Dispersion in Analysts Earnings Forecasts and Credit Rating

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1 Dispersion in Analysts Earnings Forecasts and Credit Rating Doron Avramov Department of Finance Robert H. Smith School of Business University of Maryland Tarun Chordia Department of Finance Goizueta Business School Emory University Gergana Jostova Department of Finance School of Business George Washington University Alexander Philipov Department of Finance School of Management George Mason University 18th CFEA Meetings, October 27, 2007

2 The Dispersion Effect Buying stocks with low dispersion in analysts earnings forecasts and selling stocks with high dispersion yields statistically significant and economically large payoffs (Diether, Malloy, and Scherbina (2002)). This negative relation between dispersion and returns (dispersion effect) is an anomaly. Investors pay a premium for bearing uncertainty. This anomaly is unexplained by the Fama and French (1993) three-factor model, and by the Fama-French model augmented by a momentum factor. Suggested causes for the dispersion effect: difference of opinion among investors and market frictions that prevent the revelation of negative opinions (Diether, Malloy, and Scherbina (2002)), unpriced information risk (Johnson (2004)) dispersion proxies for idiosyncratic risk, which is negatively related with returns, illiquidity (Sadka and Scherbina (2007)). Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 2

3 This paper s contribution: The Dispersion Effect Results from Financial Distress, proxied by credit risk Why credit risk? Theoretical motivation: In a structural framework (Merton (1974)), default risk as a function of the uncertainty in the firm value process, which depends on all future earnings. Dispersion in earnings forecasts only measures uncertainty in next year s earnings. Credit risk subsumes dispersion. Empirical evidence: Investors pay a premium for bearing credit risk (Dichev (1998), Campbell, Hilscher, and Szilagyi (2007), Griffin and Lemmon (2002), Avramov, Chordia, Jostova, and Philipov (2006)) same anomalous pattern. Both dispersion and credit risk are related to momentum (Zhang (2006), Avramov, Chordia, Jostova, and Philipov (2007)), suggesting a link between the two. Moreover, credit risk subsumes dispersion in explaining momentum. Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 3

4 Results The dispersion effect is driven exclusively by the worst-rated firms: Dispersion strategies yield an insignificant 31 bp/mo for investment grade, and a strongly significant 101 bp/mo for non-investment grade firms. Dispersion strategies do not work for a subsample of AAA to BB+ rated firms 95.5% market cap (74% of the number) of rated firms. The dispersion effect is only present during period of financial distress: Relation only exists during periods around credit rating downgrades only 8% of all obs. In such periods, the negative dispersion-return relation emerges as low-rated firms experience: substantial price drop along with considerable increase in forecast dispersion: Financial Distress (Credit Rating Downgrades) negative returns higher dispersion Even for this small universe of worst rated stock, the dispersion-return relation disappears when either dispersion or returns are adjusted by credit risk. The results are robust to previously proposed explanations, such as short-sale constraints, illiquidity, and leverage. Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 4

5 Data Monthly returns on all NYSE, AMEX, and NASDAQ stocks in CRSP between 1985 and 2003 with analyst data on I/B/E/S 12, 312 firms after removing: stocks with less than 6 month return data, stocks priced below $5. Of these 3, 261 firms are rated by Standard & Poor s our final sample. The dispersion effect is similar for rated and unrated firms (see Table 1). Dispersion is computed as: DISP = σ EP SF Y 1 µ EP SF Y 1 For the credit ratings, we use the Long Term Issuer Credit Rating (Compustat SPDR ) and transform it into a numerical score from 1 (AAA) to 22 (D). The dispersion portfolio returns are equally weighted across all stocks. Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 5

6 Table 1 Dispersion Strategy Payoffs For Rated and Unrated Firms PANEL A: Dispersion Strategy Profits Sample All Firms Unrated Firms Rated Firms Number of Firms 12,312 9,051 3,261 K Overall (5.16) (4.56) (7.02) (6.15) (3.35) (3.06) Non-January (5.52) (4.98) (7.30) (6.49) (3.88) (3.62) January (-0.73) (-1.23) (0.17) (-0.49) (-1.51) (-1.52) Expansion (4.83) (4.19) (6.86) (6.10) (2.96) (2.63) Recession (1.82) (1.78) (1.73) (1.49) (1.65) (1.72) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 6

