The Implications of Annual Report's Risk Sentiment for Future Earnings and Stock Returns
Posted: 14 Mar 2006
Date Written: March 2006
I examine the implications of corporate annual reports' risk sentiment for future earnings and stock returns. I measure the risk sentiment of annual reports by counting the frequency of words related to risk or uncertainty in the 10-K filings. I find that an increase in risk sentiment is associated with lower future earnings: Firms with a larger increase in risk sentiment have more negative earnings changes in the next year. Risk sentiment of annual reports can predict future returns in a cross-sectional setting: Firms with a large increase in risk sentiment experience significantly negative returns relative to those firms with little increase in risk sentiment in the twelve months after the annual report filing date. A hedge portfolio based on longing firms with a minor increase in risk sentiment of annual reports and shorting firms with a large increase in risk sentiment generates an Alpha of more than 10% annually measured using the four-factor model including the Fama-French three factors and the momentum factor.
Keywords: Annual report, risk sentiment, earnings, stock returns
JEL Classification: D80; G12, G14; M40
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