Earnings Surprises, Growth Expectations, and Stock Returns:

1. Introduction
Earnings Surprises, Growth Expectations, and Stock Returns
It is well-established that ‘growth’ or ‘glamour’ stocks have historically
underperformed other stocks in terms of realized stock returns over the five years after
portfolio formation. We show that this phenomenon can be explained by the fact that
growth stocks exhibit an asymmetric response to negative earnings surprises. We show
that growth stocks perform similarly to other stocks in response to positive earnings
surprises, but that growth stocks exhibit a much larger negative response to negative
earnings surprises. After controlling for the asymmetric response of growth stocks to
negative earnings surprises, there is no longer evidence of a stock return differential
between growth stocks and other stocks.
Our evidence provides insights into the explanation for the return differential
between growth stocks and other stocks. Existing research focuses on distinguishing
among three explanations. First, growth variables such as price-to-earnings and market-
to-book capture rationally priced risk factors [Fama and French (FF, 1992)]. Second,
market prices do not fully reflect information in these variables, in the sense that
investors have overly optimistic expectations about the prospects of growth stocks,
resulting in lower subsequent stock returns when these expectations are not met
[Lakonishok, Shleifer, and Vishny (LSV, 1994)]. Third, the returns reflect
methodological problems with the measurement of long-term abnormal returns (Fama,
1998; Kothari, Sabino, and Zach, 1999). Our evidence is difficult to reconcile with the
first and third explanations above, but fits naturally with the second explanation.
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