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  • 1. UNDERWRITER ANALYST RECOMMENDATIONS: Conflict of Interest or Rush to Judgment? Craig Dunbar, Chuan-Yang Hwang and Kuldeep Shastri * First Draft: November 1996 Current version: September 1999 * Dunbar: Richard Ivey School of Business, University of Western Ontario, London, Ontario, Canada, N6A 3K7; Hwang: Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong; and Shastri: Katz Graduate School of Business, University of Pittsburgh, Pittsburgh, PA, 15260, USA. We would like to thank Christopher K. Ma for providing us with the analyst recommendation data that is used in this study. We thank Paul Irvine, Jonathan Karpoff, Josh Lerner, Laura Robinson, Jay Ritter, Kent Womack, and seminar participants at the Securities and Exchange Commission, the University of Western Ontario, and the 1997 Financial Management Association meetings for useful comments. We also thank Amy Bonkoski and Jonathan Clarke for excellent research assistance.
  • 2. UNDERWRITER ANALYST RECOMMENDATIONS Corresponding Author Craig Dunbar Richard Ivey School of Business University of Western Ontario London, ON, N6A 3K7 Canada Abstract This paper provides an analysis of the short and long run stock market reaction to analyst recommendations on newly public firms. The reaction to underwriter non-initial buy recommendations is more positive than the reaction to buys from non-underwriters. This is consistent with underwriter recommendations being more informative given their “inside” information. In contrast, the reaction to initial underwriter buys is insignificant and less positive that the reaction to buys from non-underwriters. This is consistent with underwriter analysts facing significant conflicts of interest. It is also consistent with initial underwriter buys being uninformative since they reiterate implicit recommendations made in the IPO.
  • 3. I. Introduction The potential conflict of interest between an investment bank’s corporate finance group and its brokerage operations has been the focus of a large number of recent news reports. For example, a May 4, 1996 article in the Economist reports that “most investment banks besides buying and selling shares on behalf of investors, also serve a second set of clients - the firms whose shares they trade. It is common practice for the corporate finance arm of such banks to underwrite and bring to market new equity issues, even as their stockbroking division recommends the same share to their other customers. Can they be trusted?” Along the same vein, in a January 10, 1993 article in the Wall Street Journal, William Power states that “a funny thing usually happens about a month after a hot new stock offering. Almost like clockwork, a prominent Wall Street brokerage firm will issue a ‘buy’ recommendation. In response, an already highflying stock, frequently rises even more during the following days or weeks. Traders have a name for this. It’s the post-offering ‘booster shot.’ What many investors do not realize is that these post-offering buy recommendations are coming from the underwriters - the very Wall Street firms that sold the stock to the public in the first place.” One example of this conflict of interest is the initial public offering of Alteon, Inc. According to the Wall Street Journal, “the biotech firm went public in 1991. Stock offered at $15 nearly doubled. Alex, Brown & Sons, the lead underwriter, followed with a buy recommendation at $24/share. Two years after the initial public offering, Alteon was trading at $10.” This example suggests the existence of a conflict of interest between the different functions performed by investment bankers. 1
  • 4. Michaely and Womack (1999) provide a formal examination of the stock price impacts of this inherent conflict. They analyze a total of 214 buy recommendations that were made on First Call for 200 firms that went public in 1990 and 1991. They argue that underwriters face a conflict of interest. In this story, conflicted underwriters may make buy recommendations on poorly performing firms (“booster shots”) whose prospects do not merit such a recommendation.1 If the market recognizes this conflict of interest, the return at the time of a buy recommendation made by the lead underwriter in the firm’s IPO (referred to in the remainder of this paper as “underwriter buy recommendations”) should be less positive than the return at the time of a buy recommendation made by other, non-affiliated, analysts (referred to in the remainder of this paper as “non-underwriter buy recommendations”).2 The initial reaction must be less than complete, however, since the buy recommendation is intended to postpone rather than accelerate the impounding of negative information into a company’s stock price. Therefore, the long run return following underwriter buy recommendations would be less positive than that following non-underwriter buys. An alternative to the conflict of interest is the possibility that underwriter buy recommendations are more informative than recommendations by unaffiliated analysts. Analysts have strong incentives to produce accurate recommendations. Accuracy improves the probability an analyst will be named by Institutional Investor magazine as 1 Underwriters could have numerous reasons for providing such booster shots. As noted by Michaely and Womack, a significant portion of a research analyst’s compensation is determined by his or her “helpfulness” to the corporate finance group and their capital raising efforts. The presence of a strong and supportive research group is often argued to be a significant factor in the selection of an investment bank to help a company raise capital. Failure to positively cover firms it has helped go public could hurt the bank’s ability to generate future business. The investment bank, as market maker, also develops an inventory of stock in the company that they help to go public. The booster shot could improve their ability to sell those shares at favorable prices. We do not attempt to differentiate between the possible stories that would result in a conflict of interest. 2 The return around underwriter buys could similar to the return around non-underwriter buys, however, if the market is completely fooled by the “booster shot”. 2
