Intra-Industry Information Transfers - Profit Warnings

8/14/2019 Intra-Industry Information Transfers - Profit Warnings

1/114

P a g e | 1

Table of Contents

List of Tables.............................................................................................................................2

List of Figures...........................................................................................................................2

Chapter 1: Introduction...........................................................................................................3

Chapter 2: Literature Review.................................................................................................6

2.1.Information transfers.......................................................................................................7

2.2. Profit Warnings................................................................................................................8

Chapter 3: Hypotheses Development...................................................................................13

3.1. Market Reaction to Profit Warnings..............................................................................13

3.2. Factors That May Influence the Effects of Profit Warnings on the Industry.................14

Chapter 4: Sample Data and Methodology..........................................................................16

4.1. Sample Data...................................................................................................................16

4.2. Event Study ..................................................................................................................17

4.3. Cross-Sectional Regression Analysis............................................................................19

Chapter 5: Descriptive Statistics...........................................................................................21

5.1. Characteristics of Profit Warnings.................................................................................21

Chapter 6: Results..................................................................................................................29

6.1. Event Study Results Full Sample...............................................................................29

6.2. Event Study Results Industry-Wide Sub Sample.......................................................34

6.3. Event Study Results Firm-specific Sub Sample.........................................................38

6.4. Multivariate Cross-Sectional Analysis Full Sample...................................................42

6.5. Multivariate Cross-Sectional Analysis Industry Wide Sub-Sample...........................44

6.6. Multivariate Cross-Sectional Analysis Firm Specific Sub-Sample............................46

Chapter 7: Conclusion...........................................................................................................47

7.1. Conclusions and Implications........................................................................................47

7.2. Limitations of the Study................................................................................................51

7.3. Suggestions for Further Research..................................................................................52

Bibliography...........................................................................................................................54Appendix A: Profit Warning Classification.......................................................................A.1

A.1. Characteristics of Industry-Wide and Firm Specific Profit Warnings........................A.1

A.2. Examples of Profit Warnings and their Classification................................................A.1

Appendix B: Distribution of Average Abnormal Returns................................................B.1

List of Tables

Table 1: Profit Warnings segmented by source of warning......................................................21Table 2: Frequency Distribution of industries for announcing and non-announcing firms.....23


2/114

P a g e | 1

Table 3: Summary Statistics and Pearson correlations - Full Sample......................................26

Table 4: Summary Statistics and Pearson Correlations - Industry Wide Sub-sample..............26

Table 5: Summary Statistics and Pearson Correlations Firm Specific Sub-sample..............26

Table 6: Test of Significance between ACAR of Announcing and Non-Announcing Firms...27

Table 7: Accounting Ratios for Companies making Profit Warnings......................................28

Table 8: Effects on Returns in Response to Announcements - Full Sample............................30

Table 9: Effects on Returns in Response to An nouncements Industry-Wide Sub Sample...34

Table 10: Effects on Returns in Response to Announcements Firm-Specific Sub Sample. .38

Table 11: Cross-Sectional Multivariate Model Results - Full Sample.....................................42

Table 12: Multivariate Cross-Sectional Analysis - Industry Wide Sub-Sample Results..........44

Table 13: Multivariate Cross-Sectional Analysis Firm Specific Sub-Sample - Results.......46

List of Figures

Figure 1: AAR and ACAR for Full Sample of Announcing Firms..........................................32

Figure 2: AAR and ACAR for Industry-Wide Sub Sample of Announcing Firms..................36

Figure 3: AAR and ACAR for Industry-Wide Sub Sample of Announcing Firms..................37

Figure 4: AAR and ACAR for Firm-Specific Sub Sample of Announcing Firms...................40

Figure 5: AAR for Firm-Specific Sub Sample of Non-Announcing Firms.............................41


3/114

P a g e | 1


4/114

P a g e | 3

Chapter 1: Introduction

Perhaps the simplest way of rephrasing the heading of this study is as follows: Is there a

difference between the share price behaviour of non-announcing firms in response to firm

specific and industry-wide announcements as pertaining to profit warnings.

This document is a study of intra-industry information transfer between the returns of firms

releasing information, through profit warnings, and those of non-announcing firms in the

same industry. Many intra-industry information transfer studies have been conducted in the

past but in different contexts such as; mergers, stock repurchases, dividend omissions and

bankruptcy announcements. There have also been prior studies which studied the market

reaction to profit warnings in the announcing firm, however little research has been done in

the area of industry wide information transfers due to profit warnings and thus this study

intends to increase our knowledge in this area.

This study aims to evaluate the impact of a profit warning on the announcing companys own

share price behaviour and the share price behaviour of other companies in the same industry.

Jin () notes that a significant shortcoming of previous studies is that they failed to distinguish

between firm specific factors and industry-wide factors; as a result this study treats industry

factors (profit warnings) and firm specific factors (profit warnings) separately in an attempt

to accurately describe the intra-industry information transfer and hence derive propermeaningful conclusions.

The results of this study suggest that announcements that convey industry wide information

cause the announcing company and the non-announcing companies in the industry significant

negative cumulative abnormal returns. This observation implies that the information

conveyed in the warning was new information to the market, for both the announcing

company and the non-announcing companies, and thus caused the abnormal movement of the

share price. Our research also showed that profit warnings for companies conveying companyspecific information caused negative abnormal returns for the announcing company; however

it did not have the same negative abnormal effect for non-announcing companies in the same

industry. This indicates that the market only gains new information about the announcing

company from the company specific profit warning as shown by the insignificant abnormal

returns for the non-announcing companies, as expected.

The cross-sectional regression of the full sample demonstrates the intra-industry effect of

profit warnings since it shows that the size of the effect of the profit warning on the

announcing company affects the size of the abnormal returns for non-announcing companies


5/114

P a g e | 3

in the industry. The larger the market reaction for the announcing companies the lager the

market reaction for non-announcing companies. We also found that in the full sample the

intra-industry effect is more prevalent depending on the Earnings to Price ratio for the

announcing company; the higher the EPR the more negative the cumulative abnormal returns

in non-announcing companies.

The regression of the industry wide information sub-sample shows that the intra-industry

effect is influenced by not only the size of the market response on the share price and the

market capitalisation of the announcing firm but also the homogeneity of the services/

product offered of the industry. With respect to the market reaction, the greater the market

response on the announcing companys share price, the greater the affect on the non-

announcing companies share price. With respect to the size of market capitalisation, the

greater the size of the announcing company the greater the abnormal returns for the non-

announcing companies. The homogeneity of the industry looks at how similar the services/

product offered is and it was found that, for the industry wide sub-sample, the more

homogenous the industry the less the abnormal returns were found to be for the non-

announcing companies. This finding for the homogeneous industry group is against our

expectations and suggests that homogeneous industries provide an environment conducive to

competitive reactions.

For the company specific profit warning sub-sample it was found that there was no real

significant relationship between the variables we tested, except for the size of the announcing

company, thus suggesting the lack of an intra-industry effect. This seems plausible since there

is no real reason for abnormal returns of the non-announcing companies for problems directly

related to another company only. The results did however show that the greater the size of the

announcing company the less the cumulative abnormal returns on the non-announcing

companies, this could be due to more information generally being available for large

companies so less of a market response.

The following chapters of this study are structured as follows: Chapter 2 comprises the

literature review, encompassing a summary of literature as pertaining to profit warnings and

intra-industry information transfers. Chapter 3 deals with the hypothesis development, in this

section our hypotheses are derived and defined. Chapter 4 relates to the methodology used in

the data collection process as well as the hypothesis testing procedures. Chapter 5 contains

the descriptive statistics followed by the detailed results of the study (in Chapter 6). Chapter 7

contains the detailed conclusions as well as recommendations for further studies.


