Question

1. Explain how the positive earnings announcement price drift (or Surprise Unexpected Earning (SUE)) works. How would you use SUE in this Fall 2020 earning reporting season if you were a hedge fund manager?

2. Explain how you would use the Security Market Line (SML) to discern the breadth of a portfolio’s individual stock winners vs. losers.

Answer 1

PARTA

Let us first understand the earning announcement price drift with respect to a stock. When a company declares it's earnings for a quarter or two, it's direct impact is shown on investor's move. The period generally is for 60 days till the next announcement. Now, this earning announcement could be of two types and that is - 1) Positive earning 2) Negative earnings

After earning declaration, a trend is developed in the market. Hence, an upward trend is developed if the market likes the earning annoucement of a company. Market reacts to the difference of expected return versus actual returns.

SUE to be used in fall 2020 earning reporting season- An earning season is the four parts of the year when most of the companies disclose their earning that means quarterly. There is no fixed dates of earning seasons but normally companies declare their earning in Jan ( for quarter of Oct , Nov and Dec) and like wise April, July and Oct. Earning seasons are most important for market.

To be noted that there many strategies to deal with earning seasons. These are 1) Analyst report 2) Stock watching 3) Beyong the consensus.

The earning report doesn't guarantee any trend like below expectation doesn't mean that company will not grow in coming times and above the expectation doesn't guarantee the continuous earning. Hence, as a hedge fund manager, I would suggest the following.

1. Don't buy the estimaes by analysts as only parameter for investment because earning is difficult to predict because companies themselves are not able to predict futue earning. For example, a company may be showing huge profit in current report but may turn turtle due to cost recognition in future.

2. Ignoring the consensus as consensus are the average of number of estimates. The best estimate is divided by the worst estimates.

3. Sell is not the parameter- Normally, market behaves towards sell of a stock which didnot give expected return. There could be The expected earning could be wrong against the corporate plan. At corporate level, they may have earned at par or more than the expected earning.

Hence, as a hedge fund manager, I would first look at the estimate then company profile and futue expenses to be written down then come to conclustion whether to buy or not to buy such investment.

PARTB

Security Market line the graphical representation of expected return on a security plotted against the systematic or market risk. Security Market line helps to determine or understand whether the stock will give expected return compared to market risk. SML is a tool in capital asset pricing model. Market risk cannot be eliminated by diversified investment and it has to be part of the calculation. The formula given is as shown below

Required return = riskfree rate of return + beta(market return-riskfree return)

Hence when we plot a security on SML it could be either above the SML or below. If plotted security is above the SML the it assumed to be undervalued and if below then over valued in price. Undervalued means- stock is offering greater return against it's inherent risk and vice versa.