Daily Academic Alpha: The Dong Lou Showcase

Daily Academic Alpha: The Dong Lou Showcase

March 31, 2015 Uncategorized
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(Last Updated On: January 18, 2017)

Dong Lou splashed on the academic scene in 2009 and boy has he been busy!

Prof Lou has some great papers out there that have inspired a lot of research and investing ideas at Alpha Architect.

A few of our favorites:

‘Consistent’ Earnings Surprises

We hypothesize that analysts with a bullish stock recommendation have an interest in not being subsequently contradicted by negative firm-specific news. As a result, these analysts report downward-biased earnings forecasts so that the company is less likely to experience a negative earnings surprise. Analogously, analysts with a bearish recommendation report upward biased earnings forecasts so that the firm is less likely to experience a strong positive earnings surprise. Consistent with this notion, we find that stock recommendations significantly and positively predict subsequent earnings surprises, as well as narrow beats versus narrow misses. Stock recommendations also predict earnings-announcement-day returns. A long-short portfolio that exploits this predictability earns abnormal returns of 125 basis points per month.

Industry Window Dressing

We explore a new mechanism through which investors take correlated shortcuts, and present strong evidence that firm managers undertake real actions to take advantage of these shortcuts. Specifically, we exploit a regulatory provision governing firm classification into industries, wherein a firm’s primary industry is determined by the segment with the highest sales. We find that investors overly rely on this primary industry classification: Firms just above the industry classification cutoff have significantly higher betas with respect to that industry, compared to nearly identical firms just below the cutoff. In addition, they have more sector mutual fund holdings and analyst coverage from that industry. We then show that firm managers exploit investor shortcuts. Firms around the classification threshold of 50% sales are significantly more likely to report sales of barely over 50% from the more favorable industry—a pattern we term industry window dressing. Further, these window dressing firms have significantly lower segment profit margins and inventory growth compared to other firms in the same industries, consistent with these firms slashing prices to increase sales in the favorable sector. Moreover, we provide evidence that both the firm and top executives gain large tangible benefits from industry window dressing, by engaging in significantly more SEOs and stock-financed M&As, along with significantly more insider selling after switching into favorable industries.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

  • RT1C

    Brilliantly clever!