnings announcement date (day zero). The variance employed in this
calculation is the variance of the AAER calculated over the twenty days
prior to the earnings announcement date.
Table 4 shows the 36 quarter summary cumulative excess returns and t-
statistics for each of the ten SUE categories. It is obvious from the table that
SUE works very effectively in predicting subsequent excess returns. Negative
SUES have negative excess returns and positive SUES have positive excess
returns, and the results are virtually monotonic. In the case of the extremely
high SUES (f lo), the cumulative excess return averaged g.Ojb, with 2.4% of
this occurring 20 days before the announcement date and 1.3% occurring on
the announcement date. However, the mean cumulative excess returns over
the 90 days after the announcement date was 4.3%. In other words, stock
prices adjusted to the unexpectedly favorable earnings information over a
period of time after the dates of announcement. On the negative side, i.e.,
where the unexpected earnings information was unfavorable, results were
roughly comparable.
Notice that in the middle two categories (f 5 and f6), the results show no
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns 283

Table 4
Analysis of cumulative excess returns and betas over 36 quarters, 1971.%1980.2.
_
SUE category

I 2 3 4 5 6 7 8 9 10

Cumulative excess return?

Days -20 to 90 -8.7 -7.3 - 5.6 -3.6 -1.1 1.2 2.8 3.9 6.9 8.0
Days 1 to 90 -4.0 -3.2 -3.3 -1.8 -0.8 0.5 1.2 1.6 3.4 4.3
Days -20 to -1 -3.3 -3.1 - 1.7 -1.4 -0.4 0.4 0.9 1.5 2.2 2.4
Day 0 -1.4 -1.0 -0.7 -0.2 0.1 0.3 0.6 0.8 1.3 1.3
t-statistics
Days -20 to 90 -3.06-3.43 -4.30 -4.35 -3.02 1.51 1.96 2.10 2.55 2.86
Days 1 to 90 -3.69 - 3.24 -5.56 -4.74 -2.63 1.37 2.74 2.44 3.57 4.58
Days -20 to -1 - 1.78 -2.81 -2.12 -3.19 -1.76 0.64 0.83 1.10 1.16 1.17
Day 0 -5.84 -3.93 -2.72 - 1.23 0.21 1.30 2.61 3.29 5.18 5.09
Beta analysis
Average beta@) 1.02 1.00 0.97 1.00 1.03 1.03 1.01 1.02 1.02 1.02
Maximum beta 1.30 1.65 1.25 1.19 1.16 1.16 1.15 1.20 1.49 1.35
Minimum beta 0.67 0.57 0.71 0.85 0.89 0.94 0.89 0.76 0.65 0.60
gad 0.15 0.19 0.12 0.08 0.07 0.05 0.07 0.09 0.16 0.19
(B - l)&&,q 0.93 -0.117 -1.34 0.289 2.47 3.36 0.87 1.33 0.86 0.49

,Excess returns are calculated on a dally basis as the difference between an individual stocks
return and an equally weighted NYSE-AMEX index. Within each SUE category these excess
returns are averaged on a daily basis for each quarter of the analysis. The cumulative averages
of the 36 average quarterly excess returns are shown in the table by SUE category. The sample
Size ranges from a minimum 618 companies (1971.3) to a maximum of 1946 in 1980.1 (see table
1 for additIonal details on sample size). l-values are calculated via the procedure outlined by
Ruback (1982).
The average beta IS calculated as follows. For each quarter, average the returns within each
of the 10 SUE categories by day and regress this mean daily return against the corresponding
market return. This provides a beta for each quarter for each of the 10 SUE categories. These
betas are then averaged over the 36 quarters.
Not significant at the 0.05 level.
dThe standard deviation of 36 betas.

substantial effects. This is to be expected since these are the companies that
had very small, if any, unexpected earnings, either positive or negative.
Taking the two highest SUE categories (#9 and # lo), we can make the
following generalization: of the total response in stock returns over the
period extending 20 days before the announcement of earnings to 90 days
after the announcement, 31% occurred before the day of announcement, 18:);
on the day of announcement, and 51% after the day of announcement. For
the corresponding two lowest SUE categories ( # 1 and #2), the response
averaged: 40% prior to announcement, 154 on the day of announcement,
and 45% after the announcement date. These results are remarkably
consistent in suggesting that the market does not assimilate unexpectedly
favorable or unfavorable quarterly earnings information by the day of
284 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