  • 5. an “All-American”, for example. Dunbar (1999) reports that changes to an investment bank’s All-American ranking has a positive impact on its IPO market share. The corporate finance group, therefore, would also want their firm’s analysts to have a track record of accurate recommendations. Given these incentives and the analyst’s superior information on the IPO firm (due, in part, to their participation in the investment bank’s extensive due diligence investigation), underwriter buy recommendations should be more informative. If the market believes that underwriter buy recommendations are more informative, the return at the time of an underwriter buy recommendation should be more positive than the return at the time of a non-underwriter buy recommendation. If the market’s response were not complete, the long run return following underwriter buy recommendations would be more positive than that following non-underwriter buys.3 Michaely and Womack’s (1999) results are consistent with the conflict of interest hypothesis. They find that underwriter analysts recommend the poorly performing stocks of their clients in an attempt to shore-up prices. They also find that the market recognizes that these recommendations are less credible than those by non- underwriter analysts since the stock price reaction to underwriter recommendations is less positive than that to those by non-underwriters. Finally, they find that the long-run performance after the recommendation is significantly more negative for firms that are recommended by their underwriters as compared to the ones that are recommended by non-underwriters. Based on this evidence, they conclude that the recommendations by underwriter analysts show significant evidence of bias and conflict of interest.4 3 If the information content of the recommendation were fully reflected at the time of the recommendation, the long-run performance would be no different between groups. 4 3
  • 6. The purpose of this paper is to re-examine the stock price impacts of underwriter recommendations. Like Michaely and Womack (1999), we consider whether the short and long-run price effects of these recommendations are consistent with underwriters being more or less credible given their past relation with the firm. Our study differs in two important respects, however. First, we consider the sequence of underwriter buy recommendations. The first buy recommendation by the underwriter analyst (referred to in the remainder of this paper as “underwriter initial buy recommendations”) is likely to be more conflicted than subsequent buy recommendations (referred to in the remainder of this paper as “underwriter non-initial buy recommendations”) since reputational pressures to support the issue in the early aftermarket are greater. 5 Also, even if the underwriter has superior information regarding the issuer, underwriter initial buy recommendations are less likely to be informative. By acting as the underwriter in an IPO, the investment bank implicitly is making a buy recommendation. If the brokerage arm of the bank makes a buy recommendation shortly thereafter, is this informative? Second we consider subsequent recommendations by underwriters when examining long-run performance of firms. It would not seem appropriate, for example, to consider negative long-run performance in the year after a buy recommendation as evidence of conflict of interest if the underwriter reverses its recommendation before the negative performance is realized. We analyze 847 buy recommendations in 1992 through 1994 on 420 firms that went public in 1992. The initial market reaction is similar for underwriter and non- 5 As noted to us by one analyst, if the stock doesn’t perform in the longer-run, the management is most likely to be blamed. If the stock doesn’t perform in the initial aftermarket, the underwriter is likely to be blamed. 4
  • 7. underwriter buy recommendations (1.21% and 1.36% market adjusted returns, respectively). Differences emerge, however, when considering the sequence of the underwriter recommendations. The market reaction to underwriter initial buy recommendations is not significantly different from zero (-0.19% market adjusted return). It is significantly lower than the reaction to underwriter non-initial buy recommendation and non-underwriter buys, however. This is consistent with a conflict of interest. It is also consistent with initial recommendations being uninformative since they are essentially reiterations. The market reaction to underwriter non-initial buy recommendations is significantly positive and greater than the reaction to non- underwriter buy recommendations (2.98% market adjusted return versus 1.36%). This is consistent with underwriter recommendations being more informative given their superior information on the IPO firm. The long-run stock price performance is more negative for firms after underwriter than non-underwriter buy recommendations, consistent with conflict of interest, although the difference in returns is not statistically significant (the difference in size- matched one-year post-recommendation returns for the two groups is 5.6%). The sequence of underwriter buy recommendations has a significant impact on this finding, however. The long-run abnormal size-matched return for firms receiving an underwriter non-initial buy recommendation is 6.4% higher than that for firms receiving a non- underwriter buy recommendation, although the difference is not statistically significant. This is consistent with underwriter non-initial buy recommendations being more informative. On the other hand, the long-run abnormal size-matched return for firms receiving an underwriter initial buy recommendation is 11.8% lower than that for firms receiving a non-underwriter buy recommendation (significant at the 5% level). 5
