Publicly traded companies report earnings on a quarterly and annual basis. This is a financial report that unveils profitability and sales during a period. Prior to the announcement, financial analysts and company executives often make forecasts of what those results will be, and investors tend to respond to the results based on the barometer that was set. In some cases, investor reaction is delayed, and once it sets, it appears to unfold over a period of weeks or longer. This phenomenon is known as post-earnings-announcement drift, and it accounts for some of the profits earned and losses attained in the stock market.
In post-earnings-announcement drift, the stock moves in the direction of the earnings surprise for months on average. If the profit results are better than expected, for instance, the stock will continue to advance over time in response. Conversely, in the event of an earnings disappointment, the stock will lose ground for the duration of the drift. Certain researchers suggest that the theory of drift, which is also known as the standardized unexpected earnings (SUE) effect, indicates that investors are not responding appropriately to notable profit details.
There is an undertone in this market theory that investors are naive in responding to a company's earnings report. In its simplest form, this strategy should allow investors to buy stocks that have recently announced better-than-expected earnings. If the investment is held for several months, investors should profit.
Professional investment managers, including mutual fund and hedge fund managers, might also use the instance of post-earnings-announcement drift to attempt to capitalize on the stock movement. Some mutual fund managers even proclaim the theory as the investment portfolio's primary strategy. The downside for doing so, however, is a high amount of volatility in the fund, which is a risky proposition. An investment fund's composition is also unlikely to reflect diversification because the aim is to follow earnings surprises, not traditional exposures. The unpredictable nature of post-earnings-announcement drift also leads to volatility in the pace at which funds flow in and out of investment portfolios at the hands of investors.
Researchers, analysts, and other financial professionals often track the performance of various investment strategies and derive average monthly or yearly profits earned through these styles. Market participants have attempted to use this approach with investors who apply the post-earnings-announcement drift style. Results, however, seem inconclusive as the attempt to track investment performance is blurred by many variables. Certain research studies suggest that the cost for completing transactions in the financial markets heavily influences the profitability that this opaque investment strategy delivers.