What happens when publicly traded companies issue their annual 10-K reports? Empirical evidence suggests that the stock market pays immediate attention to the tables, but less to the text. Yet the information in the text eventually is reflected in stock prices. In other words, for a significant period of time, price-relevant information about public companies is effectively hiding in plain sight.
Over the past two decades, the amount of text included in 10-Ks has grown substantially. For example, for the typical company, the number of words quadrupled, to more than 60,000 in 2017 from about 15,000 in 1995. Over roughly the same period, the amount of boilerplate and repetition increased; for the median firm, redundant sentences also quadrupled. Finally, the text has become more consistent from year to year, as the share that changed from one report to the next shrank.
A team of economists from Harvard Business School and the University of Illinois at Chicago has studied the value of the textual disclosures in these reports. The authors find that although there is little immediate impact, modifications to the text are highly predictive of changes in the company’s stock price over the months after the report, as the implications slowly and gradually become apparent to the market.
The vast majority of the text changes are concentrated in the Management Discussion and Analysis (MD&A) of the 10-K. These disclosures also tend to be more negative than positive, perhaps because the reports are typically drafted by lawyers who tilt toward disclosing negative trends more than positive ones. When the authors applied natural language text processing to evaluate the changes, they found that 86 percent reflected negative sentiment shifts and only 14 percent positive shifts. Furthermore, the text differences contain useful information for predicting future earnings: Changes in the 10-K written text today predict earnings surprises in the future.
Given this negative bias to the textual changes and their ability to predict future earnings, the study shows that companies with 10-K text modifications experience noticeably lower future stock returns than other firms. For example, the authors construct a portfolio that goes long on companies with no material textual changes and shorts firms that contain such changes. That portfolio earns an abnormal positive return of up to 7 percent per year above the market.