A Penny Saved is a Penny Earned: Avoiding Investment Losses Through the Early Detection of Financial Shenanigans

Abstract

In this study, we investigate the benefits available to investors for identifying firms exhibiting the early warning signs of “financial shenanigans” in the post Sarbanes-Oxley era. We examine a sample of 202 firms placed on the Center for Financial Research and Analysis / RiskMetrics Group’s Biggest Concerns List over the period from January 2005 through December 2008. Using calendar-time portfolio regressions, we find these firms underperform on a risk-adjusted basis while appearing on the list, as evidenced by significantly negative alphas. We also document significant negative cumulative abnormal returns immediately following the firms’ placement on the list and significantly negative holding period returns while they remain on the list. We find no significant differences in common firm characteristics between the biggest concerns firms and a matched sample of firms based on industry and size. Finally, we show the extent to which otherwise passive investors in various Russell indices could have boosted their overall returns by purging the firms appearing on the Biggest Concerns List from their portfolios.

Keywords: Financial Shenanigans, Sarbanes-Oxley, Portfolios, Passive investors