Caution: Watch for Red-Flags Words

The average annual 10-K financial statement a public company files with the Securities and Exchange Commission runs about 35,000 words. It's a daunting task to read through a filing, and even more so to absorb the pertinent information that gives an accurate picture of the health of the company. Investors tend to focus on the numbers, but recent research by two Notre Dame finance professors shows that the words matter, too.

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Tim Loughran and Bill McDonald studied more than 50,000 10-Ks filed during 1994-2008 to see whether 13 so-called "red flag" phrases were related to suspicious—if not illegal— behavior on the part of managers. The phrases were first described in a Barron's article, "Watch Their Language" by Vito J. Racanelli. They include such terms as "unbilled receivables," "bill and hold" and "related party transaction."

What the business professors found was that, yes, the red-flag phrases did signal trouble. In "Barron's Red Flags: Do They Actually Work?" Loughran and McDonald describe some of the problems associated with the "worrisome words," including excess filing period returns, analyst earnings forecast dispersion, subsequent return volatility and fraud allegations.

In particular, using textual analysis and the documents available on the EDGAR database of financial filings, the researchers found:

• When a company uses phrases such as "substantial doubt" or "materially and adversely affected" in its 10-K, its stock returns are lower when the document is filed with the SEC.
• The same terms also were found to be linked to greater analyst forecast dispersion, which refers to the amount of disagreement among analysts with regard to the expected earnings per share. It serves as a measure of analysts' ex­pectations about the firm's future profitability.
• When "related party transaction" or "consulting relationships" appear in a filing, the firm's stock return is more volatile in the following year.
• If the filing contains unusual phrases relating to corporate governance and earnings, there is an increased likelihood that the firm will later be accused of fraud. Thus, if phrases such as "unbilled receivables" or "bill and hold" appear, it is more likely that someone will subsequently file a class-action lawsuit against the company.

"Essentially, we are examining very small effects, but ones that we expect to be zero in an efficient market," said McDonald. The findings are especially significant to mega-traders who trade millions of shares of stock daily, usually using automated systems. Here, even very small changes can translate into millions of dollars. "The crux of our ‘red flags' paper is that these phrases are signals that the filing needs to be re-examined carefully to identify the exact context of the red flag," he added. "Measured semantics are not likely the central driver of stock prices, but we are finding that, at the margin, they do impact them."

In an earlier paper, "When is a Liability not a Liability? Textual Analysis, Dictionaries, and 10-Ks," the researchers used an identical 10-K sample to examine whether the Harvard Psychosociological Dictionary could be used to identify problems in the financial statements.

What they reported was that certain words such as "liability" and "expense," which carry a negative connotation in common use, have a straightforward meaning within the context of a company's 10-K. They proposed an alternative list of 2,337 words that are likely to have a negative meaning when used to describe opera­tions. The Notre Dame Finance Dictionaries— recently licensed by Dow Jones for use in its new products that perform semantic analysis of its news feeds—can be found can be found here. The study is forthcoming in the Journal of Finance.