  • 8. The negative post recommendation performance for initial underwriter buys is driven by a group of firms for which the underwriter reverses its recommendation with a subsequent sell. For this group, the one-year average abnormal size-matched return is -31.1 %. Much of this negative performance comes after the underwriter reverses its recommendation, however. Measured from the buy recommendation to the 1 year anniversary or the day of subsequent sell recommendation, whichever comes first, the average abnormal return for underwriter initial buy recommendations is only 6.8% lower than that for firms receiving a non-underwriter buy recommendation (the difference is not statistically different from zero). Thus, while the negative post-recommendation average performance is consistent with a “rush to judgment” on the part of the underwriter analyst, it is not consistent with conflict of interest. An example of such a rush to judgment is provided in a February 2, 1993 article in the Wall Street Journal. In this article, William Power describes Fresh Choice, a stock that “hit the market at $13 a share in early December 1992, underwritten by Alex, Brown and Sons. Fresh Choice soared to 22 by the time its quiet period expired in early January. Alex Brown’s Camille Humphries then put out an initial ‘buy’ report, boosting the stock even more during the following four weeks. At least Ms. Humphries wasn’t afraid to change her mind at some point. Before the stock market opened on Monday, she trimmed her recommendation to a ‘hold.’ The stock has fallen 3 points to 28 since then.” A few other studies have examined the impact of investment bankers’ affiliation with issuing firms and their recommendations. The main foci of these studies have been whether the existence of a relation between an investment banker and the issuing 6
  • 9. firm affects the earnings forecasts issued by the investment banker. For example, Lin and McNichols (1997) report that earnings forecasts by underwriters are no more favorable than those by non-underwriters around seasoned equity issues. Dugar and Nathan (1995) and Hansen and Sarin (1999) report similar evidence. Two studies also examine the recommendations of underwriter and non- underwriter analysts. Lin and McNichols (1997) report that underwriter recommendations are more positive than non-underwriter recommendations for firms around seasoned equity offerings. They report that the short and long run stock performance after underwriter buy recommendations is no different than that after non- underwriter buy recommendations.6 Overall, their results are inconsistent with both the conflict of interest and superior information hypotheses. The results in this paper differ largely because we consider underwriter initial and non-initial recommendations separately. The remainder of this paper is organized as follows. The next section provides a description of the data used in our analysis of underwriter and non-underwriter recommendations. The results are presented in Section III, while Section IV concludes the paper. II. The Data We initially collect data on all firm-commitment IPOs of equity in 1992 from Security Data Corporation’s (SDC’s) New Issues database.7 For each of these 420 6 Long run returns in Lin and McNichols (1997) are measured over either one year after the recommendation or until the recommendation is reversed. 7 We restrict the sample to securities offered by U.S. corporations and exclude closed-end fund and real estate investment trust offerings. We also exclude offers of American Depository Receipts and units 7
  • 10. offerings, we obtain data on the offering date (SDC variable D), the book manager of the offering (SDC variable BOOKPAR), the gross proceeds raised in the offering, excluding over allotments (SDC variable PROCDS), and the offering price (SDC variable P). The aftermarket prices for the stock and return data are obtained from the Center for Research in Security Prices (CRSP) database. Broker recommendations are obtained from Zack’s Investment Research, Inc. (Zacks). Zacks collects recommendations from individual brokers and translates them into the following codes: 1 for strong buy, 2 for moderate buy, 3 for hold, 4 for moderate sell and 5 for strong sell. For each recommendation made on a 1992 IPO firm, we identify the date of the recommendation, the recommendation code, the code for the broker’s prior recommendation on the firm (given a value 6 if there is no prior recommendation) and the name of the broker making the recommendation. Consistent with previous research using Zack’s data, recommendations are classified as “buys” if their code is strictly less than 3 and their prior recommendation code is strictly larger.8 If the prior recommendation is a 6, the recommendation is classified as an “initial buy.” Our initial sample consists of 1750 unique recommendations on firms going public in 1992. Table I summarizes the frequency with which recommendations are made on individual firms. The second column considers recommendations made by any broker. No recommendations are made on almost 47% of the IPOs in 1992. For those offerings receiving recommendations, most receive several. Of the 224 IPOs with recommendations, 84% receive 3 or more and 27% receive eight or more. The third (bundles of warrants and common stock). The restrictions are similar to those applied by Lee, Lochhead, Ritter and Zhao (1996). 8 For example, see Stickel (1995). 8
