Dispersion in Analysts’ Earnings Forecasts and Market Efficiency

• Author: Byoung‐Kyu Min,Tong Suk Kim,Ki‐Deok Kim
• DOI: http://doi.org/10.1111/irfi.12204
• Date: 01 March 2020
• Published date: 01 March 2020

Dispersion in Analysts’Earnings

Forecasts and Market Efficiency*

TONG SUK KIM

†

,KI-DEOK KIM

‡

AND BYOUNG-KYU MIN

§

†

College of Business, Korea Advanced Institute of Science and Technology (KAIST),

Seoul, Republic of Korea

‡

Samsung Asset Management, Seoul, Republic of Korea and

§

Discipline of Finance, Business School, The University of Sydney, Sydney, Australia

ABSTRACT

Recent studies show that firms with higher analysts’earnings forecasts dis-

persion subsequently have lower returns than firms with lower forecasts

dispersion. This paper evaluates alternative explanations for the dispersion–

return relation using a stochastic dominance approach. We aim to discrimi-

nate between the hypothesis that some asset pricing models can explain the

puzzling negative relation between dispersion and stock returns, and the

alternative hypothesis that the dispersion effect is mainly driven by investor

irrationality and thus is an evidence of a failure of efficient markets. We find

that low dispersion stocks dominate high dispersion stocks by second- and

third-order stochastic dominance over the period from 1976 to 2012. Our

results imply that any investor who is risk-averse and prefers positive skew-

ness would unambiguously prefer low dispersion stocks to high dispersion

stocks. We conclude that the dispersion effect is more likely evidence of

market inefficiency, rather than a result of omitted risk factors.

JEL Codes: G12; G14

Accepted: 9 May 2018

I. INTRODUCTION

It has been documented that firms with higher analysts’earnings forecasts dis-

persion subsequently have lower returns than firms with lower forecasts disper-

sion. In particular, Diether et al. (2002) show that an equal-weighted portfolio

of stocks in the highest quintile of dispersion underperforms the portfolio of

stocks in the bottom quintile by 9.48% per year, and this is particularly true for

small stocks and “past losers.”If forecast dispersion proxies for future cash flow

uncertainty, it is puzzling that investors pay, rather than require, a premium

for bearing such uncertainty. Furthermore, this cross-sectional dispersion–

return relation cannot be explained by the standard asset pricing models,

* We would like to thank Prof. Ramazan Gencay (Editor) and an anonymous reviewer for their

valuable and insightful comments. This work was supported by the National Research Foundation of

Korea Grant funded by the Korean Government (NRF-2010-327-B00257).

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:1, 2020: pp. 247–260

DOI: 10.1111/irfi.12204