7 Table 2 Composition of Dispersion Portfolios Percentage of Stocks Returns (% per month) Rating Portfolio UR IG NIG UR IG NIG All D D D D D D1 - D (7.02) (1.41) (3.64) (5.16) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 7

8 Table 3 Returns By Sequentially Sorted Credit Rating (C1-C5) And Dispersion Groups (D1-D5) PANEL A: Raw Returns A1: K=1 Month Holding Period D1 D2 D3 D4 D5 D1-D5 C (4.60) 1.26 (4.21) 1.30 (4.53) 1.27 (4.32) 1.28 (3.89) 0.11 (0.55) C (4.57) 1.18 (3.97) 1.29 (4.06) 1.30 (4.00) 1.21 (3.51) 0.15 (0.77) C (4.05) 1.18 (3.70) 1.17 (3.69) 1.24 (3.74) 0.93 (2.56) 0.30 (1.45) C (3.42) 1.10 (3.09) 0.95 (2.48) 0.89 (2.34) 0.62 (1.49) 0.62 (2.71) C (1.97) 0.48 (1.10) 0.23 (0.47) 0.08 (0.18) (-0.06) 0.85 (2.88) C1-C (1.87) (2.44) (3.10) (3.78) (4.17) A2: K=3 Month Holding Period D1 D2 D3 D4 D5 D1-D5 C (4.48) 1.20 (4.12) 1.25 (4.38) 1.24 (4.25) 1.13 (3.51) 0.22 (1.11) C (4.51) 1.21 (4.09) 1.16 (3.78) 1.25 (3.90) 1.11 (3.25) 0.21 (1.14) C (3.95) 1.12 (3.62) 1.19 (3.81) 1.18 (3.58) 0.96 (2.66) 0.23 (1.18) C (3.14) 1.00 (2.79) 0.98 (2.60) 0.76 (2.06) 0.69 (1.68) 0.44 (1.96) C (1.77) 0.40 (0.90) 0.30 (0.64) 0.10 (0.22) (-0.13) 0.80 (2.81) C1-C (1.99) (2.55) (2.96) (3.75) (3.96) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 8

9 Table 3(continued) PANEL B: Risk-Adjusted Returns B1: K=1 Month Holding Period D1 D2 D3 D4 D5 D1-D5 C (5.02) 0.51 (4.48) 0.52 (4.66) 0.54 (5.19) 0.53 (4.50) 0.16 (0.93) C (4.79) 0.43 (3.77) 0.49 (3.87) 0.49 (4.42) 0.46 (3.66) 0.15 (0.91) C (3.48) 0.42 (3.46) 0.31 (2.60) 0.40 (3.69) 0.17 (1.26) 0.29 (1.56) C (3.09) 0.28 (1.99) 0.18 (1.35) 0.06 (0.41) (-1.16) 0.62 (3.18) C (0.48) (-1.20) (-2.26) (-3.74) (-3.65) 0.75 (3.05) C1-C (3.17) (3.77) (4.68) (5.90) (5.52) B2: K=3 Month Holding Period D1 D2 D3 D4 D5 D1-D5 C (5.08) 0.50 (4.75) 0.52 (5.02) 0.52 (5.47) 0.43 (4.07) 0.24 (1.24) C (5.09) 0.48 (4.37) 0.42 (4.07) 0.47 (4.43) 0.40 (3.38) 0.20 (1.30) C (3.46) 0.38 (3.68) 0.38 (3.53) 0.36 (3.50) 0.24 (1.85) 0.20 (1.13) C (2.57) 0.25 (1.99) 0.22 (1.77) (-0.39) (-0.55) 0.44 (2.30) C (0.19) (-1.61) (-2.34) (-3.79) (-3.92) 0.72 (3.08) C1-C (3.65) (4.32) (5.16) (6.28) (5.59) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 9