  • 11. column examines the frequency with which the book manager in the offering makes recommendations on the IPO firm. No recommendations by book managers are made in almost 62 % of the IPOs. For those with recommendations by the book manager, multiple recommendations are less common. Specifically, 56% receive only one recommendation while 16% receive three or more. The last column of Table I reports the frequency with which non-underwriters make recommendations. Approximately 49% of the IPOs receive no coverage by non-underwriters. Of the 213 IPOs with recommendations, 74% receive three or more and 20% receive eight or more (although not necessarily from the same broker). It should be noted that there are advantages and disadvantages to using Zacks as the source of broker recommendation information. A significant advantage is that Zacks covers a large number of brokers. For the period between 1992 and 1994, Zacks includes recommendations made by over 140 brokers in each year. In contrast, First Call, used by Michaely and Womack (1999), covers only 14 of the largest brokers. One consequence of this greater coverage is that more multiple recommendations are observed.9 This is important since we find significant differences in both short and long- term market reactions to initial and subsequent recommendations. However, the use of Zacks has two important disadvantages.10 First, Zacks relies on published reports by brokerage houses and not all comments made by brokers are disseminated as published reports. It is not obvious how to account for any bias that this may cause. We must be careful, nonetheless, to explicitly recognize that our conclusions apply only to published recommendations. Second, Zacks dates 9 Only 21 % of the IPOs in Michaely and Womack receive three or more recommendations. The corresponding figure in our sample is 84 %. 10 See Womack (1996) for a complete discussion. 9
  • 12. recommendations based on the date a report is published. In many cases, the content of a report is available to investors beforehand. While this should reduce the power of our tests examining the market response to recommendations, the effect does not appear to be significant. Importantly, our initial evidence on short- and long-run returns around buy recommendations is qualitatively similar to that found by Michaely and Womack (1999). III. The Results The Stock Price Impact of Recommendations For each buy recommendation on 1992 IPO firms (initial or otherwise), we obtain stock return data from CRSP for the three-day period surrounding the recommendation, and for the first year after the recommendation (250 trading days). Those recommendations on firms without CRSP data are excluded from the analysis.11 The resulting sample consists of 847 buy recommendations. We also collect the market returns over the same periods with the market being proxied by the Nasdaq composite index for Nasdaq listed stocks and the value weighted NYSE/AMEX index for all other firms. Finally, we also obtain returns for size-matched firms from the same exchange.12 11 We also exclude recommendations that are clearly in error. For example, recommendations by IPO book managers are reported within 25 days of the IPO in a few cases. The SEC (Rule 174 of the Securities Act of 1933, rule 15c2-8 of the Securities Exchange Act of 1934 and the 1988 revision to Rule 174) does not allow such activity. 12 The matched firms must have been trading for at least 5 years on the same exchange as the firm going public without having an equity offering and have the closest market capitalization to the IPO firm, computed on December 31 of the year prior to the IPO. If a matched firm delists prior to the period of analysis, proceeds from a sale at delisting are invested in the CRSP value weighted NYSE/AMEX index. The matching procedure is similar to that in Loughran and Ritter (1995). We also matched based on size and book to market ratio (the closest book to market ratio where firm size is between 70 % and 130 % of the issuer). The long-run performance using these matched firms is generally more positive. The evidence reported in this paper using size-matched returns is, therefore, biased towards finding evidence of a conflict of interest. 10
  • 13. Table II reports the stock price reaction around buy recommendations. 13 The price reactions in the three-day period surrounding the recommendation date are in line with ex ante expectations and previous evidence (e.g. Womack, 1996). Specifically, in this three-day period, stocks that receive buy recommendations from analysts increase in price by 1.34% on average (with a t-statistic of 5.3), while the market-adjusted price change is 1.09% (with a t-statistic of 4.4). Post-recommendation abnormal performance is defined as the difference between the buy and hold one-year return from the day after the recommendation for the firm and the average buy and hold return for four size-matched firms over the same period.14 We use multiple firms in our matching procedure because our sample size is fairly small. In such cases, abnormal performance can be biased by the selection of a few unusual matching firms. The post-recommendation performance of the stocks is consistent with the initial market reaction. An analysis of pre-recommendation performance indicates that firms exhibit significantly positive returns from the first trading day to the day before the buy recommendation. The Impact of the Relationship between the Analyst and the Firm Table II also reports the differential stock price impact of buy recommendations made by underwriter and non-underwriter analysts. In the three-day period around buy recommendations by underwriter analysts, stock prices do not change significantly after 13 We report means and standard t-statistics in Tables II through VI. The mean returns are qualitatively similar. Also, the significance of individual estimates is similar using non-parametric statistics, such as the Wilcoxan rank sum test. 14 Qualitatively similar results are obtained if the two-year post-recommendation period is examined. 11
  • 14. adjusting for market movements, whereas the group with non-underwriter buy recommendations experiences a significant (at the 1% level) increase of 1.16%. However, the difference between the means for these two groups is not statistically significant (with a t-statistic of 0.7). The difference in the post-announcement performance is not significant across the two groups, although the non-underwriter buy recommendations experience slightly higher returns in the 250 trading days following the announcement. The results also suggest that the pre-recommendation performance of stocks that receive underwriter buy recommendations is, on average, inferior to the pre- recommendation performance of stocks that receive non-underwriter buy recommendations. Specifically, the market-adjusted return from the first trading day after the IPO to the day prior to the recommendation is 10.0% for stocks with underwriter buy recommendations, while the corresponding return for the non- underwriter buy recommendation group is 23.9%. The difference in the two returns is statistically significant at the one-percent level with an associated t-statistic of 2.8. The two groups also differ in that recommendations by underwriters come, on average, earlier than those issued by non-underwriters. This is consistent with the hypothesis that underwriters provide early “booster shots” for poorly performing firms. The Impact of the Sequence of Underwriter Buy Recommendations Table III reports the stock price impacts of buy recommendations broken down by their sequence. The first column presents the evidence for non-underwriter buy recommendations, all of which are initial recommendations (repeating the evidence 12