6/114

P a g e | 3

___________________________________________________________________________


7/114

P a g e | 3


8/114

P a g e | 6

Chapter 2: Literature Review

Many studies have reported an association between the returns of firms releasing information

and those of non-announcing firms in the same industry. This relation is known as intra-

industry information transfer and has been documented in different contexts such as mergers,

stock repurchases(), dividend omissions and initiations(), and bankruptcy announcements(),

but little or no research has been done in relation to profit warnings. Several studies in the

past have investigated intra-industry information transfer of earnings related information such

as those by Jin () and Baginski (), but neither of these considered the effects of the

announcements on announcing and non-announcing firms in the industry separately.

Jackson and Madura () and Elayan, Meyer and Sun ()found that there is a strong negative

response to profit warnings. They also noted that the share price of the announcing firm

began to be affected about five days before the warning is issued and continued to decrease

for up to five days after, with little or no overreaction to the announcement.

Previous studies by Lang and Stulz() and Caton, Goh and Kohers ()also show that, on

average, the information transfer preserves the implication of the news, that is; if a firm

releases good (bad) news, the market perceives the non-announcing firms to have good (bad)

news.

Several studies show that there are considerable incentives for management to announce

profit warnings in a timely manner despite the fact that they are considered as voluntary

disclosures left to the managements discretion. Skinner (), Lang and Lundholm() and

Richardson, Teoh and Wysocki() all give different reasons why it is in the managements

interests to disclose information to the public.


9/114

P a g e | 6


10/114

L i t e r a t u r e R e v i e w P a g e | 12

2.1. Information transfers

Intra-industry information transfer is described as the process whereby information

conveyed to the market about one firm (the announcing firm) conveys value-relevant

information about other non-announcing firms operating in that industry.1

Firths () study marked the beginning of the information transfer literature which grew out

of Ball and Browns () results. Firth () finds that other information sources, besides

conventional sources (such as interim reports) used to anticipate the firms annual earnings

announcement included the financial results of closely competing firms. Firth () finds that

investors used information contained in the announcement of financial results to re-evaluate

the share prices not only of the company whose results are being announced, but also of

closely competing companies in the same industry.

Prior research has also focused on the information transfer associated with management

earnings forecasts. Baginski () used earnings forecast data to test the hypothesis that the

sign of the earnings of announcing firms conveyed value relevant information to

shareholders of non-announcing firms. The result is consistent with that of Firth () in terms

of earnings forecast data.

Other studies have studied information transfers resulting from events other than earnings

announcements and management forecasts. Caton, Goh and Kohers () find that a dividend

omission announcement transmits unfavourable information across the announcing

company's industry that affects cash flow expectations and ultimately stock prices. Other

studies have found evidence of spill over effects associated with mergers, stock repurchases,

and nuclear and chemical plant accidents.

As stated earlier Jin () determines that a common shortcoming of earlier studies is that they

failed to distinguish industry common factors from firm specific factors. Industry-wide

factors are those that are common to the entire industry, and the effects of which will be felt

among all firms in that industry, while firm specific factors are factors that affect only the

one firm. Since it is reasonable to assume that industry common factors cause intra-industry

information transfers, co-mingling industry factors with firm specific factors may lead to an

inaccurate description of the intra-industry information transfer issue and hence improper

conclusions about it. A signal about industry common factors should affect security prices

of the announcing firm as well as other firms in the same industry. But a signal about firm

specific factors (with no resultant competitive shift) should affect security prices of the

announcing firm only.1Usually resulting in a material movement in the reference price of the non-announcing firmswithin theindustry


11/114


2.2. Profit Warnings

A profit warning is an announcement by a publically traded company in which the company

advises that its earnings won't meet analyst expectations. Profit warnings form part of

managements voluntary financial disclosures, and as such they are not mandated by any

regulatory body, and it is purely up to the discretion of management as whether to make

profit warning announcements or not.

2.2.1. Managements Incentives to Disclose information

Disclosure in this context implies the act of releasing all relevant information pertaining

to a company that may influence an investment decision. To make investing as fair as

possible for everyone, companies must disclose both good and bad information. In the

past, selective disclosure was a serious problem for investors because insiders would

frequently take advantage of information for their own gain - at the expense of the

general investing public. Disclosure of financial information with regards to a publically

listed company will lead to a reduction in the asymmetric information between company

insiders and its investors (or the general public). Asymmetric information is a situation in

which one party in a transaction has more or superior information compared to another.

This often happens in transactions where the seller knows more than the buyer; this

could be a harmful situation because one party can take advantage of the other partys

lack of knowledge(). With increased advancements in technology, asymmetric

information has been on the decline as a result of more and more people being able to

easily access all types of information.

While it may be clear as to why management might want to disclose good news there is

also benefit that can be obtained by disclosing bad news to the public as well.

Managers may damage their reputations if they consistently fail to disclose bad news in a

timely and appropriate manner (). Failing to disclose bad news consistently will also

have further negative consequences, analysts will become less likely to follow the firm,

thus reducing liquidity and hence the firms stock price will suffer. Lang and Lundholm()

find that increased voluntary disclosure lowers the cost of information acquisition for

analysts and therefore increases their supply; This results in increased investor following,

reduced information asymmetry and greater demand for a firms shares leading to a

lower cost of capital, thus a net benefit for the firm despite the bad news.

Another incentive or benefit that managers may derive from disclosure of bad news

relates to an attempt by management to walk down financial analysts forecasts of


12/114


earnings to beatable targets. The argument is that managers release disclosures during the

year that guide financial analysts to believe that end-of-period earnings will be lower

than the actual announced earnings. This would generate good news on the official

announcement date since actual earnings will be above the recent expectations (based on

the profit warning statement) the result would be a positive share price reaction at the

earnings announcement date. The intentional walk down of analysts forecasts may be

justified by managements expectations that the capital market punishment for reporting

a negative surprise at announcement date is greater than the reward from reporting a

positive surprise. Richardson, Teoh and Wysocki(), a U.S. study provides evidence that

firms walk down analysts (it should perhaps be noted that no relevant studies were found

for the South African market but this does not imply that firms do not walk down

analysts in South Africa).

There is also a legal incentive for management to disclose information to the public in

that profit warnings act to help mitigate the legal liability of managers. Shareholders may

sue when there are consistent large stock price declines on earnings announcement days,

since shareholders can allege that managers failed to disclose adverse earnings news

promptly and appropriately(); and as a result they can claim that due to the managers

failure to promptly disclose material bad news they bought overvalued stocks that

devalued after management revealed this information.


13/114


The Johannesburg Stock Exchange (JSE) also obliges companies to keep investors

informed in a timely manner about any material, price-relevant information2. The

incentive behind such disclosure regulations is to encourage informed decision making

by all parties to securities transactions and hence to decrease asymmetric information

between insiders and outsiders. Compliance to the listing rules of the JSE is mandatory

for all listed companies and failure to comply may result in a civil or criminal liability

and may result in a number of sanctions including suspension of trading or de-listing of

the company. It should be noted here that Profit warnings are considered as voluntary

price sensitive announcements and as a result companies have no obligation to issue

them, unless not doing so would breach the listing requirements (as given at the bottomof the previous page).

It should also be noted that according to Skinners () findings and those of Collett () both

the number of negative trading disclosures and their absolute impact is much higher than

the number and impact of positive announcements in the United States. This could be

explained by the fact that Shareholders are more likely to mount a class action if bad

news is withheld than good news. Similarly, fund managers will look more favourably on

directors who deliver company performance above expectation.

Another incentive for disclosure is the existence of Employee Stock Option Plans

(ESOPs). As Aboody and Kaznik () suggest, management makesopportunistic voluntary

disclosure decisions that maximize their stock option compensation, this is done by

disclosing bad news before the award of ESOPs in order to depress the share price and

hence the option exercise price, which is set at the market price at the date of award.

2 JSE Listing Rule 3.4 under General Obligation of Disclosure states that the following provisionsapply in respect of material price sensitive information:

With the exception of trading statements, an issuer must, without delay, unless the information is kept confidential for alimited period of time in terms of paragraph 3.6, release an announcement providing details of anydevelopment(s) in such issuers sphere of activity that is/are not public knowledge and which may, by virtueof its/their effect(s), lead to material movements of the reference price of such issuers listed securities.

