Why the post-earnings announcement drift happens

The post-earnings announcement drift is a really cool way to exploit investor underreaction. The essence of post-earnings announcement drift is that when a company presents results and surprises expectations to the upside, the share price will react positively on the day of the announcement but then continues to drift higher for weeks and sometimes months as investors digest the news. This drift is stronger for less liquid small-cap stocks and stocks that are less covered by research analysts because in these cases new information travels more slowly.

But what causes the post-earnings announcement drift and what if I tell you that you can improve on the drift?

Tobias Kalsbach and Steffen Windmüller from TU Munich have provided an intriguing explanation for the post-earnings announcement drift: The psychological anchor provided by the 52-week high in the share price.

Their argument is that if a stock trades near its 52-week high and a company announces positive news, investors are reluctant to update their beliefs about the company and won’t start buying shares as much as for a stock that is well below its 52-week high. In essence, people (subconsciously or consciously) think that the stock is already expensive and has little headroom despite the good news. Thus, positive news for a company that already trades at the upper end of its 52-week trading range is incorporated more slowly and the post-earnings announcement drift is stronger.

Conversely, if a company announces negative news or misses earnings expectations but already trades well below its 52-week high (ideally close to its 52-week low), investors are similarly reluctant to adjust their expectations, and the negative post-earnings announcement drift is more pronounced.

This can be exploited to improve on the returns of a simple post-earnings announcement drift strategy. Instead of buying stocks with positive earnings surprises and selling stocks with negative earnings surprises, one should focus on buying stocks with positive earnings surprises that trade near their 52-week highs and selling stocks with negative earnings surprises that trade near their 52-week lows. This way an additional alpha (adjusted for the usual four systematic factors) of 0.55% per month or 6.8% per year can be harvested, according to the research by Kalsbach and Windmüller.