10 Table 4 Unconditional Dispersion Strategy Returns over Different Rating Subsamples PANEL A: Dispersion Portfolios Based on Remaining Observations Stock Sample Dispersion Percent of Total Number of Percentage Profits Market Cap Firms of Firms All firms 0.76 (3.35) AAA-D 0.76 (3.35) AAA-C 0.75 (3.33) AAA-CC 0.75 (3.33) AAA-CCC (3.35) AAA-CCC 0.76 (3.34) AAA-CCC (3.25) AAA-B (3.18) AAA-B 0.68 (3.07) AAA-B (2.81) AAA-BB (2.57) AAA-BB 0.40 (1.98) AAA-BB (1.58) AAA-BBB (1.35) AAA-BBB 0.22 (1.13) AAA-BBB (0.92) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 10

11 Table 5 Determinants of the Dispersion Effect PANEL A: Regressions of Returns on Lagged Characteristics D t (-2.64) (-1.62) (-3.04) (-2.59) (-1.62) (-1.12) (-2.63) (-2.29) (-1.36) (-2.52) (-0.62) CR t (-3.55) (-3.03) (-3.09) (-3.10) (-2.24) (-2.61) Size t (0.11) (-0.56) BM t (0.79) 0.22 (1.45) r (t 7:t 2) (2.02) (1.54) Leverage t (0.77) 0.02 (1.02) 0.01 (1.01) D t 1 Leverage t (-0.68) 0.03 (0.64) (-0.53) (-0.52) T urnover t 2,NY SE/AMEX (-0.47) (-0.30) T urnover t 2,Nasdaq (-1.19) (-1.03) Idiosyncratic V olatility t (-2.99) (-3.81) (-3.22) Institutional Ownership t (1.27) 0.22 (0.70) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 11

12 Table 5(continued) PANEL B: Dispersion Profitability in Firms with and without Leverage (Including All Firms: rated and unrated) Firms All With Data on Debt Zero Debt Positive Debt Ave Number of Firms/Month 2,948 2, ,247 Dispersion profits (D1-D5) (5.16) (4.74) (4.06) (4.45) PANEL C: Returns by Sequentially Sorted Rating and D Groups D Quintile (D 1=Lowest, D 5=Highest Adjusted-Dispersion) D 1 D 2 D 3 D 4 D 5 D 1-D 5 C (4.48) 1.35 (4.39) 1.24 (4.29) 1.27 (4.21) 1.35 (4.39) (-0.14) C (4.41) 1.13 (3.64) 1.30 (4.22) 1.30 (4.24) 1.29 (3.70) 0.02 (0.09) C (3.85) 1.21 (3.80) 1.13 (3.70) 1.19 (3.67) 0.98 (2.73) 0.15 (0.96) C (2.45) 1.14 (3.11) 0.99 (2.78) 1.05 (2.88) 0.62 (1.51) 0.25 (1.19) C (0.83) 0.57 (1.29) 0.36 (0.79) 0.25 (0.54) (-0.15) 0.35 (1.35) C1-C (2.70) (2.64) (2.78) (3.32) (4.19) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 12

13 Table 6 Dispersion Strategy Payoffs Based on Characteristic Adjusted Returns PANEL A: Credit-Rating-Adjusted Returns D1 D2 D3 D4 D5 D1-D5 C (1.24) (-0.64) 0.00 (0.00) 0.06 (0.71) (-0.56) 0.20 (1.07) C (1.49) (-0.46) (-0.28) 0.06 (0.75) (-0.05) 0.16 (0.87) C (1.14) 0.00 (0.03) 0.07 (0.74) 0.07 (0.79) 0.01 (0.10) 0.11 (0.63) C (1.45) 0.27 (2.34) 0.03 (0.30) 0.09 (0.82) (-0.37) 0.07 (0.83) C (1.76) 0.10 (1.38) (-0.25) (-0.15) 0.03 (0.90) 0.27 (0.96) All Rated (2.99) (0.56) (2.69) (2.42) (1.52) (0.73) PANEL B: Size-Adjusted Returns D1 D2 D3 D4 D5 D1-D5 C (2.09) 0.35 (2.57) 0.17 (1.31) 0.38 (3.16) 0.20 (1.43) 0.11 (0.56) C (1.85) 0.10 (0.81) 0.14 (1.28) 0.27 (2.09) 0.27 (1.76) (-0.10) C (1.15) 0.23 (1.75) 0.07 (0.58) 0.09 (0.69) (-0.45) 0.21 (0.97) C (1.73) 0.07 (0.49) (-1.17) (-2.17) (-2.43) 0.67 (2.85) C (-1.11) (-2.39) (-2.76) (-4.10) (-3.95) 0.83 (2.71) All Rated (2.45) (1.18) (0.14) (-1.52) (-3.49) (3.39) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 13