earnings announcements. Instead, only about one-half of the total response

occurring over the period from 20 days preceding to 90 days following the
announcement has taken place by the announcement date.
Analysis of the f-statistics in table 4 reveals that all but one (f6) of the
cumulative excess returns for the post announcement period are statistically
significant. A similar pattern is revealed for the entire period of analysis, -20
to +90. All of the cumulative excess returns for the negative SUE categories
( # 1 through f 5) are significant in the pre-announcement period, but none
of the cumulative excess returns in the positive SUE categories show
significance. These pre-announcement t-statistics are likely to be understated
because of the unusually high variance of returns exhibited before the
announcement of earnings. This high variance is evident in fig. 1, which is
discussed below. The announcement day excess returns are significant in all
but the middle SUE categories (#4, 5, and 6). The significance of these
excess returns is also likely to be understated because of the high variance
exhibited in the pre-announcement period. Using the variance estimated over
the post-announcement period to test the significance of the announcement
date returns revealed that all but those in SUE category #5 were highly
significant.
Fig. 1 shows the pattern of these cumulative excess returns on a day-to-
day basis. It is clear that adjustments occur both before and after the
announcement dates of earnings. Fig. 1 dramatically shows the ability of
SUE to discriminate among the over- and under-performing stocks, and
shows how the adjustment of stock prices to unexpected earnings continues
after the quarterly earnings are announced. Category # 10 continues upward
from the announcement date, while category # 1, with very small
interruptions, continues downward. Categories # 5 and # 6 are basically flat.
These patterns could not exist if the full impact of the earnings were
assimilated on the day of announcement.
Risk (beta) is not explicitly taken into account in calculating the
cumulative excess returns because, as shown in the previous section, it
appears to make little difference. However, we do calculate portfolio betas for
each of the 10 SUE portfolios in each of the 36 quarters of our analysis.
Portfolio OLS betas are calculated on a daily basis over the 60 day period
prior to the starting point (+ 1) of the previous analysis in each of the 36
quarters. l4 These betas are averaged over the 36 quarters of the analysis.
Table 4 shows the results of these beta calculations. For both the highest
SUE portfolio, # 10, and the lowest SUE portfolio, # 1, the portfolio beta
averaged 1.02. The maximum betas at both extremes were very close to the
same, as were the minimum portfolio betas. Significance tests reveal that the

This analysis was repeated using Scholes-Williams betas, and the results were virtually
identical.
 R.J. Rem&man, Jr. et al., Unexpected earnings and abnormal stock returns 285

lOY9-1

SUE
category

C
U
M 6% -
U
L
A
T 4% -

V
E
,

A
V
E
R
A
G
E

E 1
X -2% 7
C
E
S
S
-4%

R
E
T
U -6% :
I
R
N

-8% -

- 10%
i---L-
-20 -10 0 IO 20 30 40 50 60 70 60 so

DAYS FROM EARNINGS ANNOUNCEMENT

Fig. 1. Cumulative excess returns averaged over the 36 quarter period 1971. 31980.2 for 10
SUE categories ranging from the most negative SUE category (#l, SUES -4.0) to the most
positive SUE category (# 10, SUE > +4.0). The sample size ranges from a minimum of 618
companies (1971.3) to a maximum of 1496 in 1980.1 (see table 1 for additional details on sample
size). Day 0 on the horizontal axis is the announcement date of earnings.

average portfolio beta in 8 of 10 cases was not significantly different from

one [and the two averages that were significant were for the middle two
categories (# 5 and # 6)].

6. Summary and conclusions

In summary, we have presented evidence concerning the SUE effect that is
based upon the largest sample of stocks for the longest time period that has
286 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal stock returns

been used to date in studying this phenomenon. Reinganum found that

abnormal returns could not be earned over the period he studied using
standardized unexpected earnings. We find, in contrast, that abnormal three
month returns could have been earned during the period Reinganum
analyzed for portfolios purchased one or two months after the close of the
fiscal quarter. Moreover, such abnormal returns could have been earned both
before and after Reinganums sample period for any of the five portfolio
position starting periods analyzed, as all of these mean returns (differences
between the high and low 20 stock portfolios averaged over 36 quarters)
were significant at the 0.05 or better level.
In assessing the form and effect of risk adjustments (beta) for this analysis,
we utilized betas calculated by the &holes-Williams methodology as an
alternative to OLS betas. Overall, little difference occurs in the results,
particularly when averaged over a number of quarters. What is perhaps
surprising is the little difference in the overall results from making no risk
adjustments. In other words, it is scarcely noticeable in the final analysis, in
terms of abnormal returns averaged over a number of quarters, which form
of beta adjustment is used and, indeed, if any is used at all.
Finally, we have documented the exact returns response of stocks to
unexpected earnings. This is accomplished by examining the returns for
stocks, classified by SUE category, before, on and after the announcement
date of earnings. On average, we find that roughly one-half of the total
excess return from stocks, when measured over the total period 20 days prior
to 90 days after the earnings announcements, occurs over the 90 day period
starting the day after the day of announcement. This lagged response to the
unexpected earnings surprise is not attributable to the risk of these
portfolios, as all 10 SUE categories have portfolio betas approximating 1.0.
Our conclusion is that a significant SUE effect has existed over the entire
decade of the 1970s and there is no evidence to suggest that it has
disappeared. This is supported by the fact that in the last quarter of our data
period (1980.2) we recorded the two largest abnormal returns of any of the
36 quarters (in the + 2 and + 3 starting positions), and the abnormal return
for the + 1 starting position was extremely high (0.163). Also, the mean
returns for the last 11 quarters of our sample following Reinganums sample
period are higher than the other two periods we analyze.
It should be noted again that, following Reinganum, we have constructed
portfolios with betas of 1.0 such that differences in returns betwen the high
and low SUE portfolios should be zero. Our results show that risk-adjusted
excess returns are overwhelmingly significant for portfolios consisting of the
20 highest and lowest SUE stocks. Thus, one cannot easily dismiss the SUE
effect as Reinganum has done. Rather, one has to conclude that Reinganums
small sample and unusual period of analysis gave him the results he found. It
is significant that, when a larger sample of stocks is used over his time
 R.J. Rendleman, Jr. et al., Unexpected earnings and abnormal slork returns 287

period, there are still very significant abnormal returns for the + 1 and +2
portfolio position starting points.
We have also concluded that the typical SUE portfolio has a beta of
approximately 1.0, and that risk adjustment procedures are not the critical
issue here. One must look elsewhere for an explanation of these results.

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