On Corporate Earnings Calls, Investors Can Believe the Hype
The stock market listens to executives who speak in superlatives.
Based on the research of Jeffrey Hales
Don’t believe overblown talk. That’s a useful principle in advertising and politics, where audiences are often skeptical of speakers prone to exaggeration.
In business communications, though, it turns out that you can believe the hype — if it’s coming from executives on quarterly earnings calls. New research from Texas McCombs finds that the use of extreme language is actually beneficial for capital markets. It helps investors and analysts to more accurately interpret a company’s numbers.
“The market appears to be paying attention not just to quantitative numbers, but also to what management is saying around them and how they’re saying it,” says Jeffrey Hales, accounting professor and co-author of the new paper, “Hyperbole or Reality? Investor Response to Extreme Language in Earnings Conference Calls.”
Companies often use language more freely in such calls than in their written reports, he says. When executives speak in superlatives, their words can cause a stronger reaction in stock prices, boost trading volume, and alter analyst forecasts. They can even foreshadow a company’s future earnings.
A Dictionary for Corporate Diction
Hales has long been fascinated by how corporate communications affect stock trading. In an earlier experiment, he found that individual investors reacted to vivid language in corporate reports, especially when investors had strong motivations to scrutinize it. But would their collective reactions be strong enough to move markets outside of a laboratory setting?
Thanks to advances in technology, Hales found a way to investigate that question. With Khrystyna Bochkay of the University of Miami and Sudheer Chava of the Georgia Institute of Technology, he automatically analyzed the transcripts of 60,940 earnings calls from 2006 to 2015. The goal: to measure the amount of extreme language in each call.
To measure it, the researchers needed a yardstick. That led them to create a dictionary.
Out of the transcripts, computers extracted 23,355 common words and phrases. Each one got rated on a scale of linguistic extremity by five live reviewers. Numbers ranged from -5 for highly negative to 5 for highly positive.
When reviewers’ scores were averaged, words like “astonishing,” “incredible,” and “exceptional” got ratings of 5. A slightly less extreme 4 went to expressions like “strong,” “tremendous,” and “exceed expectations.” On the negative end of the scale, “failure,” “horrible,” and “bankrupt” drew a -5.
Using their dictionary, the researchers analyzed each call, comparing percentages of extreme words — from a 4 to a 5 — with those of moderate ones — from a 1 to a 3.
Trading in Extremes
Word choice, they discovered, affected trading volume during the three days after a call. The most linguistically extreme calls — both positive and negative — produced 22% higher trading volume than the most straightforward ones.
Similarly, for stock prices both positive and negative speech moved investors. For example, firms with the highest (or lowest) ratios of extreme praise to extreme blame saw 20% higher (or lower) three-day returns than the average stock.
“Seeing extreme words that are positive, and are not offset by negative words, helps the market sort out whether it should be particularly happy.” — Jeffrey Hales
Analysts, like investors, also seemed to take notice. Extreme language made them more likely to revise forecasts and recommendations to buy, hold, or sell that company’s stock.
“It puts some color on the numbers and what they actually mean,” says Hales. “It could also stimulate analysts to go back to the numbers and try to understand why management is using certain language.”
Lingering Linguistic Effects
The implications don’t stop there. Extreme language by executives predicted corporate performance a year later. A 41% rise in positive language equaled 51% higher future sales, as a percentage of assets.
The words themselves aren’t affecting earnings, Hales notes. Rather, it’s that executives are using them appropriately. If they use superlatives to describe a firm’s finances, future earnings confirm that they were right.
“Management appears to be reserving extreme language for stuff that’s credible and that the market can expect to show up over the next year.” — Jeffrey Hales
Hales credits the regulations that govern corporate disclosures. “If we had a weaker regulatory system, it’s possible that managers would abuse the use language more than they appear to be doing,” he says.
The lesson for investors is not to dismiss corporate big talk as pure hype, he says. “Take a closer look and see whether they have a compelling case to be using that language.”
CEOs can take heart from these findings, too. “Don’t be afraid to use language you think is a bit extreme if you think it’s supported by underlying facts,” Hales says. “It helps you communicate more effectively with the marketplace.”
Should a CEO feel tongue-tied, he adds, never fear. They can search for inspiration in his downloadable Dictionary of Extreme Language.
“Hyperbole or Reality? Investor Response to Extreme Language in Earnings Conference Calls” appears in the March 2020 issue of the Accounting Review.
Story by Steve Brooks