The Contribution of Fundamental Analysis after a Currency Devaluation

Abstract

Investors' need for forward-looking accounting information is greatly increased when an economic shock occurs during a reporting period. This is particularly true when the shock occurs late in the reporting period, so that current earnings information cannot be extrapolated to the future. Under these conditions, earnings lose value relevance and investors are forced to rely on other information. The basic idea underlying this paper is that, when the value-relevance of earnings is reduced by severe economic change, the detailed performance information provided in financial statements may still be useful in predicting future earnings and cash flows. Currency devaluations provide a natural experimental setting to investigate the effects of severe economic change. The findings from this setting likely extend to other instances in which firms encounter an economic shock during a reporting period (e.g., a terrorist attack, an oil embargo, or a labor strike).

The specific setting we investigate is the December 1994 peso devaluation in Mexico. The economic shock from the peso devaluation was typical of other currency devaluations. Inflation increased dramatically from 7 percent in calendar 1994 to 52 percent in 1995, and stock prices dropped by about 50 percent. A unique aspect of the 1994 Mexican devaluation is that most of the exchange rate decline occurred during the final week of December. The timing of the peso devaluation produces an ideal research setting: First, 1994 earnings cannot be extrapolated to the future so investors need alternative information. Second, we can use annual report data to test whether pre-shock accounting information can provide forward-looking information about post-shock operating performance and stock returns.

Associations with contemporary returns show that earnings in the year of the devaluation lose value relevance (as expected), but fundamental signals, which incorporate the more detailed accounting information provided in financial statements, retain considerable explanatory power (25 percent). After the devaluation, fundamental signals based on changes in selling and administrative expenses and changes in gross margin are significant in several analyses, including predictions of future earnings, analysts' forecast revisions, and analysts' forecast errors. Because analysts underutilize those signals, an opportunity exists after the devaluation for a substantial profit from a zero investment trading strategy.

JEL Classification: G12, G14, M41, N20