Investigating the Incremental Usefulness of Firm-Specific Differential Persistence of Earnings Components on Abnormal Excess Returns

The purpose of this study is to examine the incremental usefulness of firm-specific differential persistence of earnings components on abnormal excess returns. In most previous research, the differential persistence of earnings components has been estimated using a cross-sectional approach. The main assumption in the cross-sectional approach is that the differential persistence of accruals and operating cash flows are equal in all companies, while the differential persistence of earnings components is a firm-specific phenomenon and this approach makes it possible to estimate a variety of differential persistence among different companies. For this purpose, this study presents a trading strategy based on firm-specific estimates of differential persistence of earnings components that its effect on the abnormal excess returns has been examined in the presence or absence of loss companies. The strategy is to measure the difference between the forecasted earnings based on firm-specific differential persistence of earnings components and the forecasted earnings based on the operating earnings, which is called the unexpected earnings.

To test the hypotheses, we selected the data of 143 companies listed on the Tehran Stock Exchange from 2001 to 2018 using the systematic elimination method. For analyzing information and testing hypotheses, Carhart's (1997) four-factor model has been used.

The findings of this study showed that the differential persistence of earnings components leads to abnormal excess returns that increase in the absence of loss companies. Many argue that a trading strategy based on firm-specific differential persistence of earnings components, on the one hand, and investors fixation on earnings, on the other hand, identifies useful information that is often overlooked by unaware investors. Thus, this trading strategy targets the mispricing of securities and, by identifying mispriced securities, earns abnormal excess returns. Also, according to Kraft et al. (2006), investors' fixation on earnings does not misprice loss companies. This issue is because the investors consider the reported losses of the companies and then analyze the components of the losses and the reasons. Thus, the presence of loss companies in estimations weakens the abnormal returns of the trading strategy based on the firm-specific differential persistence of earnings components.

This study shows that investors can achieve abnormal excess returns by considering the information content of the earnings components in the valuation of securities.