Tuesday, October 25, 2005

SSRN-Strength of Analyst Coverage Following IPOs by Christopher James, Jason Karceski

James and Karceski report that firms who have poor IPO performance get more than just price stabilization in the after market. However, while price stabilization tends to end relatively quickly, the firms whose IPO did poorly also get longer term more favorable coverage in the period following their IPO. This supports the "booster shot" hypothesis.
"Firms with poor aftermarket performance are given higher target prices and are more likely to receive strong buy recommendations, especially by analysts affiliated with the lead underwriter. This favorable coverage is relatively short-lived, lasting for only the first one or two analyst reports, typically less than six months."
What is so cool about this finding is that James and Karceski do not find the same degree of positive recommendations for stocks that went up immediately after their IPO. This finding is important for it seemingly differentiates the momentum stories from the so-called "booster shot" explanation.
"Another alternative is that analysts pre-commit to provide more than a favorable recommendation. As suggested by Michaely and Womack (1999), analysts may commit to provide a "“booster shot"” by increasing the strength of their recommendation in the face of an unfavorable market response to the IPO. This argument suggests a negative relationship between strength of affiliated coverage and stock price performance."
The findings?
"Lead analysts post much higher relative target prices for IPO firms that
have non-positive initial returns and for firms that trade at or below the IPO offer price when coverage is initiated. For these broken deals, lead analyst target price ratios are on average more than 26 and 36 percentage points higher than target price ratios for firms with zero or negative initial returns or for firms with non-positive return to coverage."
To control for the "of course it is not a strong buy, it has already gone up" phenomena, the authors use a group of analysts that were not associated with the IPO. The authors find that analysts associated with lead underwriters are more positive on the stock (which is consistent with the booster shot hypothesis):
"Lead analysts are also more optimistic relative to other analysts in broken deals in their recommendations as well. The average lead analyst target price ratio for broken deals is 14 percentage points higher than the average target price ratio set by other analysts."
Interestingly the ranking of investment bankers seems to matter (or at least the ranking of their clientele).
"Virtually all (96%) of the 85 broken deals underwritten by a top-ranked underwriter received coverage. In contrast, only 53% of broken deals underwritten by less prestigious underwriters received coverage. The percentage of IPOs underwritten by top-ranked underwriters that receive coverage does not differ significantly by whether or not the IPO is a broken deal. In contrast, broken
deals underwritten by less prestigious underwriters are significantly less likely to receive coverage than successful IPOs underwritten by less prestigious underwriters (the t statistic is -3.68). Thus, one reason to use a top-rated underwriter appears to be a higher likelihood of analyst support if returns are poor in the aftermarket."
Very interesting.

James, Christopher M. and Karceski, Jason J., "Strength of Analyst Coverage Following IPOs" (February 28, 2005). AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=600721

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