Academic journal article Academy of Accounting and Financial Studies Journal

Share Performance Following Severe Decreases in Analyst Coverage

Academic journal article Academy of Accounting and Financial Studies Journal

Share Performance Following Severe Decreases in Analyst Coverage

Article excerpt

INTRODUCTION

Earlier researchers, such as Chang, Dasgupta, and Hilary (2006), argue that security analysts likely help to mitigate information asymmetry between managers and outside investors by: (a) synthesizing complex information for less sophisticated investors; and (b) making private information available to the public. (Examples of private information include that gained from firm visits and, prior to enactment of Regulation Fair Disclosure, discussions with top managers.) Chang, et al., and several other studies provide evidence that analyst coverage is negatively associated with information asymmetry (Hong, Lim, and Stein, 2000; Gleason and Lee, 2003).

Other researchers provide evidence that, especially when confronted with complex information, analysts make important recommendation and forecasting errors that do not reduce information asymmetry (Gilson, 2000; Louis, 2004; Feng, 2005; and Shane and Stock, 2006). Even worse, analysts have come under heavy criticism in recent years for allegedly issuing intentionally biased recommendations or biased earnings forecasts in order to gain lucrative brokerage or underwriting fees for their firms. Evidence to support the claim that conflicts of interest lead analysts to intentionally biased recommendations or forecasts is provided by Lin and McNichols (1998), Michaely and Womack (1999), and others. Also, evidence that analysts tend to disproportionately cover firms that they view favorably is provided by McNichols and O'Brien (1997), Rajan and Servaes (1997), Bradley, Jordan, and Ritter (2003), and Cliff and Denis (2004). Building on studies that highlight analysts' economic incentives for providing firm coverage, Doukas, Kim, and Pantzalis (2005) state that analysts increase coverage for certain firms in anticipation of greater underwriting and brokerage business. In turn, firms receiving high analyst coverage experience high investor demand for their stocks, resulting in overvaluation. Doukas, et al., find that firms receiving high analyst coverage have overvalued stocks that subsequently experience low future returns. They also find that firms receiving weak analyst coverage have undervalued stocks that subsequently experience high future returns.

We add to the literature on analyst behavior and security prices by examining shareholder reactions to severe losses in analyst coverage. There are two main reasons for analysts to drop existing coverage of a firm. First, analysts may conclude that the firm is no longer a good prospect for generating future income (through brokerage and underwriting fees) for the analyst's firm. Second, analysts may become pessimistic about the firm's future share performance and would rather drop coverage than issue a sell recommendation. These motivations are not mutually exclusive and brokerage firms rarely give public explanations for dropping coverage of a firm's stock. Therefore, shareholders are left alone to infer the information content of dropped analyst coverage. If shareholders believe that analysts generally drop coverage because they have private, negative information that they choose not to reveal through a sell recommendation, then shareholders would interpret dropped coverage as "bad news." This bad news would likely motivate many shareholders to sell their shares in the firm. A severe decrease in analyst coverage of a firm might lead to shareholder overreaction and security undervaluation because shareholders fear that analysts have chosen to drop coverage rather than to issue sell recommendations. If shareholders initially overestimate the role of private, negative information in analysts' decisions to drop coverage, then an initial mispricing caused by shareholders' overreaction to dropped coverage would only be corrected over time as the feared bad news fails to materialize. Under this scenario, positive abnormal returns would be earned in a period following dropped analyst coverage.

Our primary research question is whether firms suffering severe losses in analyst coverage subsequently earn abnormal returns consistent with investor overreaction and security mispricing. …

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