  • 15. from Table II). The second column presents the evidence on underwriter initial buy recommendations. The third column presents the evidence on underwriter non-initial buy recommendations. The sequence of the underwriter recommendation has a substantial impact on the stock price reaction. In particular, the three-day market- adjusted return for initial underwriter buys is not significantly different from zero. In contrast, non-initial buys are associated with a three-day market-adjusted return of 2.55% that is significant at the 5% level. The difference between the two returns is 2.74% and has an associated t-statistic of 2.1. The three-day market-adjusted return for underwriter initial buy recommendations is significantly lower than that for non- underwriter buy recommendations. The three-day market-adjusted return for underwriter non-initial buy recommendations is significantly greater than that for non- underwriter buy recommendations. The size-matched abnormal 250 trading day return is most positive following underwriter non-initial buy recommendations (9.9%) and most negative following underwriter initial buy recommendations (-8.0%). The difference between these two abnormal returns is significant at the 10% level. Also, the size-matched abnormal 250 trading day return for initial underwriter buy recommendations is significantly lower than that for non-underwriter buy recommendations. The market-adjusted return from the IPO to the day before the recommendation is most positive for non-underwriter buys (it is only statistically significantly greater than the market-adjusted return from the IPO to the day before underwriter initial buy recommendations, however). The evidence suggests that the market views underwriter non-initial buy recommendations to be more informative. The abnormal short and long run price adjustments are most positive following underwriter non-initial buy recommendation. 13
  • 16. The evidence for underwriter initial buy recommendations, in contrast, is more consistent with conflict of interest. The short and long run price adjustments are most negative following initial underwriter buys. In Table IV, we examine underwriter initial buy recommendations more closely. We split the sample of underwriter initial buy recommendations into two groups: those with “reversals” within one year of the buy recommendation and those without “reversals”. A reversal occurs if the underwriter analyst changes his/her recommendation from a buy to a sell (the Zacks recommendation code is between 3 and 5 and the previous recommendation for the broker is given a strictly lower code). In the first column of Table IV we examine the 79 cases where no reversal occurs. The 3-day abnormal return around the underwriter initial buy recommendation is an insignificant –0.06%. The abnormal return in the year after the underwriter initial buy recommendation is an insignificant 5.5%. The second column of Table IV presents evidence for the 46 underwriter initial buy recommendations that are reversed within one year. The 3-day abnormal return around the underwriter initial buy recommendation is an insignificant –0.41%. The abnormal return in the year after the underwriter initial buy recommendation is –31.1% (significant at the 1% level). Most of this negative performance arises before the investment bank reverses its position. The abnormal size-matched return is –17.6% from buy to sell and –13.2% from the sell to the 250th trading day after the underwriter initial buy recommendation. While underwriters are willing to reverse their positions, they appear to wait until a significant amount of shareholder wealth is destroyed. Accounting for reversals, the size-matched abnormal returns after a buy recommendation are not significantly negative, however. The mean size-matched 14
  • 17. abnormal return from the day after the recommendation to trading day +250 or the day the recommendation is reversed (whichever comes first) is –3.0% for all 125 initial underwriter buys (t-statistic of 0.5). This is not statistically different from the long-run abnormal returns following underwriter non-initial buy recommendation and non- underwriter buys. We also break down the sample of underwriter initial buy recommendations based on various recommendation and IPO characteristics.15 In most cases, the pattern of returns is similar to that noted above for the full sample. One notable exception arises when we partition the recommendations based on venture capital backing of the IPO firm. In 63 cases where the IPO received no venture capital backing, the mean one-year abnormal performance after the underwriter initial buy recommendation is an insignificant 2.3%. In 62 cases where the IPO received venture capital backing, the mean one-year abnormal performance after the underwriter initial buy recommendation is –16.3% (significant at the 5% level). In 25 of these 62 cases, the underwriter reverses its recommendation within one year. The one year mean abnormal return for those 25 underwriter initial buy recommendations is –46.7% (significant at the 1% level). Most of this negative performance arises before the investment bank reverses its position. The abnormal size-matched return is –28.9% from buy to sell and –18.3% from the sell to the 250th trading day after the underwriter initial buy recommendation. These results are surprising because the long-run performance of all venture-backed IPOs in 1992 is not different that the overall sample 15 Characteristics include the overall timing of the underwriter initial buy recommendation (i.e. whether it is the first recommendation by any analyst for the firm; if it is not first, the relation between the strength of the underwriter recommendation and the most recent recommendation made by another firm’s analyst), the return from IPO to the underwriter initial buy recommendation (positive or negative), the reputation of the IPO underwriter (capital above $1 billion in 1992 vs. capital below $1 billion) and the presence of venture capital backing for the IPO firm (from Securities Data Company’s New Issues database) 15
