Profit warnings seem certain to rise this year. High-profile restatements have already rattled UK markets while hopes for US corporate profits are fading. Meanwhile, a new study examining the market impact of voluntary profit warnings finds that while the news will likely hammer stock price, it actually boosts liquidity in the markets.
‘There is virtue in disclosing bad news,’ observes study co-author Ajit Dayanandan, associate professor of finance at the University of Alaska in Anchorage. ‘Announcements of profit warnings significantly improve the market liquidity of companies, and so lower their cost of capital.’ He adds that the effect is at its strongest for companies with extremely negative market news.
Sampling almost 2,000 US profit warnings from 1995 to 2010, Dayanandan and his colleagues also discovered that the stock price consequences vary by business cycle. Specifically, the announcement day abnormal return for a profit warning during an economic expansion is –14 percent, compared with −10.7 percent during an economic contraction.
‘Investors don’t expect profit warnings during boom times, so their reaction is greater,’ posits Dayanandan. He also notes that the stock market response is most negative late in the expansion, when investors have experienced more good times to reinforce their optimism. In addition, profit warnings, like earnings announcements, can rub off on industry peers at home and – to a lesser extent – abroad.
Dayanandan’s research team found about 10 percent of domestic rivals’ negative abnormal returns can be blamed on the announcement. The ricochet effect averages around 4 percent for a company’s international competitors, with the chemicals and petroleum, computer equipment and electronics industries most vulnerable to this kind of contagion.
Lastly, the data reveals that negative returns tend to accumulate before the warning announcement, suggesting either market anticipation or – more ominously – information leakage.
Involuntary disclosure
When it comes to a corporate data breach, it’s a matter of ‘when’ not ‘if’. A recent study shows that how a company notifies the public, the amount of information disclosed and the number of records breached all play a role in crafting the perfect IR response. ‘The earlier you disclose the better,’ says Patrick Fan, professor of accounting and information systems at Virginia Tech. ‘At the same time, however, you can disclose too much.’
Fan and colleagues Alan Wang and Ziqian Song analyzed 517 data breach events at US companies to determine the stock price effect of different corporate responses. They find that while timely, voluntary notification of data theft can dampen negative market consequences, the effect may not be equal for all events. ‘It really depends on the severity of the event,’ says Fan. ‘The higher the number of breached records, the weaker the positive effect of voluntary disclosure will be.’
Another matter for managers to consider is how much information to divulge about the hack. Fan says his empirical evidence suggests this may present an occasion for discretion. ‘In cases when a [very large] number of records is breached, companies should disclose less event-related information – especially technical details – to the public,’ he details. ‘The market will punish disclosure of too much information, as it might signal higher severity and remediation cost. That’s why you want to be fuzzy. You can leave some room for the future to tell people what’s going on.’
Until now, the SEC has not tested its 2011 cyber-security disclosure guidance with enforcement action, but that may soon change. If the commission proceeds with Yahoo – currently under investigation for sluggish reporting of two major incidents – routine data breach disclosure may become the norm.
This article appeared in the summer 2017 issue of IR Magazine