14 Table 6(continued) PANEL C: Turnover-Adjusted Returns D1 D2 D3 D4 D5 D1-D5 C (2.42) 0.28 (1.78) 0.29 (1.97) 0.38 (2.74) 0.29 (2.09) 0.17 (0.89) C (2.81) 0.28 (2.12) 0.24 (2.02) 0.41 (3.50) 0.27 (2.00) 0.16 (0.82) C (2.81) 0.27 (2.28) 0.25 (2.26) 0.32 (2.74) 0.16 (1.14) 0.22 (1.10) C (3.12) 0.36 (2.92) 0.15 (1.16) 0.03 (0.20) (-0.55) 0.51 (2.21) C (0.92) (-1.18) (-3.03) (-3.30) (-3.23) 0.92 (3.15) All Rated (3.69) (2.39) (2.89) (0.94) (-2.52) (3.50) PANEL D: Institutional-Ownership-Adjusted Returns D1 D2 D3 D4 D5 D1-D5 C (1.43) 0.21 (1.20) 0.17 (1.09) 0.32 (2.21) 0.39 (2.82) (-0.55) C (1.87) 0.19 (1.35) 0.11 (0.86) 0.37 (3.03) 0.30 (2.15) 0.01 (0.06) C (1.13) 0.21 (1.76) 0.08 (0.79) 0.30 (2.36) 0.06 (0.43) 0.10 (0.47) C (1.36) 0.13 (1.02) (-1.56) (-0.89) (-1.92) 0.50 (2.15) C (-1.05) (-2.85) (-2.67) (-3.25) (-4.24) 0.90 (2.95) All Rated (2.18) (0.50) (1.04) (-0.30) (-2.84) (2.75) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 14

15 Table 7 Analysis Overall and Around Downgrades All Firms Firms with Downgrades Overall 3 Months Around Downgrade Rating Quintile C1 C2 C3 C4 C5 C1 C2 C3 C4 C5 C1 C2 C3 C4 C5 Month-Return Obs. Overall 41,426 53,082 52,980 55,231 52,315 30,799 38,549 37,273 35,004 31,303 2,965 4,013 4,010 4,204 3,485 Expansions 38,412 48,670 49,873 50,573 48,863 28,636 35,445 35,071 32,059 29,322 2,687 3,468 3,641 3,729 3,172 Recessions 3,014 4,412 3,107 4,658 3,452 2,163 3,104 2,202 2,945 1, Number of Downgrades Overall Expansions Recessions Size of Downgrades Overall Expansions Recessions Return Dispersion Revision Earning Surprise Analyst Coverage Institutional Holdings Leverage Turnover Size ($ billions) Volatility Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 15

16 Figure 3 Returns around Rating Downgrades Monthly Return C1 C Months Around Downgrade Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 16

17 Table 8 Dispersion Strategy Payoffs Excluding 3 months Around Downgrades (months t 3 : t + 3) PANEL A: Cross-Sectional Regressions of Returns on Dispersion and a Downgrade Dummy D t 1 dummy t 3:t+3 CR t (-2.64) (-1.89) (-10.98) (-0.13) (-10.84) (-3.38) PANEL B: Returns By Sequentially Sorted Credit Rating (C1-C5) and Dispersion Groups (D1-D5) D1 D2 D3 D4 D5 D1-D5 C (4.81) 1.29 (4.34) 1.34 (4.67) 1.36 (4.60) 1.40 (4.39) 0.06 (0.29) C (4.68) 1.25 (4.22) 1.40 (4.56) 1.39 (4.46) 1.36 (3.96) 0.05 (0.24) C (4.32) 1.26 (4.03) 1.30 (4.05) 1.42 (4.35) 1.23 (3.64) 0.08 (0.41) C (3.67) 1.17 (3.20) 1.17 (3.11) 1.13 (3.05) 1.14 (2.87) 0.18 (0.79) C (2.06) 0.56 (1.29) 0.48 (0.98) 0.58 (1.26) 0.50 (1.03) 0.36 (1.17) All Rated (4.56) (3.75) (3.95) (3.12) (2.46) (1.34) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 17