With regards to Cautionary announcements Cautionary announcements listing rule 3.9 states that:Immediately after an issuer acquires knowledge of any material price sensitive information and thenecessary degree of confidentiality of such information cannot be maintained or if the issuer suspects thatconfidentiality has or may have been breached, an issuer must publish a cautionary announcement

(complying with paragraph 11.40). An issuer that has published a cautionary announcement must provideupdates thereon in the required manner and within the time limits prescribed in paragraph 11.41.


14/114


15/114


the competitive effect. According to Lang and Stulz (), the competitive effect is the

change in the value of competitors that can be attributable to wealth redistribution.

Tawatnuntachai and DMello () found that the competitive effect is more pronounced in

industries with imperfect competition, where the announcement of an event reveals

comparative information about other firms in the industry.7

If on the other hand a firm issues a profit warning whose underlying cause is not only

firm specific, but rather includes industry-wide factors the bad news effects may spill

over into other firms in the industry.8 Tawatnuntachai and DMello () found that

contagion and competitive effects are not mutually exclusive, and thus the observed

stock price reaction is the sum of the two effects. They found that a significant negative

change in non-announcing firms stock prices indicates that profit warning

announcements convey negative industry-wide information. Studies have confirmed that

profit warnings do result in negative industry effects albeit to different degrees, but as

Jin () notes no previous studies distinguished between industry-wide factors from firm

specific factors. In Jins view the combining of these two types of factors may lead to an

erroneous picture regarding intra-industry information transfer effects and hence any

conclusions drawn from such studies would be flawed.

7A competitive effect could, for example occur where there is a drop in production efficiency for theannouncing firm resulting in higher marginal costs and hence higher prices or lower profit for that firm. In thiscase, demand for competitors products could increase because their products would be substitutes for the nowmore expensive products of the announcing firm.

8Known as contagion


16/114


17/114

P a g e | 13

Chapter 3: Hypotheses Development

The content and effects of profit warnings on the industry are dependent on the degree of

asymmetric information within that industry, as well as to how firm specific events will affect

the industry as a whole. To the extent that profit warnings provide valuable information

regarding the industry, there are several issues that need to be examined.

3.1. Market Reaction to Profit Warnings

When management issues a profit warning it is presumably doing so because it believes that

the information is important in order to reduce asymmetric distribution of information

between investors and insiders. Management does so because they believe that the

information may lead to material movements of the reference price of the listed securities. A

profit warning indicating that profits will fall short of previously expected levels is an

announcement with negative implications from the investors perspective and thus it is

expected that a profit warning will result in a negative market response. This leads to the

following hypothesis:

H1: Firms that make profit warning announcements will experience negative revaluations

of their share prices at the time of the announcement.

The nature of the profit warning may be due to a firm-specific event, or it may be due toindustry wide factors that would affect most firms in the industry. Firms whose

management does not disclose the industry wide effects on profits through the use of profit

warnings may experience negative valuation effects through what is known as the

contagion effect.9 This contagion effect appears because firms that operate as direct

competitors in the same industry will have strong correlation in the value of their

investments; as such the warning announcement conveys bad news about non-announcing

firms as well as the announcing firm. Based on the expected contagion effect, the

following hypothesis was posed:

H2:Non announcing firms experience negative revaluations of their share prices as a

reaction to profit warnings that convey industry wide information.

The third hypothesis that was developed, due to previously composed contradicting

reports concerning the intra-industry effects on non-announcing firms stock prices.

Hertzel () finds that firm initiated announcements of stock repurchases have negligible

effects on industry rivals, while Tawatnuntachai and DMello (), Lang and Sultz () and

9The contagion effect implies that If the underlying conditions reflect industry-wide factors, the effects of thewarning may spill over to industry rivals.
http://www.investorwords.com/3880/profits.htmlhttp://www.investorwords.com/3880/profits.htmlhttp://www.investorwords.com/3880/profits.htmlhttp://www.investorwords.com/3880/profits.html


18/114

P a g e | 13

Baginski () all find evidence of contagion and/or competition effects on non-announcing

firms followed by firm specific announcements by announcing firms. In order to confirm

the presence and effects of intra-industry effects of profit warnings in South Africa the

following hypothesis was tested:

H3: Non-announcing firms do not respond to announcements of profit warnings that

convey firm specific information only.

3.2. Factors That May Influence the Effects of Profit Warnings on the Industry

Past research indicates that there may be a number of factors that could affect the impact

that profit warnings have on the industry.

3.2.1. General Market Reaction to the Profit Warning Announcement

If a new profit warning reveals information that is previously unknown to the market and

the information is industry wide, there should be an effect on all competing firms in that

industry. Firth () argues that when an announcement contains a strong element of

surprise, the relatively large abnormal return for the announcing firm is likely to be

mirrored, to a lesser extent, in the magnitude of the abnormal returns for industry-related

firms. Thus the following hypothesis is postulated:

H4: There exists a positive relationship between the average cumulative abnormal returns ofnon-announcing firms and the average cumulative abnormal returns of announcing

firms.


19/114

P a g e | 13

3.2.2. The Size of Firm That Issues the Announcement

The size of the announcing firm could be an indication of the level of influence, power,

and leadership of this company in the industry (). As noted by Kohers in the previousstatement the size of the firm could be a significant factor that will affect how

announcements issued by that firm will be taken by the market. Thus the argument is

that a profit warning issued by a relatively large firm may be more likely to send

industry-wide signals which negatively affect other firms that regard the announcing firm

as an important industry leader.10 This leads to the following hypothesis:

H5:There exists a negative relationship between the average cumulative abnormal returns

of the non-announcing firms and the size of the announcing firm.

3.2.3. Degree of Industry Homogeneity

Most studies relating to intra-industry information transfers indicate that industries which

are characterized by a high degree of homogeneity are more likely to exhibit intra-

industry information transfers to a larger extent.11 This implies that in an industry

comprised of firms that are relatively similar, a profit warning announcement by one firm

may result in a greater overall industry reaction.12 The higher the degree of industry

homogeneity, the more positively correlated the returns of the announcing firm would be

with those of the other firms in the industry, thus strengthening the information transfer.

Hypothesis 6 therefore tests whether industry homogeneity has an effect on the

cumulative abnormal returns of non-announcing firms in the industry.

H6:There is a negative relation between the average cumulative abnormal returns of the

non-announcing firms and the degree of industry homogeneity.

___________________________________________________________________________

10It is expected that the larger the announcing firm, the more negative reaction of the non-announcing firms willbe.

11Studies such as: Kohers (1999); Tawatnutntachai and DMello (2002) and Baginski (1987) all noted thisphenomenon

12This is because the factors which give rise to the announcement of the profit warning will affect otherfirms in the homogeneous industry and thus there will be a more significant negative reaction in the non-\announcing firms than there would have been in a less homogenous industry.


20/114

P a g e | 13


21/114

P a g e | 16

Chapter 4: Sample Data and Methodology

This section of the report deals with how the sample data was obtained, as well as with the

methodology that was applied in testing the hypotheses that were developed in chapter 3.

4.1. Sample Data

The sample data consists of well publicised profit warning announcements. The sample of

profit warnings, as well as the daily stock price information was obtained from McGregor

BFA and DataStream. The dataset includes profit warnings made by JSE listed firms

between May 1999 and February 2004. All disclosures with implications for annual

earnings will be included, not only quantitative statements, but also qualitative statements,

as they convey the direction of earnings changes to investors.

4.1.1. Profit Warning Classification

The profit warnings will be classified as either containing firm specific information or

industry-wide common information based on the reasons provided for in the profit

warning document.13

4.1.2. Data Selection Criteria - Filters

All well publicised profit warnings were considered, but those with the following

properties were excluded: Simultaneous announcements (within the industry) andannouncements made within two days of each other are excluded to ensure that the profit

warning of the announcing firm is the only factor driving the observed market reactions

around the warning announcement.

13See appendix A - The Appendix provides the basis on which profit warnings were classified and examplesof the actual announcements.


