The fourth quarter effect in small caps
In the US, the full-year/Q4 earnings season begins next week, and investors will pay particular attention to these earnings and the guidance for 2026. But did you know that companies, in particular smaller companies, are much more likely to miss analyst expectations in Q4?
Previously, I have written about research that shows that US company earnings are most truthful (least deceptive) in Q4, mainly because that is when corporate results face the strictest scrutiny from auditors.
However, there is another calendar effect at play that I did not know until I read a paper by Oliver Binz and Martin Kapons. They document a distinct drop in earnings in the fourth quarter of a company’s fiscal year. The chart below shows the evolution of earnings before extraordinary items of US companies (excluding financials and utilities) from 1989 to the end of 2023. Note the fourth quarter results circled in red, which are, without exception, below the earnings released in the neighbouring quarters.
Raw earnings over time
Source: Binz and Kapons (2025). Note: Red circles indicate Q4 earnings
Since you were asking, the data above is standardised to move Q4 of a company’s fiscal year to the end of December. While most companies in the US have a fiscal year that coincides with the calendar year, this is not true for all companies.
And to answer your follow-up question, the fourth quarter effect is not a result of the year-end holidays and business winding down towards the end of December; the fourth quarter effect is also visible for companies that have a fiscal year that ends in months other than December.
To find out what is driving this effect, the researchers ran different tests. It is neither audit nor investor scrutiny nor earnings management that drives this drop in fourth-quarter earnings. The most likely explanation is that this effect is linked to the internal systems and capabilities of companies.
The chart below splits the companies in the sample by the size of their balance sheet. The left-hand chart shows that there is no drop in fourth quarter earnings visible for sales. Plus, the drop in fourth quarter results becomes bigger, the smaller a company is. This fourth-quarter earnings effect is almost exclusively driven by the smallest 25% to 50% of all companies in the sample.
The right-hand chart shows the key drivers for this fourth quarter effect. It is primarily a sudden increase in the cost of goods sold and selling, general and administrative expenses.
Smaller companies drive the fourth quarter earnings effect
Source: Binz and Kapons (2025)
After eliminating other possible drivers of this effect, like earnings management or audit scrutiny, the authors conclude that it must be a lack of sophistication in cost and enterprise risk management systems that is driving this effect.
Smaller companies naturally have fewer resources to monitor and constantly predict costs on a quarterly basis. Instead, they are more likely to have annual cost and revenue projections that become more and more outdated as the year progresses. And in Q4, the focus typically is on the coming fiscal year, rather than getting Q4 right.
As I said above, I wasn’t aware of this effect at all, but it seems many equity analysts aren’t either. The authors document that analyst earnings estimates do not adjust for this fourth-quarter effect, indicating that they are not aware that it exists. As a result, an unusually high share of companies misses analyst expectations in the fourth quarter compared to other quarters.
Luckily, though, these missed expectations don’t seem to matter as much as they did during other quarters. I think because most investors already focus on the outlook for the coming fiscal year, they don’t react as poorly to earnings misses in the fourth quarter. Whatever it may be, the chart below shows that the share price reaction after earnings misses in the fourth quarter is more muted.
Share price reaction after earnings misses
Source: Binz and Kapons (2025)
I've always noticed a Q4 "finally giving up against overly aggressive forecasts” behavioral and organizational reset effect which might neatly fit with the study authors' conclusion about internal systems and incentives, especially at smaller firms.
The paper appears to rule out deliberate earnings management, but those two things aren’t mutually exclusive; what likely happens is passive capitulation, not active manipulation, as over the course of a full year, managements are smoothing costs, defering recognition, relying on stale annual budgets, and optimistically assuming they’ll “make it up next quarter.” When Q4 rolls around, cost overruns can no longer be deferred, internal attention shifts to next year’s plan, and the marginal benefit of fine-tuning Q4 collapses. That feels like “giving up,” even if no one is explicitly saying “let’s tank Q4.”
From the charts above, it appears as though sales don’t fall in Q4, rather costs jump. Revenue forecasts are externally anchored (customers, contracts, shipments), but cost control is internal, forecast-dependent, and system-intensive.
Small companies rely more on annual budgets, have weaker rolling forecasts, less granular cost attribution, and fewer incentives to micro-optimize Q4 once the year is “lost.” Also, forecast error has compounded for three quarters, so trying to fix it in Q4 is seen to have little reputational or economic payoff. So managements often "kitchen sink" excess costs into Q4 and rationally redeploy their efforts to the new fiscal year.
Analysts usually concentrate upon demand shocks, margins, pricing power, and management credibility, but completely miss the slow decay of forecast accuracy inside the firm because they don’t model internal budgeting systems, don't adjust expectations seasonally for cost realization, and assume symmetry across quarters (in fact, explicitly modeling and publishing a Q4 cost pop well in advance is something that'll likely have a sell-side analyst receive an angry call from the CFO or IR). So Q4 misses end up looking like “surprises,” even though they’re structural and predictable.
That all said, by Q4, valuation has already rolled forward to next year, "forward guidance" (an annoyingly redundant term; is there any other other kind?) dominates reported numbers, investors expect cleanup, and "kitchen sinking" behavior is largely tolerated as markets say "Fine, clear the decks. Show me 2026.”
It would be interesting to see if the authors' conclusions hold up across geographies. As with American household spending, American coroprate projections are largely fuelled by optimism about the future, something I have also observed in India, China, and Taiwan. By contrast, I have covered Japanese and European companies with managements who are depressed and grumpy *all* the time ... some to the degree where I wonder how they even get out of bed in the morning.
P.S. Fun language fact: In American English, the idiom "they took everything but the kitchen sink" refers to a house that's been gutted by burglars or looters but for all the most fixed elements. When my wife and I moved into our German house, I was shocked to see that the previous owners had taken along all the mounted light fixtures and appliances with them. It was the one time in my life where I could use the phrase literally!
Over time, the phrase was also humorously reversed to "they threw in everything but the kitchen sink". Americans turn everything into a verb, so on Wall Street, managements throwing all sorts of pent-up expenses into a bad quarter became known as "kitchen sinking".
We had a German guy in the office who employed some unintentionally hilarious malapropisms in English, and his best one was mishearing, and continuing to use it even after gentle correction, as "kitchen thinking" https://youtu.be/gmOTpIVxji8 .
P.P.S. The use of "Q4" (or "FQ4" if the fiscal year is not a calendar year) for corporate quarters was *not* always standard. Back in the 1980s, I would write reports where an older grumpy editor would cross out every single one and red-pencil in "4Q". She did that to everyone's reports until she finally retired.
P.P.P.S. With the exception of Japan, where every company is on a March fiscal year due to their calendar system, it has been my experience that companies who consciously choose a non-calendar fiscal year are generally lower-quality managements. Perhaps they are hoping to confuse direct peer group comparisons. If a company has a March fiscal year, that means that their "2026" number is already 3/4 finished, and their "2027" is really only three months different than other companies' "2026". Coming out of a recession or cyclical downturn, that would tend to flatter their numbers at a headline level to the inattentive.
I recognize this isn't the subject of your study but I'd guess that stock prices react most negatively to Q3 misses?