GF540 Unit 3 Earnings Drift Efficiency Argument Example

Drift After Earnings and the Cost of Trading It: A Unit 3 Market Efficiency Argument

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Purdue University Global

GF540: Investment and Securities Analysis

Unit 3 Market Efficiency Argument

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[Date]

The argument is the writer's own; the studies cited are real, and their findings are summarized rather than reproduced.

The Anomaly

When a company reports earnings well above or below what analysts expected, its share price moves on the announcement. If markets absorbed public information immediately, that move would be complete within a day or two. Bernard and Thomas (1989) showed instead that prices continued drifting in the direction of the surprise for about sixty trading days, with much of the later movement concentrated around the next quarter's announcement. A portfolio buying the most positive surprises and selling the most negative earned abnormal returns over those months. The pattern has been reproduced across many samples and periods, which makes it one of the most durable challenges to market efficiency.

Why It Matters to Each Form

Fama (1970) set out three forms of efficiency according to the information prices are said to reflect.

Weak form. Prices reflect all information in past prices. Drift is triggered by an earnings announcement, not by a price pattern, so it does not test the weak form directly.

Semi-strong form. Prices reflect all public information. An earnings announcement is public the moment it is released. If prices take two months to absorb it, the semi-strong form is under pressure.

Strong form. Prices reflect all information, public or private. Because public information is a subset of all information, any failure of the semi-strong form is also a failure of the strong form.

The argument therefore turns on the semi-strong form.

Three Readings of the Evidence

Investors underreact. The behavioral reading holds that investors anchor on past earnings and update too slowly. Bernard and Thomas found that the drift lines up with how investors would behave if they ignored the persistence of quarterly earnings changes, and that the market seems surprised by the next quarter's results in a predictable way. This reading treats drift as a genuine failure of efficiency.

Risk the models miss. A rational reading holds that firms with large surprises carry extra risk, and the abnormal returns are compensation. Fama (1998) argued that many anomalies shrink or vanish with better risk adjustment or different methods, and that apparent overreaction and underreaction occur about equally often, which is what chance would produce. On this reading drift is a measurement problem, not an inefficiency.

A cost barrier. A third reading accepts that prices adjust slowly but argues that the profit is not available after costs. Chordia and colleagues found that the drift is concentrated in illiquid stocks, where trading costs are high, and that once those costs are counted much of the apparent profit disappears (Chordia et al., 2009). Drift persists because it is too expensive to arbitrage away.

If the drift can be earned only in shares where trading costs consume it, prices are efficient in the sense that matters to investors: no one can reliably profit from the delay, even though the delay itself is real.

Weighing Them

The underreaction reading explains the pattern's shape well but struggles to explain why arbitrageurs would leave money on the table for decades. The risk reading has not produced a convincing risk factor that matches the drift's timing around announcements. The cost-barrier reading fits both observations: the delay is real, and the profit is unavailable where the delay is largest.

More recent evidence strengthens the third reading. Martineau (2022) reports that for large stocks the drift has largely disappeared in recent decades, as trading costs fell and information spread faster, while it lingers among small, thinly traded shares. That is what a cost barrier predicts: as the barrier falls, the anomaly shrinks.

A Worked Illustration of the Cost Barrier

Consider two companies that each report earnings 10 percent above expectations. The first is a large, heavily traded firm whose shares cost about 0.05 percent to buy and sell, counting commissions and the bid-ask spread. The second is a small firm with a bid-ask spread of 2 percent and little daily volume, so buying a meaningful position moves the price against the buyer by perhaps another 1 percent. Suppose the drift after each announcement is 2.5 percent over the following sixty days. For the large firm, a trader capturing the drift keeps nearly all of it, which is why traders have competed it away. For the small firm, round-trip costs of roughly 3 percent exceed the 2.5 percent drift, so the anomaly survives precisely where no one can profit from it.

The Strongest Objection

The strongest objection to the thesis is that trading costs explain why arbitrageurs stay out, but not why ordinary investors who already hold the shares fail to update their views. An investor who owns a small company and reads a strong earnings report pays no extra cost to keep holding rather than sell. If those investors consistently underreact, the drift reflects their judgment, not just a cost barrier. This objection is fair, and it means the cost-barrier reading explains why the drift persists rather than why it begins. The thesis survives because efficiency, as Fama defined it, concerns whether prices can be exploited, not whether every investor processes information well.

The Thesis

Semi-strong efficiency holds for large, liquid shares once trading costs are counted. For small, illiquid shares, prices absorb earnings news slowly, but the cost of trading prevents the delay from becoming a dependable profit. The market is efficient in the economic sense, that no strategy earns excess returns after costs, rather than in the strict sense that prices adjust instantly.

What This Means for Later Units

The position has practical consequences for valuation work in this course. For large companies, the market price is a reasonable starting estimate of value, and a valuation that differs sharply from it should be examined for errors in its own inputs before the market is called wrong. For small, thinly traded companies, the price may lag public information, but an analyst who believes so should also estimate whether the gap exceeds the cost of acting on it.

Limits of the Argument

The argument relies on published academic studies, which use data and trading cost estimates that may not match what any one investor faces. Institutional investors trading large blocks face higher costs than the estimates assume; individual investors trading small amounts face lower commissions but wider spreads. And the evidence is historical: if a new source of slow information processing appears, the anomaly could return.

References

Bernard, V. L., & Thomas, J. K. (1989). Post-earnings-announcement drift: Delayed price response or risk premium? Journal of Accounting Research, 27, 1-36. https://doi.org/10.2307/2491062

Chordia, T., Goyal, A., Sadka, G., Sadka, R., & Shivakumar, L. (2009). Liquidity and the post-earnings-announcement drift. Financial Analysts Journal, 65(4), 18-32. https://doi.org/10.2469/faj.v65.n4.3

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. https://doi.org/10.2307/2325486

Fama, E. F. (1998). Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, 49(3), 283-306. https://doi.org/10.1016/S0304-405X(98)00026-9

Martineau, C. (2022). Rest in peace post-earnings announcement drift. Critical Finance Review, 11(3-4), 613-646. https://doi.org/10.1561/104.00000122