22/114

P a g e | 16


23/114

S a m p l e D a t a a n d M e t h o d o l o g y P a g e | 20

Additionally, to narrow the focus on the share price response to profit warnings, we

exclude announcements mentioning several events, such as:

Announcements that provide half year earnings along with a warning about future

earnings are removed from the sample.

Announcements that include other information, such as dividend announcements

are removed, as the market reaction could not be fully attributable to the warning

announcement itself.

Firms are excluded from the dataset for the presence of confounding events, such

as share repurchase announcements or acquisition announcements within a two

day window of the profit warning.

The Diversified Financials industry has also been excluded since we do not

expect a strong information transfer effect to occur in this industry.

Announcing firms that do not trade on the day of a profit warning have also been

excluded from the sample since we do not expect there to be an information

transfer if the announcing firm does not react to its own profit warning.

4.2. Event Study 14

In order to identify the stock price response of the announcing firm to the announcement of

a profit warning and to capture informative announcements, the event study methodology

will be used to estimate daily abnormal returns for the 11 day window (t - 5, t + 5) to test

hypothesis 1. The event day (day t) is the date of the profit warning announcement. The

event window was assumed to consist of 250 days. Profit warnings by other firms in the

same industry around the warning announcement (days t - 2 to t + 2) will be excluded to

ensure that the profit warning of the announcing firm rather than profit warnings of the

other firms is driving the observed market reactions around the warning announcement.The

index model is used to estimate abnormal returns.

14Formulas used to conduct the event study were obtained from Investments By Bodie, Kane and Marcus,Sixth Edition.


24/114


The index model parameters are estimated using ordinary least squares method in the

following model:

Rit = i + i Rmt + it

(1)

Where:

Rit is the return for stock i in time t,

Rmt is the market return during the period t measured by the All Share Index,

i is the average rate of return the stock would realise in the period with a zero

market return,

i is the coefficient of volatility of stock is return in relation to the market return, it is the regression residuals.

Normal returns are then calculated as follows:

E(Rit) = i + iRmt (2)

Where:

E(Rit) is the expected return on stock i in time t,

iand iare the parameters of the market model,

Rmt is the market return in time t measured by the All Share Index.

To estimate the effects of the profit warning on the warning firms returns, abnormal returns

are estimated as follows:

A(Rit) = Rit E(Rit) (3)

Where:

A(Rit) is the abnormal stock return for stock i at time t,


25/114


26/114


reflect a more severe signal in declining markets. The non-announcing firms negative

market reactions in rising markets may be attenuated since investors could believe that the

industry outlook as a whole is positive and that future periods profits will rise.

The following model is estimated to examine the variables that influence the industryeffects of profit warnings:

CAR = + 1CARA + 2SIZE + 3HOMO + 4GROWTH +5SENTIMENT+ (6)

Where:

CAR is the two-day (days 0 to +1) cumulative abnormal return for the non-

announcing firms;

CARA is the two-day (days 0 to +1) cumulative abnormal return for the firm

announcing the profit warning;

SIZE is the size of the firm issuing the profit warning (measured by the natural log

of the market value of equity) on day t - 20 (relative to the profit warning);

HOMO is a dummy variable which takes the value of 1 one for homogeneous

industries (e.g. Banking, Energy and Utilities industries) and 0 otherwise. Where

homogeneous industries are industries that are similar in terms of the product or

service offering or the general operating environment. 17

GROWTH is a measure of growth of the announcing firm and is a proxy for the

growth of the industry and is measured using the earnings-price ratio (higher

earnings-price ratio implies lower growth);

SENTIMENT is an indicator of market sentiment. It is a measure of the underlying

feeling in the market during the 20 day period prior to the profit warning and is

measured by the holding period return on the JSE All Shares Index;

is the regression error term.

__________________________________________________________________________

17Specifically, the Banking and Utility industries are characterised as homogeneous, because of the regulatoryconstraints which greatly limit the ability to diversify. The Energy industry is characterised ashomogeneous due to the relatively standardised products and services with little differentiation potential.


27/114


Chapter 5: Descriptive Statistics

The subsequent section is to be used as a summary of the data that has been collected during

this study. It includes a breakdown of the types of profit warnings that were issued in various

industries as well as the various correlations that were conducted.

5.1. Characteristics of Profit Warnings

After applying the filters as discussed in section 4.1.2 to the 124 profit warnings that were

recorded over the study period the final sample consists of 51 profit warnings as shown in

Table 1: Profit Warnings. This is a substantial reduction in the size of the sample data, but if

the filters were not included the results of the study would have not been a true

representation of intra-industry information transfers, which this report aims to investigate.18

Table 1: Profit Warnings segmented by source of warning

1999 2000 2001 2002 2003 Total

Sample by source of warning

Total Sample 12 23 9 4 3 51

Industry-Wide 3 7 1 0 2 13

Firm Specific 9 16 8 4 1 38

Additional information is shown in Table 2 which contains a frequency distribution of the

announcing and non-announcing firms corresponding to each profit warning observation in

the sample on an industry basis. A total of 28 industries are represented. The distribution

suggests substantial dispersion in the industries of profit warning firms. No single industry

accounts for more than 9.09% of the sample observations and only six industries contribute

more than 5% of the observations in the sample. The least represented industries are; Banks,

Buildings and Construction materials, Chemicals, Diamond, Electrical Equipment, Farmingand Fishing, Food and Drug Retailers, Investment Companies, Other Construction and

Publishing and Printing as well as the various retailers with just one profit warning each in

the final sample.19 As noted above, the minimum number of competitors is two non-

announcing firms and the maximum is ten non-announcing firms. The mean number of

18One should also note that it was found that relative to other stock markets there is a lower disclosure record ofprofit warnings in South Africa For the same period a total of 246 profit warnings were available on ASXlisted companies, this however does not indicate poor disclosure practices on the part of South Africa. This

may be explained by different economic conditions in the two counties.

19This may be attributed to the narrow classification of industries that was employed, but this has been deemednecessary in order to ensure that only strict competitors returns within the same industry are compared.


28/114


29/114

D e s c r i p t i v e S t a t i s t i c s P a g e | 24

Table 2: Frequency Distribution of industries for announcing and non-announcing firms

IndustryNo. of Announcing

FirmsPercentage of TotalAnnouncing Firms

Average No. of Rival Firms perAnnouncement

Total No. ofRival Firms

Percentage of TotalRival Firms

Auto Parts 2 3.64% 2 3 1.30%

Banks 1 1.82% 8 8 3.46%

Building & Construction Materials 1 1.82% 10 10 4.33%

Business Support Services 3 5.45% 3 10 4.33%

Chemicals Speciality 1 1.82% 5 5 2.16%Computer Services 4 7.27% 4 15 6.49%

Containers & Packaging 1* 5.45% 4 4 1.73%

Diamond 1 1.82% 10 10 4.33%

Diversified Industrials 2 9.09% 3 6 2.60%

Electrical Equipment 1* 1.82% 8 8 3.46%

Electronic Equipment 2 3.64% 3 5 2.16%

Engineering General 3 5.45% 2 5 2.16%

Farming & Fishing 1 1.82% 10 10 4.33%

Food & Drug Retailers 1 1.82% 4 4 1.73%

Gold Mining 2 3.64% 9 17 7.36%

Insurance - Non-Life 2 3.64% 2 3 1.30%

Investment Banks 4 7.27% 3 12 5.19%

Investment Companies 1 1.82% 10 10 4.33%

Metals & Minerals 2 3.64% 9 18 7.79%

Other Construction 1 1.82% 10 10 4.33%

Other Financial 4 7.27% 2 7 3.03%

Publishing & Printing 1 1.82% 5 5 2.16%

Real Estate Holdings & Development 2 3.64% 10 20 8.66%

Restaurants and Pubs 2 3.64% 2 3 1.30%


30/114


31/114



32/114


Tables 3, 4, and 5 provide the Pearson correlations between the Average Cumulative

Abnormal Return (ACAR) for announcing and non-announcing firms from day t = 0 and

day t = +1. For the full sample, average cumulative abnormal returns for announcing firms

are negative (at -7.97%) and those for portfolios of non-announcing firms are also negative

(albeit to a lesser degree of -0.10%). For the industry-wide sub sample, average cumulative

abnormal returns for announcing firms are negative (-8.49%) and those for non-announcing

firms are also negative (-0.33%). For the firm specific sub sample, average cumulative

abnormal returns for announcing firms are negative (at -7.80%) and those of non-

announcing firms are slightly negative (-0.02%). This suggests that the profit warnings

included in the sample tend, on average, to convey bad news not only for the announcing

firms, but also for non-announcing firms (at varying degrees depending on the type of

announcement).

