Playing Favorites: How Firms Prevent the Revelation of Bad News

Playing Favorites: How Firms Prevent the Revelation of Bad News

Lauren Cohen, Dong Lou, Christopher Malloy

NBER Working Paper No. 19429
Issued in September 2013
We explore a subtle but important mechanism through which firms manipulate their information environments. We show that firms control information flow to the market through their specific organization and choreographing of earnings conference calls. Firms that “cast” their conference calls by disproportionately calling on bullish analysts tend to underperform in the future. Firms that call on more favorable analysts experience more negative future earnings surprises and more future earnings restatements. A long-short portfolio that exploits this differential firm behavior earns abnormal returns of up to 101 basis points per month. Further, firms that cast their calls have higher accruals leading up to call, barely exceed/meet earnings forecasts on the call that they cast, and in the quarter directly following their casting tend to issue equity and have significantly more insider selling.Here’s An Awesome Way To Tell If A Firm Is Hiding Bad News

MAX NISEN SEP. 16, 2013, 8:12 PM 5,753 3

Sometimes it’s not what’s said on an earnings call that tells you how a company is doing, but who gets to talk.

Firms that “cast” their conference calls by calling disproportionally on bullish or friendly analysts do worse in the future, according to a new NBER working paper.

They experience more negative earnings surprises, and are more likely to restate earnings in the future.

The authors argue that firms engage in “casting” when they have sort of negative information to hide. They call on more favorable analysts because they’re less likely to ask probing questions or press them for more details.

The negative performance comes when that negative information leaks out.

Firms have more information than analysts and shareholders, and they will only cast when it’s to their advantage.

The authors thought of three possibilities. Firms might be managing earnings and don’t want to be probed, they might have just met or exceeded expectations (which has been shown in earlier studies to indicate a greater likelihood of earnings manipulation), or they may be about to issue equity or engage in insider sales, giving them incentive to keep the stock high.

There was evidence for each of them.

“Firms with higher discretionary accruals, firms that barely meet/exceed earnings expectations, and firms about to issue equity are all significantly more likely to cast their calls,” the authors write.

Additionally, the firms that engage in this sort of behavior are the ones that are more likely to get away with it, those with fewer analysts and institutional owners.

Casting’s not something firms do many quarters in a row, they’d be unlikely to get away from it or see any benefit. They usually just do it once, likely when they want to hide something. This chart shows how often casting episodes last. It’s usually just one quarter:

NBER

When earnings calls are particularly friendly, it might not be because all is well, but because there’s something fishy going on.