Analysts' Selective Coverage and the Long-term Performance of Newly Public Firms

This study examines financial analysts’ ability to forecast future firm performance based on their selective coverage of newly public firms. We hypothesize that analysts' choice of providing selective coverage contains information about their true underlying expectation of future firm prospects. We extract this underlying expectation, which is otherwise unobservable, by obtaining residual analyst coverage from a model of initial analyst following for newly public firms. Our results demonstrate that in the three years subsequent to initial coverage, IPOs with high residual coverage have significantly better return and operating performance than those with low residual coverage. This evidence is consistent with analysts having superior predictive abilities and selectively providing coverage for firms about which their true expectations are favorable. Whether or not analysts possess ability to predict firms’ future performance is an important question for many investors relying on analysts’ advice. So far much effort has been devoted to examine analysts’ published forecasts and recommendations. Several studies (Stickel 1995; Womack 1996) report that favorable (unfavorable) changes in individual analyst recommendations are accompanied by positive (negative) returns at the time of announcement. Barber et al. (2001) propose a profitable trading strategy associated with purchasing (selling short) stocks with most (least) favorable consensus recommendations by security analysts. However, analyst opinion could also be tainted with conflict of interest and overoptimism. Michaely and Womack (1999) report that stocks with ‘buy’ recommendations by underwriter analysts perform more poorly than those recommended by unaffliated analysts. Rajan and Servaes (1997) document that analysts’ long-term growth forecasts on initial public offerings (IPOs) are on average optimistically biased at the time of issuance, with firms with the highest projected growth rates subsequently under-performing their three-year benchmarks. Chan et al. (2003) find that earnings growth forecasts reported by analysts are overly optimistic and are not predictive of future performance . This paper revisits the question of whether analysts’ opinion is predictive of firms’ future performance, focusing on analysts’ selective coverage provision. Our inference is drawn from a sample of newly public firms, as the extreme uncertainty and pronounced information asymmetry associated with the new issue market provides a powerful and unique setting to investigate analysts’ forecasting ability. Existing evidence on analyst following of seasoned firms suggests that analysts are more likely to provide coverage for firms about which their true expectations are favorable. Based on this evidence, we hypothesize that analysts’ decision to provide selective coverage contains information about their true expectations of future firm prospects. We extract analysts' aggregate true expectation, which is otherwise unobservable, by obtaining residual analyst coverage from a model of initial analyst following for newly 1 Similarly, Dechow et al. (2000) report a pronounced underperformance among firms with the highest growth forecasts made by analysts affiliated with investment bankers underwriting the unseasoned or seasoned offerings.