The Pearson correlation coefficient between ACAR (0 to +1) for announcing firms and

ACAR (0 to +1) for non-announcing firms is positive (0.123) and significant at the 0.01

level for the full sample. For the industry-wide sub sample, the Pearson correlation between

ACAR (0 to +1) for announcing and non-announcing firms is positive (0.344) and

significant at the 0.01 level. For the firm specific sub sample, the Pearson correlation

between ACAR (0 to +1) for announcing and non-announcing firms is small and positive (at

0.048), but not significant. These correlations provide preliminary evidence of anassociation between announcing firms ACAR and the stock returns of competitors in the

same industry for profit warnings conveying industry-wide information (as expected) and

for the full sample, but not for firm specific announcements. Furthermore, Table 6 shows

that the difference between the two correlation coefficients is significant at the 0.01 level (z-

score = 1.608)20.

20Z-statistic testing was applied because despite only having 13 values for the industry specific sub-sample, it has been determined in Appendix B that the daily returns of the full sample follows a normaldistribution, hence any sample drawn from this population can be tested by the z-statistic.


33/114


Table 3: Summary Statistics and Pearson correlations - Full Sample

ACAR (0 to +1)Announcing

ACAR (0 to +1)Non-Announcing

Full Sample Summary Statistics

Mean (%) -7.97% -0.10%

Standard Deviation 0.161 0.134

N 51 51

Pearson Correlation

Announcing ACAR 0 to +1 1 0.123

Significance (2-tailed) 0.015

Table 4: Summary Statistics and Pearson Correlations - Industry Wide Sub-sample



I.W. Sub-Sample Summary Statistics

Mean (%) -8.49% -0.33%


N 13 13

Pearson Correlation



Table 5: Summary Statistics and Pearson Correlations Firm Specific Sub-sample



F.S. Sub-Sample Summary Statistics

Mean (%) -7.80% -0.02%


N 38 38

Pearson Correlation




34/114


Table 6: Test of Significance between Correlation Coefficients of ACAR for Announcing andNon-Announcing Firms21

Correlation Coefficient BetweenAnnouncing and Non-AnnouncingFirms' ACAR (0 to +1)

N

Industry-Wide Sub Sample (R1) 0.344 13

Firm Specific Sub Sample (R2) 0.048 38

R1 - R2 0.296

z-score 1.608


Table 7 shows accounting ratios for companies making profit warnings segmented by

industry. Return on Equity (ROE) is a key indication of the companys performance as it

provides information on how well managers are employing funds invested by the

shareholders to generate returns. The positive earnings per share (EPS) and ROE ratios

indicate good recent performance for the companies making profit warnings. The EPS for

the Banking is the highest at 332.12 cents/share and the ROE for the Food and Drug

Retailers is the highest at 43.30%. The average market sentiment of 0.123 % suggests that

the overall outlook prior the announcement of the profit warnings was positive

21This table yields the result of a test of the hypothesis that the two correlation coefficients obtained from therelationship between the average cumulative abnormal return (0 to +1) for the announcing firms andnon-announcing firms are equal between the industry-wide and firm-specific sub samples.


35/114


Table 7: Accounting Ratios for Companies making Profit Warnings

Industry

Average

MCAP(ZAR m)

Average

PER

Average

ROE

Average

EPS(cents)

Average

Sentiment*

Auto Parts 484.86 5.78 11.90 239.53 0.82

Banks21296.4

1 8.04 21.45 332.12 0.78

Building & ConstructionMaterials 882.99 6.42 -14.75 142.00 0.22

Business Support Services 2887.04 8.91 -7.66 98.45 0.06

Chemicals - Speciality 1589.90 8.66 4.36 95.48 -0.14

Computer Services 429.33 7.07 -13.90 30.61 -0.10

Containers & Packaging 1631.48 -4.33 18.23 39.60 -0.50

Diamond 588.38 4.21 6.19 95.90 -0.10Diversified Industrials 60.80 8.15 7.98 228.20 -0.30

Electrical Equipment 1505.46 5.19 10.44 140.94 0.09

Electronic Equipment 38.79 -3.94 -25.38 -1.35 0.02

Engineering - General 159.31 1.78 7.63 67.53 0.54

Farming & Fishing 601.65 4.35 15.00 71.90 -0.20

Food & Drug Retailers 3757.54 18.31 43.30 47.60 1.40

Gold Mining 7922.33 4.47 12.36 301.20 -0.04

Insurance - Non-Life 3943.29 18.54 15.60 263.07 0.02

Investment Banks 3047.23 5.02 23.59 196.00 -0.03

Investment Companies 131.42 0.30 -55.04 12.65 0.09

Metals & Minerals41660.5

0 5.18 21.40 281.23 -0.09

Other Construction 1253.15 4.07 2.20 72.76 0.04

Other Financial 554.16 7.69 -76.60 12.28 -0.01

Publishing & Printing 1027.54 11.37 0.50 191.00 -0.10Real Estate Holdings &Development 318.71 5.96 2.00 71.08 -0.02

Restaurants and Pubs 105.76 0.65 13.30 19.73 -0.10

Retailers - Hardlines 1237.76 8.57 17.92 246.43 0.36Retailers - MultiDepartment 1826.97 7.88 21.84 23.80 1.05

Retailers - Soft Goods 716.62 10.64 1.91 2.31 -1.08

Shipping & Ports 3432.92 5.98 29.02 195.98 0.76

Average 3681.87 6.25 4.10 125.64 0.123

Note: MCAP =(Number of shares issued at end year) x (share price at year end).

PER = (Closing share price on last day of company's financial year / (Earnings per share)

ROE = (Net profit after tax before abnormal, less outside equity interests / (diluted weightednumber of shares outstanding during the year).

EPS = (Net Profits After Tax) / (shareholders equity - outside equity interests).

* Holding period return over 20 days prior to the profit warning.


36/114


All accounting ratios are for the year end closest to the announcement of the profit warning.


37/114



38/114

R e s u l t s P a g e | 46

Chapter 6: Results

This section of the report describes the results that have been obtained (from the event study

and the multivariate regression) in a graphical manner through the use of tables and graphs,

there is also a detailed explanation of the information that can been drawn from each set of

results that has been obtained.

6.1. Event Study Results Full Sample

Table 8 presents the event study results for the full sample of profit warnings for

announcing and non-announcing firms for the period of five days before, to five days after

the announcement day. Cumulative abnormal returns are also reported in Table 8 for days

-1 to 0; 0 to +1; -1 to +1 and -2 to +2.


39/114


Table 8: Effects on Returns in Response to Profit Warning Announcements - Full Sample22

Average Abnormal Return (%)

Day Relative toAnnouncement

Announcing Firms Non-Announcing Firms

-5 0.90% 1.37%

-4 0.87% 2.11%

-3 0.34% -0.42%

-2 -0.19% 1.03%

-1 -0.62% 0.07%

0 -4.89% -0.31%

1 -3.09% 0.21%

2 -1.25% -0.55%

3 -0.52% 0.31%

4 -0.21% -1.22%

5 0.22% 0.15%Average Cumulative Abnormal Return (%)



-1 to 0 -5.51% -0.25%

0 to +1 -7.97% -0.10%

-1 to +1 -8.60% -0.04%

-2 to +2 -10.04% 0.44%

N 51 51

22This table reports mean abnormal returns and mean cumulative abnormal returns around the announcements

of 51 profit warnings between January 1999 and December 2003. Non-announcing average abnormal returns

are the equally-weighted average abnormal returns of portfolios of other firms with the same industry

classification as announcing firms. Abnormal returns are calculated using the market model. Average

Cumulative Abnormal Return is the sum of the average abnormal returns for the days specified (-1 to 0, 0 to

+1, -1 to +1, and -2 to +2).