18 Figure 1 Wealth Process of Dispersion Strategy 6 5 Wealth (C1) Wealth (C3) Wealth (C5) Wealth Process Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 18

19 Figure 2 Wealth Process of Dispersion Strategy in Non-Downgrade Periods 6 5 Wealth (C1) Wealth (C3) Wealth (C5) Wealth Process Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 19

20 Table 9 Dispersion Strategy Payoffs over Diminishing Subsamples Based on Cumulative Past Returns Stock Sample Dispersion Percent of Total Number of Percentage Profits Market Cap Firms of Firms All Firms 0.76 (3.35) , Top 96 % 0.50 (2.28) , Top 92 % 0.48 (2.21) , Top 88 % 0.44 (2.11) , Top 84 % 0.43 (2.06) Top 80 % 0.45 (2.16) Top 76 % 0.43 (2.09) Top 72 % 0.46 (2.17) Top 68 % 0.47 (2.23) Top 64 % 0.46 (2.18) Top 60 % 0.42 (1.98) Top 56 % 0.45 (2.07) Top 52 % 0.46 (2.10) Top 48 % 0.45 (2.03) Top 44 % 0.42 (1.85) Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 20

21 Conclusion We document a strong link between credit risk and the profitability of dispersion based strategies. The dispersion effect is driven exclusively by the worst-rated firms - 5% of market cap. Even for these worst-rated stocks, the dispersion-return relation disappears when either dispersion or return is adjusted by credit risk. Previous explanations for the dispersion effect (short-sale constraints, leverage, illiquidity) do not capture the effect of credit risk on dispersion profitability. Financial distress drives the dispersion effect. The dispersion-return relation is only significant around credit rating downgrades, which are only 8% of all observations. In such periods, prices of low-rated stocks declines substantially and uncertainty about firm fundamentals (forecast dispersion, forecast revisions, and earning surprises) rises considerably. In the remaining 92% of the sample, the dispersion-return relation is non-existent. Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 21

22 References Avramov, Doron, Tarun Chordia, Gergana Jostova, and Alexander Philipov, 2006, Credit Ratings and The Cross-Section of Stock Returns, Working Paper, University of Maryland. Avramov, Doron, Tarun Chordia, Gergana Jostova, and Alexander Philipov, 2007, Momentum and Credit Rating, Journal of Finance 62. Campbell, John Y., Jens Hilscher, and Jan Szilagyi, 2007, In Search of Distress Risk, Journal of Finance, forthcoming. Dichev, Ilia D., 1998, Is the Risk of Bankruptcy a Systematic Risk?, Journal of Finance 53, Diether, Karl B., Christopher J. Malloy, and Anna Scherbina, 2002, Difference of Opinion and the Cross-Section of Stock Returns, Journal of Finance 57, Fama, Eugene F., and Kenneth R. French, 1993, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics 33, Griffin, John M., and Michael L. Lemmon, 2002, Book-to-Market Equity, Distress Risk, and Stock Returns, Journal of Finance 57, Johnson, Timothy C., 2004, Forecast Dispersion and the Cross-Section of Expected Returns, Journal of Finance 59, Merton, Robert C., 1974, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance 29, Sadka, Ronnie, and Anna Scherbina, 2007, Analyst Disagreement, Mispricing, and Liquidity, Journal of Finance, Forthcoming. Zhang, X. Frank, 2006, Information Uncertainty and Stock Returns, Journal of Finance 61 (1), Avramov, Chordia, Jostova, and Philipov (2006) Dispersion in Analysts Earnings Forecasts and Credit Rating 22

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