  • 18. of 420 IPOs. Gompers and Lerner (1995) find that stock prices significantly decline after venture capital distributions. They argue that this is consistent with venture capitalists timing their distributions at the market peak. The evidence in this paper potentially indicates one source of this timing ability. It is possible that venture capitalists get underwriters to support prices so that they can distribute shares at higher prices. Overall, the evidence in Table IV does not support the conflict of interest hypothesis. Accounting for reversals, the long-run performance after underwriter buys is no different than that following non-underwriter buys, inconsistent with conflict of interest. The market reaction at the time of an underwriter buy recommendation is not significantly different from zero. The short and long run return evidence, therefore, supports the hypothesis that underwriter initial buy recommendations are uninformative IV. Summary and Conclusions This paper provides an analysis of 857 analyst buy recommendations on 420 firms that went public in 1992. Our analysis focuses on testable implications of two alternative hypotheses. First, conflict of interest for underwriter analysts suggests that firms receiving buy recommendations from the lead investment bank in their IPO have poor stock performance relative to firms receiving buy recommendations from other, unaffiliated, analysts after the recommendations. Second, the superior information of underwriters suggests that firms receiving underwriter buy recommendations have better stock performance relative to firms receiving non-underwriter buy recommendations at the time of and subsequent to the recommendations. 16
  • 19. We find that the returns in the 3-day period around buy recommendations and the 250 trading day post-recommendation abnormal returns are not significantly different across the groups with recommendation by underwriters and those by non- underwriters. We then consider initial and underwriter non-initial buy recommendations separately. The returns in the 3-day period around underwriter non-initial buy recommendations are significantly more positive than the returns for non-underwriter buys. The long-run performance after underwriter non-initial buy recommendation is also more positive than the long-run performance after non-underwriter buys (although not statistically significantly). This evidence is consistent with underwriter non-initial buy recommendations being more informative given their superior information on the firm. The returns in the 3-day period around underwriter initial buy recommendations are significantly less positive than the returns for non-underwriter buys. While this is consistent with conflict of interest, it is also consistent with underwriter initial buy recommendations being uninformative since they are essentially reiterations of the implicit buy recommendation made by the underwriter in the IPO. Accounting for recommendation reversals, the long-run performance after initial underwriter buys is no different than the long-run performance after non-underwriter buys. The long run return evidence is not consistent with the conflict of interest story (a conflicted investment bank would not make a recommendation unless the market’s initial reaction was less than complete). The fact that underwriters are likely to make early recommendations that they eventually reverse is consistent, however, with a rush to judgment. 17
  • 20. References Celarier, Michelle, 1996, Who is pulling the strings, Euromoney, April, 40- 44 Dugar, Amitabh and Siva Nathan, 1995, The effect of investment banking relationships on financial analyst’ earnings forecasts and investment recommendations, Contemporary Accounting Research 12, 131-160. Dunbar, Craig, 1999, Factors affecting investment bank initial public offering market share, Journal of Financial Economics, forthcoming. Economist, 1996, Underwrite, oversell, May 4, 78. Irvine, Paul, 1996, The marginal impact of analyst initiation of coverage, Working paper, Emory University. Gompers, Paul and Josh Lerner, 1995, Venture Capital Distributions: Short-Run and Long-Run Reactions, Working Paper, Harvard University. Hansen, Robert and Atulya Sarin, 1999, Is honesty the best policy? An examination of security analyst forecast behavior around seasoned equity offerings, Working paper, Virginia Tech. Lee, Inmoo, Scott Lochhead, Jay Ritter and Quanshui Zhao, 1996, The costs of raising capital, Journal of Financial Research 19, 59-74. Lin, Hsiou-wei and Maureen McNichols, 1997, Underwriter relationships and analysts’ earnings forecasts and investment recommendations, Working paper, Stanford University. Loughran, Tim and Jay Ritter, 1995, The new issues puzzle, Journal of Finance 50, 23-51. Lowenstein, Roger, Today’s analyst often wears two hats, The Wall Street Journal. McLaughlin, J., 1994, The changing role of securities analyst in initial public offerings, Insights, 8. Michaely, Roni and Wayne Shaw, 1994, The pricing of initial public offerings: Tests of adverse selection and signaling theories, Review of Financial Studies 7, 279-319. Michaely, Roni and Kent Womack, 1999, Conflict of interest and the credibility of underwriter analyst recommendations, Review of Financial Studies 12, 653-686. Power, William, 1993, Why hot, new stocks get booster shots, The Wall Street Journal, February 10, c1-c2.