40/114


6.1.1. Effects on Announcing Firms Full Sample

The largest average abnormal return for announcing firms occurs on day t = 0 (-4.89%)followed by day t = +1 (-3.09%) and the average cumulative abnormal returns from day t

= -1 to t = +1 (-8.60%) and from day t = -2 to t = +2 (-10.04%), all of which are highly

significant with p-value = 0.00. These negative results are consistent with the expectation

that share prices in announcing firms will fall following a profit warning. These results

therefore provide support for hypothesis 1 (H1 on pg. ), which stipulated a negative

reaction in the announcing firms to the announcement of a profit warning.

On the days prior to the announcement there is presence of significant and negative

average abnormal returns which is consistent with the findings of Elayan, Meyer and Sun

(2002). There is a relatively gentle decline and a gradual increase in negative average

abnormal returns on the days before the profit warning compared to the large declines on

day t = 0 and day t = +1. This provides support for the notion that investors have

identified firms with poorer than expected earnings and have started to downgrade

market prices or there was some information leakage prior to the announcement of the

profit warnings.

There are no significant daily average abnormal returns after the two-day announcement

period (days t = 0 to t = +1) suggesting that the majority of the response to the profit

warnings occurs over this period. The significant negative reaction on the day following

the warning (-3.09%) could be the result of some market participants delaying their

trading until they observe the assessment, based on research bulletins or trading, of

informed investors.

Figure 1 overleaf, provides a visual depiction of average abnormal returns and average

cumulative abnormal returns over the event window for the full sample of announcing

firms.


41/114


Figure 1: AAR and ACAR for Full Sample of Announcing Firms23

The large negative spike in average abnormal returns on day t = 0 can clearly be seen.

Figure 1 also shows that in the days prior to the profit warning the market starts a

downward anticipatory movement. There is then a sharp drop over days t = -1 to t = 0

and a further fall from day t = 0 up to day t = +1 and thereafter a recovery as shown by

the average cumulative abnormal return trend line.

6.1.2. Effects on Non-Announcing Firms Full Sample

The average abnormal return for non-announcing firms on day t = 0 (-0.31%) issignificant at the 5% level (p-value = 0.038). The average cumulative abnormal returns

from days t = -1 to t = +1 (-0.04%) are significant at the 1% level (p-values = 0.01) 24. By

observation alone it is not clear whether the decline on day t = 0 is significant, but the p-

value for the t-test performed on the differences of returns from zero show that it is

significant at the 1% level (P-value = 0.02) These results provide evidence of an intra-

industry information transfer from firms announcing profit warnings to non-announcing

firms.

6.1.3. Full Sample Results Summary of Findings

The contagion effect dominates the competitive effect on average which results in

negative abnormal returns for the announcement-period. Thus, the unfavourable

information conveyed by profit warning announcements has a net negative effect on the

equity value of the other firms in the industry. Therefore, the finding of previous

studies that the market revises the announcing and non-announcing firms values in the

same direction in the context of different corporate events also extends to profit

warnings and confirms Hypothesis 1.

23This Figure shows the relation between Days Relative to the Profit Warning announcement (x-axis), AverageAbnormal Return (AAR) and the Average Cumulative Abnormal Return (ACAR) for the full sample of profitwarnings (N = 51) for announcing firms over the event window (t = 5 up to day t = +5).

24p-values for t-tests of the differences of the returns from zero. p-values display the smallest level ofsignificance for which the hypothesis can be rejected ().


42/114


6.2. Event Study Results Industry-Wide Sub Sample

Table 9 presents the event study results for the industry-wide information sub sample of

profit warnings for announcing and non-announcing firms for the period of five days before,

to five days after the announcement day. Cumulative abnormal returns are also reported in

Table 9 for days -1 to 0, 0 to +1, -1 to +1 and -2 to +2.

Table 9: Effects on Returns in Response to Profit Warning Announcements Industry-Wide SubSample




-5 0.32% 0.02%-4 0.37% -0.09%

-3 0.27% -0.98%

-2 -0.74% 0.78%

-1 -1.40% -1.75%

0 -3.84% -1.66%

1 -4.64% 1.33%

2 -0.45% -1.02%

3 -0.34% -0.64%

4 -1.20% -0.88%

5 -0.24% -0.09%

Average Cumulative Abnormal Return (%)



-1 to 0 -5.24% -3.41%

0 to +1 -8.49% -0.33%

-1 to +1 -9.89% -2.08%

-2 to +2 -11.07% -2.31%

N 13 13


43/114


6.2.1. Effects on Announcing Firms Industry Wide Sub Sample

The largest average abnormal return for announcing firms occurs on day t = 1 (-4.64%)

(p-value = 0.00) followed by day t = 0 (-3.84%)25 (p value = 0.01). The average

cumulative abnormal returns from days t = -1 to t = +1 (-9.89%) and from days t = -2 to t

= +2 (-11.07%), both with p-value = 0.00. This shows a negative reaction in announcing

firms to the announcement of profit warnings that convey industry-wide information.

This was the expected reaction as the profit warnings convey negative implications on all

firms in the industry from the markets perspective.

There are also significant and negative average abnormal returns on day t = -2 (-0.74%,

p-value = 0.03) and day t = -1 (-1.40%, p-value = 0.01). These negative average

abnormal returns could be attributed to some of the factors discussed previously in

section 6.1.1 or investors may have been able to predict adverse industry conditions from

alternative sources, such as from forecasts of a drought for the agriculture industry,

before a profit warning was issued.

The presence of further decline in AAR up to five days after the announcement period

suggesting that the full response to the profit warning conveying industry wide

information occurs over an extended period of time. This could be because of investors

continually re-adjusting their valuations according to how the market reacts to the news

for the industry in the days after the announcement.

As above, for the full sample, the significant negative reaction on the day following the

warning (-4.64%, p-value = 0.01) could be the result of some market participants

delaying their trading until they observe the assessment, based on research bulletins or

trading, of informed investors.

Figure 2: AAR and ACAR for Industry-Wide Sub Sample of Announcing Firms

Figure 2 provides a visual depiction of average abnormal returns and average cumulative

abnormal returns over the event window for the industry-wide information sub sample of

13 announcing firms. The large negative spike in average abnormal returns on days t = 0

and t = 1 is clearly shown. Figure 2 also shows that in the days prior to the release of the

profit warning, there is a downward anticipatory movement. There is then a sharp drop

over days t = 0 to t = 1 and a further fall from day t = 1 up to day t = +5.25This result was not expected, some possible explanations are examined later in this section


44/114


6.2.2. Effects on Non-Announcing Firms Industry Wide Sub Sample

Figure 3 plots the average abnormal returns and the average cumulative abnormal returns

in non-announcing firms against the day relative to the profit warning for the industry-

wide information sub sample. At first glance there seems to be a somewhat mixedreaction in the AAR of non announcing firms; in the pre-announcement period, there is a

significant and negative average abnormal return for non-announcing firms on day t = -3

(-0.98%), followed by a smaller but positive AAR on day t = -2 (0.78%), but which was

found to be insignificant (p-value = 0.21). By observing the trend line of the ACAR

shown in Figure 3 there is a gradual increase in the negative abnormal return up until its

maximum point of -1.75% on day t = -1 followed by a further general declining trend

similar to that of the announcing firms shown in Figure 226.

The significant average abnormal returns, which show a negative trend up to and after

the announcement could be explained by one of the same factors for announcing firms

prior to the announcement of a profit warning, as described in section 6.2.1 (on pg. ).

