Is Conditional Persistence Fully Priced?

Amir, Kama and Livnat (2011) argue that the market reaction to an accounting variable should depend not on its unconditional persistence (a variable’s autocorrelation coefficient), but on its conditional persistence (the power of a variable’s persistence to explain the persistence of a variable higher in the hierarchy). They provide evidence supporting this argument using the DuPont decomposition of ratios. We conjecture that equity investors do not fully price accounting information based on their conditional persistence, but instead are fixated on the traditional concept of unconditional persistence in valuing stocks, leading to predictable post-SEC filing stock returns. First, we show that conditional persistence is reflected in contemporaneous stock returns. Then, we construct a trading strategy based on the distance between the conditional and the unconditional persistence of operating profit margins (OPM) and asset turnover (ATO). We find that buying stocks of firms with relatively high conditional persistence of OPM, and selling stocks of firms with relatively low conditional persistence of OPM, earns positive and significant abnormal stock returns for buy-and-hold periods of 90, 180, and 365 days starting after SEC filings. Furthermore, when the conditional persistence of OPM is relatively low, the post-announcement drift related to earnings surprises diminishes substantially, and post-announcement drift related to revenue surprises largely disappears. Our findings suggest that conditional persistence is not fully priced and may provide a plausible explanation for earnings and revenue surprise drifts.