Earnings Surprises, Growth Expectations, and Stock Returns:

to positive and negative surprises. When earnings news is positive, returns climb steeply
over a small range of forecast error, to a maximum a little over 10% (thus even when the
news is good, the reaction is stronger for growth stocks). However, when firms miss
their forecasts the effect is dramatic. For even small forecast errors (of less than 0.5% of
stock price) the stock price reaction declines rapidly into the –10% to –15% range, and
continues to increase more slowly beyond this, into the –15% to –20% range. The sharp
drop is the earnings “torpedo” – the fact that firms miss analysts’ forecasts, even by small
amounts, causes disproportionately large stock price declines. It is the fact of the missed
forecast, rather than its magnitude, that seems to “matter” to investors. Another aspect of
our results that is clear from figure 5 is the fact that when earnings news is positive,
growth stocks outperform value stocks, but that when growth stocks disappoint, they
underperform value stocks by substantially more than they outperform when the news is
good (i.e., the area between the two plots is much greater in the negative forecast region
than in the positive forecast region). As our regressions show, it is this large differential
reaction to bad news that accounts for the overall underperformance of growth stocks.
We turn to these regressions next.
4.2 Regression analysis
In this section, we provide statistical tests of our predictions using regression
analysis. We begin in table 3 by regressing stock returns on growth portfolio
membership and both the sign of the earnings surprise and the magnitude of the earnings
surprise. We further allow for a growth variable interaction with each of these
explanatory variables. The purpose of these regressions is to demonstrate that the
negative relation between growth and future stock returns (the MB effect) is robust to the
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