Figure 3: AAR and ACARfor Industry-Wide Sub Sample of Non-Announcing Firms

6.2.3. Industry-Wide Sub Sample Summary of Results

Table 9 shows that the average abnormal return for non-announcing firms on day t = 0 (--

1.66%) is significant at the 1% level (p-value = 0.01). The average cumulative abnormal

returns from days t = -1 to t = +1 (-2.08%) and from days t = -2 to t = +2 (-2.31%) are

also significant at the 1% level (p-values = 0.01). These results provide evidence of an

intra-industry information transfer from firms announcing profit warnings that convey

industry-wide information to non-announcing firms. There is a net contagion effect

resulting in a negative effect on the equity value of other firms in the industry. Thus, if

the underlying conditions that give rise to profit warnings reflect industry-wide factors,

there is a spill over effect to the rest of the industry. These results therefore provide

support for hypothesis 2 (H2) which states that there is a negative reaction in non-

announcing firms to the announcement of profit warnings that convey industry-wide

information.

26 The increase in positive AAR on day t = 1, has been evidenced but after applying the t-tests was found not to

be significant (p-value = 0.26), despite this point there is a clear negative trend over the period after theannouncement for up to days (t = 5), the AAR for days t = 3 and t = 4 have been found to be significantusing the t-tests.


45/114


6.3. Event Study Results Firm-specific Sub Sample

Table 10presents the event study results for the firm-specific information sub sample of

profit warnings for announcing and non-announcing firms for the period of five days before,

to five days after the announcement day. Cumulative abnormal returns are also reported in

Table 10 for days -1 to 0, 0 to +1, -1 to +1 and -2 to +2.

Table 10: Effects on Returns in Response to Profit Warning Announcements Firm-Specific SubSample




-5 1.10% 1.83%

-4 1.04% 2.87%

-3 0.36% -0.22%-2 -0.01% 1.11%

-1 -0.36% 0.69%

0 -5.24% 0.15%

1 -2.56% -0.17%

2 -1.53% -0.39%

3 -0.58% 0.64%

4 0.13% -1.34%

5 0.38% -0.29%

Average Cumulative Abnormal Return (%)



-1 to 0 -5.60% 0.83%

0 to +1 -7.80% -0.02%

-1 to +1 -8.16% 0.66%

-2 to +2 -9.69% 1.39%

N 38 38

6.3.1. Effects on Announcing Firms Firm-Specific Sub Sample

The largest average abnormal return for announcing firms occurs on day t = 0 (-5.24%)

followed by day t = +1 (-2.56%), both highly significant with p-values of 0.00. The

average cumulative abnormal returns from days t = -1 to t = +1 (-8.16%) and from days t

= -2 to t = +2 (-9.69%) are also significant with p-values of 0.00. Thus, there is a

negative reaction in announcing firms to the announcement of profit warnings that

convey firm specific information. It is interesting to note that the maximum negative

average abnormal return for firm specific announcements (-5.24% on day t = 0) is greater

than that of industry-wide announcements (-4.64% on day t = 1). However, this


46/114


difference is not statistically significant (p-value = 0.271). Thus, there is no differential

reaction to industry-wide announcements and firm specific announcements for the firms

making the announcement.

There are significant and negative average abnormal returns on the days prior to theannouncement of the profit warnings suggesting either an information leakage prior to

the announcement of the profit warnings or investors may have identified firms that have

specific problems before the release of the profit warnings and downgraded market

prices before day t = 0.

There is a positive and significant average abnormal return on day t = + 4 (0.13%, p-

value = 0.03), possibly suggesting a small correction to over-reaction to the profit

warning. After this correction there are gradual adjustments in the equity value until the

stock price reaches its true equilibrium value. Figure 4 provides a visual depiction of

average abnormal returns and average cumulative abnormal returns over the event

window.

Figure 4: AAR and ACAR for Firm-Specific Sub Sample of Announcing Firms

The large negative spike in average abnormal returns on day t = 0 is clearly shown.Figure 4 also shows that in the days prior to the release of the profit warning (days t = -2

and t = -1), there is a downward anticipatory movement. There is then a sharp drop on

day t = 0 followed by further decline up to day t = +3 thereafter a recovery as shown by

the average cumulative abnormal return trend line.


47/114


6.3.2. Effects on Non-Announcing Firms Firm-Specific Sub Sample

Figure 5shows the relation between days relative to the profit warning (x-axis) and

average abnormal return (y-axis) for the firm specific sub sample of profit warnings (N =

38) for non-announcing firms over the event window (day 5 to day +5).

Figure 5: AAR for Firm-Specific Sub Sample of Non-Announcing Firms

The daily ACAR have not been included in the figure due to the findings which implied

that there are no significant average abnormal returns for non-announcing firms over the

entire event window. The average abnormal return on day t = 0 and the average

cumulative abnormal return over the periods t = -1 to t = +1 and t = -2 to t = +2 are

statistically insignificant.


48/114


6.3.3. Firm-Specific Sub Sample Summary of Results

The results for this section suggest that profit warnings containing firm specific

information have no significant effect on their industry rivals and hence imply that thereis no evidence of either a contagion or competitive intra-industry effect. These results

provide support for hypothesis 3 (H3 on pg. ) which stated that non-announcing firms do

not respond to the announcement of profit warnings that convey only firm specific

information. By inspection of Figure 5 it can be seen that there is no clear finding of

abnormal returns around the announcement day for non-announcing firms in the firm

specific sub sample, which is confirmed by tests for statistical significance27.

6.4. Multivariate Cross-Sectional Analysis Full SampleFive independent variables are used to explain the market reaction in non-announcing firms

to profit warnings and provide evidence on the three hypotheses previously developed. The

two day (days t = 0 to t = +1) ACAR of the non-announcing firms is the dependent variable.

Since negative Price-Earnings Ratios (PER) are not very meaningful, observations with

negative EPRs have been removed from the sample and the regression has been run with

only positive EPRs in the model28. The regression results for the sample are shown in Table

11.

Table 11: Cross-Sectional Multivariate Model Results - Full Sample

Variable Value p-value

Intercept 0.1223 0.3280

ACARA 0.0835 0.0792

LNMVE -0.0141 0.4905

HOMO 0.0215 0.5976

SENTIMENT 0.2633 0.3320

EPR -0.0021 0.0938

Regression Summary Statistics R-Squared 0.0582

Adj. R-Squared 0.0420

F-statistic 3.4809

N 50

27This observation has been backed up by statistical tests. i.e. Determining the p-values for t-tests of thedifferences of the average abnormal returns from zero

28A negative PER implies that investors will be given money to buy a company's earnings, which is not thecase.


49/114


Table 11provides the parameter estimates of the independent variables The Model is

significant at the 1% level (F-statistic = 3.4809).

6.4.1. Coefficient - ACARA Full Sample

The coefficient for the average cumulative abnormal return for announcing firms

(ACARA) is positive and significant at the 10% level in the Model (p-value = 0.0792).

This conforms to our expectationsand provides support for hypothesis 4 (H4 on pg. ) for

the full sample of profit warnings.The 1 coefficients are less than one, indicating that

stock price reactions of non-announcers will be less than the abnormal return of the

profit warning firms.

6.4.2. Coefficient LNMVE Full Sample

The coefficient for the natural log of the size of the announcing firm (LNMVE) is

negative but insignificant. This is contrary to our expectations and indicates that the size

of the announcing firm is not a determinant of the stock price reaction of non-

announcing firms for the full sample of profit warnings. Thus hypothesis 5 (H5 on pg. )

is not supported for the full sample of profit warnings.

6.4.3. Coefficient - HOMO Full Sample

The coefficient for the homogeneous industry (HOMO) which is a dummy variable that

takes the value of one for homogeneous industries29 (e.g. Banking, Energy and Utilities

industries), has been found to be positive but insignificant. Thus, hypothesis 6 (H6 on pg.

) is not supported for the full sample of profit warnings.

6.4.4. Coefficient - SENTIMENT Full Sample

The coefficient for the market sentiment variable (SENTIMENT) is positive but

insignificant. This provides some evidence that the negative stock price reaction in non-

announcing firms is attenuated when the recent market sentiment has been positive.

