Information Overload, Investor Inattention and Lazy Prices — Cohen, Malloy and Nguyen

AuthorAthenarium / Posted on

Lazy, lazy prices…

Many say that it’s getting harder to find investment opportunities. They say that markets are more efficient today and investors more sophisticated. While this is true in many respects, there is growing literature on investor inattention, information lags and pockets of market inefficiencies – the focus of this short post. In particular, we’ll look at Lauren Cohen, Chris Malloy and Quoc Nguyen’s paper on Lazy Prices, which argues that “investors are inattentive” to changes in company filings. That is, it can take a surprisingly long time for markets to incorporate certain types of information into asset prices.

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Information overload

While technology has reduced the cost of producing and disseminating research, the total volume of information has grown exponentially. If individuals, organisations and markets can’t keep up with the rising vastness and complexity of information, then asset prices may fail to incorporate important information.

Indeed, Paul Tetlock found a “weak link between information arrival and asset price movement” in his literature review of information transmission in finance. His paper suggests a degree of “underreaction of prices to information”. In theory, we’d also expect greater price drift in stocks that receive less individual and institutional attention.

Price drift, stale news and information cascades

Investors sometimes react to noninformation and overweigh certain aspects of a narrative too. In a separate paper, Tetlock found individual investors, for example, to trade more aggressively on stale and repetitive news. Another paper, Market Madness? The Case for Mad Money, found evidence of temporary overreaction when Jim Cramer made public recommendations on CNBC’s Mad Money television show.

Robert Shiller made similar observations in his seminal book Irrational Exuberance, highlighting the important role that the news media plays in the spread, dissemination and reinforcement of ideas. Since humans are inattentive, herd like and temperamental by nature, it can take an accumulation of news and plenty of time to move national attention.

Announcement effect

Cohen, Malloy and Nguyen (CM&N) cite research that found the “announcement effect” in company filings to have weakened. These papers argued that 10-K reports have become “less informative” over time. At first glance, this appears a sensible view. After all, many annual and quarterly filings today are outright monstrosities. The authors note that the average 10-K report in 2015 is six times longer than the average report in 1995!

Inattention and lazy prices

However, CM&N offer an alternative explanation for the weakening announcement effect: that investors are failing to recognise and incorporate “subtle but important signals from annual reports at the time of the releases”.

In a study of U.S. public company filings, CM&N find that investors are less likely to recognise year-on-year changes in textual discussions relative to year-on-year changes in financial statements. Their paper finds a six-to-twelve-month lag in asset price adjustments following meaningful textual changes in company reporting.

Given the availability of public information, the result implies a “broad-based form of investor inattention”. That is, information can go unnoticed until investors are told where to look. It can take capital markets some time to incorporate various types of information. The increased complexity and volume of company reporting may exacerbate this as well.

Information signals

Unsurprisingly, investors process information better when companies make explicit year-on-year quantitative and qualitative comparisons. In this way, we might take the clarity and transparency of executive communications and company filings as a signal in of itself.

Put another way, changes in reporting practices and language are potentially important signals of firm operations. To make their point, CM&N cite the curious case of biomedical products firm Baxter International in 2010; whose share price fell more than 20 percent after the New York Times reported that the FDA had recalled their products (infusion pumps).

But eagle-eyed investors who followed Baxter’s 10-K reports (released just two months prior) may have seen an increase in disclosures pertaining to the FDA, OIG, DOJ and FTC’s “increasing scrutiny” and “enforcement efforts”. Perhaps these investors might have anticipated more negative news than their peers?

Short changers, long non-changers

Baxter International is not an isolated case. CM&N suggest that an investment portfolio that shorts companies that change their reporting and disclosures (“changers”), and longs “non-changers” can earn “up to 7% per year in value-weighted abnormal returns over the following year”. Furthermore, “these returns continue to accrue out to 18 months, and do not reverse”. To the authors, this is suggestive of “fundamental information for firms”. Additionally, their robustness checks suggest that these findings are not due to size, timing, industry, illiquidity, events (e.g., M&A) or related factors.

Negative signals predominate

One explanation for the results above is that changes in company disclosures and commentary tend to signal negative news. Using natural language processing analysis, CM&N find “that 86% of changes consist of negative sentiment changes”. Firms are perhaps more careful with disclosing upcoming bad news to avoid lawsuits. 

Management discussion and risk factors

Finally, the authors show that changes in firm reporting are often concentrated in the Management Discussion and Analysis (MD&A) section. However, reporting changes in the Risk Factors section tend to offer greater information to investors. They find that changes in language that refer to executive teams, litigations and lawsuits, and increased usage of “negative sentiment” words, “are especially informative for future returns”. 

Read between the lines

What should we make of all this? In my opinion, lazy prices are good news for the careful investor. Those that distinguish between information and noninformation, between new and stale information, may find an edge. While great investors cannot know everything, they have to know what’s important. And they must know what the market has and hasn’t incorporated into asset prices.

To paraphrase author L.J. Rittenhouse, good things may come to those that can read and invest “between the lines”. Rittenhouse advocates for greater scrutiny and decoding of executive communications. They may reveal something about the company’s strategy, products, relationships and capital stewardship that numbers may struggle to show.

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