  • 21. Puri, Manju, 1996, Commercial banks in investment banking: Conflict of interest or certification role?, Journal of Financial Economics 40, 373-401. Ritter, Jay, The long-run performance of initial public offerings, Journal of Finance 46, 3-27. Stickel, Scott, 1992, Reputation and performance among security analysts, Journal of Finance 47, 1811-1836. Stickel, Scott, 1995, The anatomy of performance of buy and sell recommendations, Financial Analysts Journal 51, 25-39. Womack, Kent, 1996, Do brokerage analysts’ recommendations have investment value? Journal of Finance 51, 137-167.
  • 22. Table I Description of the recommendations made for the 420 firms going public in 1992 A recommendation is defined as a “sell” if the Zacks recommendation code is between 3 and 5 (hold, moderate sell or strong sell) and the previous recommendation for the broker has a strictly lower code or the broker had no previous recommendation for the firm (Zacks code of 6). A recommendation is defined as a “buy” if the Zacks recommendation code is between 1 and 2.9 (strong buy or moderate buy) and the previous recommendation for the broker has a strictly higher code or the broker had no previous recommendation for the firm (Zacks code of 6). Recommend- Recommend- Recommend- ations made ations made ations made by any broker only by lead only by non underwriter underwriters IPOs where 1 recommendation is made 16 90 31 (% of total number of IPOs with recommendations) (7.1) (55.9) (14.6) IPOs where 2 recommendations are made 20 45 25 (% of total number of IPOs with recommendations) (8.9) (28.0) (11.7) IPOs where 3 recommendations are made 20 18 36 (% of total number of IPOs with recommendations) (8.9) (11.2) (16.9) IPOs where 4 recommendations are made 33 7 31 (% of total number of IPOs with recommendations) (14.7) (4.3) (14.6) IPOs where 5 to 7 recommendations are made 75 1 47 (% of total number of IPOs with recommendations) (33.5) (0.6) (22.1) IPOs with 8 or more recommendations 60 0 43 (% of total number of IPOs with recommendations) (26.9) (0.0) (20.1) Total number of IPOs with recommendations 224 161 213 IPOs with no recommendations 196 259 207 Total number of IPOs 420 420 420
  • 23. Table II Descriptive statistics on mean returns around brokerage buy recommendations between 1992 and 1993 of firms going public in 1992, broken down by type of broker. The t- statistic tests the hypothesis that values for underwriter and non-underwriter recommendations are equal. A recommendation is defined as a “buy” if the Zacks recommendation code is between 1 and 2.9 and the previous recommendation for the broker has a strictly higher code or the broker had no previous recommendation for the firm. Based on these definitions, buy recommendations by the underwriter in the IPO are included if there are no buys or sells by other brokers on the same day. Buy recommendations by non-underwriters are included if there are no contemporaneous buys or sells by other brokers including the underwriter. Market adjusted returns are the raw buy and hold returns minus the buy and hold return for the value weighted NYSE/AMEX index return if the firm trades on the NYSE or AMEX or the buy and hold return for the Nasdaq composite index return if the firm trades on Nasdaq. The abnormal size-matched buy and hold return is defined as the buy and hold return for the firm over the noted time interval (or until the firm is delisted) minus the return on four size-matched firms (firms that have been trading at least 5 years and have not had an equity offering over that period and have the closest market capitalization to the IPO firm measured at December 31 of the year prior to the IPO) over the same period (if a matching firm delists or has an equity offering prior to this point, the proceeds from a sale at its delisting date are reinvested in the CRSP value weighted NYSE/AMEX index. The +,*, and ** marks indicate that the individual mean values are significantly different from zero using a t-test at the 10 %, 5 % and 1 % level, respectively. All Buys By IPO By non- t –statistic underwriter underwriter (underwriter = non-underwriter) 3 day return around the 1.34** 1.21* 1.36** 0.3 recommendation (%) 3 day market adjusted return 1.09** 0.76 1.16** 0.7 around the recommendation (%) Buy and hold return from day +1 to 18.1** 14.9** 19.0** 0.8 +250 after recommendation (%) Abnormal size-matched buy and 2.6 -1.8 3.8 1.1 hold return from day +1 to +250 (%) Market adjusted return (%) from 20.4** 10.0** 23.9** 2.8 IPO to day before recommendation Days from IPO to recommendation 167** 132** 178** 4.5 Number of observations 847 191 649