6.4.5. Coefficient - EPR Full Sample

The coefficient for the earnings-price ratio (EPR) is negative and significant at the 10%

level (p-value = 0.0938). Thus the EPR is a significant explanatory factor for the stock

price reaction of non-announcing firms.

29Homogeneous industries are industries that are similar in terms of the product or service offering orthe general operating environment. Specifically, the Banking and Utility industries are characterised ashomogeneous, because of the regulatory constraints which greatly limit the ability to diversify. The

Energy industry is characterised as homogeneous due to the relatively standardised products andservices with little differentiation potential.


50/114


6.5. Multivariate Cross-Sectional Analysis Industry Wide Sub-Sample

The same regression as the one discussed above was then carried out for the Industry Wide

Sub-Sample, and the results are summarized in the table below.

Table 12: Multivariate Cross-Sectional Analysis - Industry Wide Sub-Sample Results


Intercept 0.0563 0.3979

ACARA 0.0588 0.0247

LNMVE -0.0078 0.0952

HOMO 0.0104 0.0787

SENTIMENT -0.0058 0.5359

EPR 0.0000 0.7762

Regression Summary Statistics

R-Squared 0.7283Adj. R-Squared 0.5585

F-statistic 4.2894

N 13

The adjusted R-squared for the industry-wide sub sample (0.5585) is higher than that of the

full sample (0.0420) indicating that the independent variables in the models explain more of

the variation in the ACAR of the non-announcing firms for the profit warnings conveying

industry-wide information than for profit warnings conveying industry-wide and firm

specific information as in the full sample.


51/114


6.5.1. Coefficient - ACARA Industry Wide Sub-Sample

The coefficient for the average cumulative abnormal returns for announcing firms

(ACARA) is positive and significant at the 5% level in the model (p-value = 0.0247).This indicates that for profit warnings conveying industry-wide information there is a

negative reaction in non-announcing firms, however to a lesser extent than in the

announcing firms since the coefficient is less than one. This provides support for

hypothesis 4.

6.5.2. Coefficient - LNMVE Industry Wide Sub-Sample

The coefficient for the natural log of the size of the announcing firm (LNMVE) is

negative and significant at the 10% level (p-value = 0.0952). This indicates that for profit

warnings that convey industry-wide information, the larger the size of the announcing

firms, the more negative is the ACAR of the non-announcing firms. This supports

hypothesis 5 for profit warnings that convey industry-wide information.

6.5.3. Coefficient - HOMO Industry Wide Sub-Sample

The coefficient for the homogeneous industry variable (HOMO) is positive and

significant at the 10% level (p-value = 0.0787). This provides evidence that the higher

the degree of industry homogeneity, the less negative is the cumulative abnormal returns

of non-announcing firms, contrary to our expectations.

6.5.4. Coefficient - SENTIMENT Industry Wide Sub-Sample

The coefficient for the market sentiment variable (SENTIMENT) is positive but

insignificant in the model. This provides some evidence that the negative stock price

reaction in non-announcing firms, following the announcement of a profit warning that

conveys industry-wide information, is attenuated when the recent market sentiment has

been positive.

6.5.5. Coefficient - EPR Industry Wide Sub-Sample

The coefficient for the earnings-price ratio (EPR) is negative, but insignificant thus is not

an explanatory factor for the stock price reaction of non-announcing firms in response to

profit warnings that convey industry-wide information.


52/114


6.6. Multivariate Cross-Sectional Analysis Firm Specific Sub-Sample

The regression models for the firm specific sub sample, presented in Table 13, are not

statistically significant (F-statistic = 0.8567). The adjusted R-squared for the Model is

negative (-0.0089) indicating a poor fit of the regression.

Table 13: Multivariate Cross-Sectional Analysis Firm Specific Sub-Sample - Results


Intercept -0.0687 0.5051

ACARA 0.0734 0.1148

LNMVE -0.0126 0.0986

HOMO -0.0037 0.9548

SENTIMENT 0.0216 0.9370

EPR 0.0000 0.2397Regression Summary Statistics

R-Squared 0.0543

Adj. R-Squared -0.0089

F-statistic 0.8567

N 37

The coefficient for the natural log of the size of the announcing firm (LNMVE) is positive

and significant at the 10% level (p-value = 0.0986). This indicates that the greater the sizeof the announcing firm, the smaller is the negative average cumulative abnormal return in

the non-announcing firms for profit warnings that convey firm specific information to the

market.

The remaining coefficients were found to be statistically insignificant.

__________________________________________________________________________


53/114



54/114

P a g e | 47

Chapter 7: Conclusion

This section of the report will discuss the implications of the findings as derived from the

results, followed by a discussion regarding the limitations of the study and closing with

recommendations for future studies.

7.1. Conclusions and Implications

Investors utilise publicly available information, including information provided in profit

warnings, in their decisions about capital allocation. For this reason, the J.S.E. obliges listed

companies to keep investors informed in a timely manner about material price-relevant

information.Thus the main contribution of this study lies in the answer to the question of

whether there is a difference between the share price behaviour of non-announcing firms in

response to firm specific announcements and industry-wide common announcements.

7.1.1. Conclusions Drawn From the Event Study

For profit warnings conveying industry-wide information the announcing firms and the

rivals of the announcing firms incur significant negative abnormal returns. This reaction

implies that participants of financial markets gather new information about industry

conditions for rivals as well as for announcing firms from profit warnings that are issued

due to industry-wide factors.

For profit warnings conveying firm specific information the announcing firms incur

significant negative abnormal returns, whereas, the rivals of the announcing firms do not.

The significant negative reaction shows that market participants gather new information

about the announcing firms from firm specific announcements but not for the rival firms,

shown by the insignificant average abnormal returns. This is because firm specific

factors are problems unique to a particular firm and therefore should have no effect on

rival firms.

By separately documenting the intra-industry information transfer process for the

industry-wide information and firm specific information sub-samples, this study

overcomes a shortcoming of previous studies in the area of information transfers which

lead to an inaccurate description of the intra-industry information transfer process.

The finding of significant negative abnormal returns in the days leading up to the

announcement day provides evidence of some information leakage. This is consistent

with the results of Jackson and Madura () in the U.S. In contrast Helbok and Walker()

and Collett () did not find the same in the U.K. which could suggest a lower level ofleakage in periods running up to trading updates in the U.K. than in the U.S. and South


55/114

P a g e | 47

Africa. Alternatively, investors in South Africa and the U.S. may have identified firms

with poorer than expected earnings and had started to downgrade market prices prior to

the profit warning. This could be due to investors in South Africa and the U.S. utilising

other sources of information to predict the negative effects before the profit warning is

issued.

7.1.2. Conclusions regarding Full Sample Multivariate Regression

For the full sample of profit warnings the average cumulative abnormal return of the

announcing firms was a significant contributor to the cumulative abnormal return of the

non-announcing firms. Thus, if the profit warning contains new information that affects

the whole industry the market will inflict a more negative price adjustment on all the

firms in the industry.

The positive market sentiment coefficient for the full sample of profit warnings provides

evidence that the negative stock price reaction in non-announcing firms is attenuated

when the recent market sentiment has been positive. That is, the market punishes

competing firms to a lesser extent when market sentiment is relatively favourable.

Once the negative EPRs are excluded from the cross-section regression model, the EPR

becomes a significant explanatory factor for the stock price reaction of non-announcing

firms. The negative coefficient indicates that the higher the EPR (lower industry growth),the more negative is the stock price reaction in non-announcing firms. This could be

explained by the notion that firms that are not growing do not have the ability to expand

into areas not affected by the reasons given for the profit warning, resulting in greater

negative average cumulative abnormal returns in non-announcing firms.

The size of the announcing firms is not a significant contributor to the cumulative

abnormal return of the announcing firms for the full sample of profit warnings. Perhaps

investors did not distinguish between

Intra-Industry Information Transfers - Profit Warnings

Documents

Transcript of Intra-Industry Information Transfers - Profit Warnings