Quickly Disclosing Bad News Could Help Companies Benefit from Market Signals

The movement of a company’s stock price contains a wealth of information. The price essentially encapsulates traders’ knowledge about all the factors affecting the company’s prospects, ranging from consumer preferences to government regulations. If the firm announces a decision to pursue a new product or strategy and the stock price rises, managers can assume they’re on the right track and perhaps invest even more money in that venture. Conversely, if the price plunges, the company might realize that they should reverse course.

“You can look at the market reaction as an approval or disapproval of what you are doing,” says Zeqiong Huang, an assistant professor of accounting at Yale SOM. “If the market is giving me a thumbs-down,” then the firm can backtrack.

Huang and her colleagues wondered if managers could learn even more from the market, based on the actions of traders who were aware of issues relevant to the firm’s strategic decisions. In particular, the researchers wanted to investigate the effect of the company’s disclosure policy—that is, how quickly the firm revealed bad news about expected losses to shareholders.

Disclosing negative forecasts faster than positive ones could ultimately help the firm make better strategic decisions, according to a model developed by Huang’s team. That approach pays off at times when the company doesn’t have any bad news to share. If traders know that a company usually reveals bad news promptly, the study finds, they are more likely to sell its stock short when they have knowledge of external factors that could cause problems in the future. When traders bet on the stock price dropping, it alerts managers that they may be leading the firm in the wrong direction.

“Price has been a very powerful, efficient signal,” Huang says. With this disclosure system, the company can extract more information from the market, and “from that information, we take the right path forward.”

Informed traders could possess a variety of information that firm managers lack. Let’s say the company hopes to start selling its products in China. Traders with family, friends, or other connections in that country might have a more accurate sense of the local culture, consumer habits, and policy environment. When they see the firm’s announcement to expand their market, the traders might believe that the move is a misstep and predict that the stock price will fall.

Those traders can respond by short selling. That is, they borrow shares of the firm, sell them at the current price, and buy them back later when the price drops. Then they return the shares to the borrower and keep the difference.

For managers who want to learn as much as possible from their company’s stock price movements, short selling is a useful signal. The question is how to use disclosure policy to motivate informed traders to short sell whenever they see the firm making a poor decision.

Huang and her colleagues—Qi Chen and Xu Jiang at Duke University, Gaoqing Zhang at the University of Minnesota, and Yun Zhang at George Washington University—examined three disclosure systems that could affect trader incentives. In the first system, the firm was more likely to release bad news than good news. In the second, the reverse was true. And in a neutral system, they were equally likely to disclose good and bad news.

The researchers then created a model in which a firm chose a disclosure system and released information accordingly. Informed traders could buy or sell, relying on their knowledge of factors affecting the firm’s prospects. Based on the orders coming in from both informed and uninformed traders, a market maker—a bank or other firm that maintains market liquidity by buying and selling at the market price—sets the stock price.

The model confirmed previous research showing that under a neutral disclosure system, informed traders had a stronger incentive to make a move when they felt the firm was going in the right direction than when they saw rough waters on the horizon. Consider the scenario in which a company announces a new project that seems promising and traders buy shares, pushing up the stock price. The firm then learns from the market’s sign of approval and makes better decisions—for instance, continuing to pursue or allocating more resources to that project. The improved decisions drive the firm’s value even higher, and traders are rewarded for their foresight.

But traders’ motivation to take action was weaker if they believed the company had made the wrong decision. If they engaged in short selling and pushed the price down, the firm would realize they’d made a mistake and change direction, bumping the price back up.

“Short sellers will get burned,” Huang says. “They were betting on the price falling.”

Huang’s team found that the logic changed if the firm adopted a general policy of disclosing bad news quickly. If a company is known for releasing bad news quickly, the market maker can assume that there are no problems whenever the firm is quiet. They’re more optimistic about the firm’s prospects and set a higher stock price. As a result, traders with knowledge of potential problems are more motivated to short sell; the higher current price means they’ll reap bigger profits later. The short selling then alerts the firm that they should reconsider their strategy.

The study suggests that companies should be proactive about revealing difficulties they foresee with their projects. While the increased incidence of short selling will drive down the stock price in the short term, that’s better than the alternative. If firms blindly charge ahead on the wrong path, Huang says, eventually “the price will tank even more.”