Published October 30, 2009

Watch the language - it's earnings season

By WONG WEI KONG

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IT'S earnings season and most of the focus rightly is on the financial numbers reported by companies.

So far, the figures haven't been bad. At the end of last week, the combined net profit of $693.4 million for the 21 Singapore Exchange-listed companies that have filed results for Q3 2009 was a 24.6 per cent increase over the same period last year. Of the 21 companies, 13 reported higher profits from a year ago.

But investors may want to look at something else too, if they want to have an indication of a company's future performance. And it has nothing to do with figures, and all to do with words.

At least, that is what's suggested by research done so far into earnings press releases, often seen as the major news event of the season for many companies as well as investors, analysts and the financial media.

The language used by companies to communicate their earnings has been the subject of academic studies for some time. The basis of this is that the language used in a press release is likely to communicate values and sentiments that are not neutral. This is because while the disclosure of numbers is bound by regulatory requirements, companies have a relatively free hand in their use of language in earnings press releases as long as it is accurate and not misleading. So a lot can be read into the choice of words, and the tone of the language used.

If one accepts this argument, then the findings of a recent paper by the research division of the Federal Reserve Bank of St Louis, called Beyond the Numbers: An Analysis of Optimistic and Pessimistic Language in Earnings Press Releases, are worthy of some thought, if not debate.

The paper, the first of its kind, examined whether managers use optimistic and pessimistic language in earnings press releases to provide information about expected future performance to the market. It also looked at whether the market responds to optimistic and pessimistic language usage in earnings press releases, after taking into account any earnings surprise and other factors likely to influence the market's response to the earnings announcement. The researchers used textual-analysis software to measure levels of optimistic and pessimistic language for a sample of about 24,000 earnings press releases issued by US companies between 1998 and 2003.

One key finding was that the levels of optimistic and pessimistic language used by managers in earnings press releases reliably predicted future performance. This suggested that managers used language to communicate information to investors about their future earnings expectations.

Second, there appeared to be a significant market response to the levels of optimistic and pessimistic language used in earnings press releases on top of the reaction to other factors such as earnings surprises and whether the firm beat analysts' expectations, experienced negative earnings, or had included a management forecast. In other words, and all things being equal, the market seemed to put a premium on optimistic language used in press releases.

Finally, the unexpected use of optimistic and pessimistic language was priced, whereas expected usage wasn't. This suggested that companies over time had built expectations about the way they use language, so the market reacted to levels of optimistic and pessimistic language usage that differed from investors' expectations. So the market seemed to react more to optimistic language used by a company normally conservative in its choice of language, for instance.

Without a proper study done on Singapore companies, it's impossible to say if these findings are applicable to the local context. Also, measuring language use is arguably a less exact science than analysing numbers. But it still suggests it might be worthwhile for investors to take more note of the language companies use in reporting their earnings. How companies choose their words may well have a bearing on future financial or stock price performance.