  • 24. Table III Descriptive statistics on mean returns around brokerage “buy” recommendations between 1992 and 1993 on firms going public in 1992, broken down by the sequence of the recommendation. A recommendation is defined as a “initial buy” if the Zacks recommendation code is between 1 and 2.9 (strong buy or moderate buy) and the previous recommendation for the broker is 6 (not covered). A recommendation is defined as a “non-initial buy” if the Zacks recommendation code is between 1 and 2.9 (strong buy or moderate buy) and the previous recommendation for the broker has a strictly higher code (but not 6). Recommendations are included if there are no contemporaneous buy or sell recommendations by other brokers. Market adjusted returns are the raw buy and hold returns minus the buy and hold return for the value weighted NYSE/AMEX index return if the firm trades on the NYSE or AMEX or the buy and hold return for the Nasdaq composite index return if the firm trades on Nasdaq. The abnormal size-matched buy and hold return is defined as the buy and hold return for the firm over the noted time interval (or until the firm is delisted) minus the return on four size-matched firms (firms that have been trading at least 5 years and have not had an equity offering over that period and have the closest market capitalization to the IPO firm measured at December 31 of the year prior to the IPO) over the same period (if a matching firm delists or has an equity offering prior to this point, the proceeds from a sale at its delisting date are reinvested in the CRSP value weighted NYSE/AMEX index. The +,*, and ** marks indicate that the individual mean values are significantly different from zero using a t-test at the 10 %, 5 % and 1 % level, respectively All “buys” Underwrite Underwrite t-statistic t-statistic t-statistic by non- r initial r non-initial (H0: (H0: (H0: underwriter “buy” “buy” column (1) column (1) column (2) (1) (2) (3) = column = column = column (2)) (3)) (3)) 3 day return around 1.36** 0.27 2.98* 1.6 1.9 2.1 recommendation (%) 3 day market adjusted return around 1.16** -0.19 2.55* 2.0 1.8 2.1 recommendation (%) Buy and hold return from trading 19.0** 12.8* 20.2* 1.2 0.2 0.8 day +1 to +250 around recommendation (%) Abnormal size-matched return from 3.8 -8.0 9.9 1.9 0.7 1.8 trading day +1 to +250 (%) Market adjusted return (%) from first 23.9** 7.9* 14.1+ 2.7 1.2 0.9 trading to day before recommendation Days from IPO to recommendation 178** 88** 216** 7.6 2.3 9.3 Number of observations 649 125 66
  • 25. Table IV Descriptive statistics on mean returns for underwriter “initial buy” recommendations between 1992 and 1993 on firms going public in 1992 broken down by the nature of subsequent recommendations by the underwriter A recommendation is defined as a “initial buy” if the Zacks recommendation code is between 1 and 2.9 (strong buy or moderate buy) and the previous recommendation for the broker is 6 (not covered). Recommendations are included if there are no contemporaneous buy or sell recommendations by other brokers. Market adjusted returns are the raw buy and hold returns minus the buy and hold return for the value weighted NYSE/AMEX index return if the firm trades on the NYSE or AMEX or the buy and hold return for the Nasdaq composite index return if the firm trades on Nasdaq. The abnormal size-matched buy and hold return is defined as the buy and hold return for the firm over the noted time interval (or until the firm is delisted) minus the return on four size-matched firms (firms that have been trading at least 5 years and have not had an equity offering over that period and have the closest market capitalization to the IPO firm measured at December 31 of the year prior to the IPO) over the same period (if a matching firm delists or has an equity offering prior to this point, the proceeds from a sale at its delisting date are reinvested in the CRSP value weighted NYSE/AMEX index. Recommendation reversals are cases where the underwriter issues a sell recommendation within one year of the initial buy (sell recommendations are those with a Zacks recommendation code between 3 and 5 where the previous recommendation for the underwriter is given a strictly lower code) The +, *, and ** marks indicate that the individual mean values are significantly different from zero using a t-test at the 10 %, 5 % and 1 % level, respectively. Initial Buys Initial Buys with All Initial with no a subsequent Buys recommendation recommendation reversal reversal 3 day return around recommendation (%) 0.41 0.03 0.27 3 day market adjusted return around -0.06 -0.41 -0.19 recommendation (%) Buy and hold return from trading day +1 to +250 20.9** -3.1 12.8* relative to buy recommendation (%) Size-matched buy and hold return from trading 5.5 -31.1** -8.0 day +1 to +250 relative to buy recommendation (%) Size-matched buy and hold return from trading 5.5 -17.6* -3.0 day +1 to the later of day +250 or the day before a recommendation reversal (%) Size-matched buy and hold return from the day of - -13.2** - a recommendation reversal to trading day +250 relative to the initial buy (%) day +1 to the later of trading day +250 or the day before a recommendation reversal(%) Number of observations 79 46 125