Daily Academic Alpha: The Dong Lou Showcase
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:
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.
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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Definitions of common statistics used in our analysis are available here (towards the bottom)