Small Firm Governance and Analyst Following

ABSTRACT Prior research strongly indicates that small firms receive reduced security analyst coverage relative to large firms. In this study we ask whether corporate governance in small firms is related to the number of analysts who follow the firm. After controlling for a variety of firm-specific factors that could influence analysts' incentives, we find that small firms with better corporate governance (superior shareholder rights) are indeed followed by a greater number of analysts. Our findings are consistent with analysts exhibiting a preference for covering firms with reduced agency conflict and better information disclosure. Additional evidence suggests that analyst following increases with trading volume and revenue growth, but decreases with share price momentum, firm complexity, and share ownership by inside board members. Key words: investment banking and brokerage, ownership structure, corporate governance JEL classification: G24, G32, G34 INTRODUCTION A number of studies have investigated the factors that influence analysts' decisions to provide coverage of a firm's stock. These studies generally find that smaller firms and firms with lower trading volume are followed by fewer analysts. l The evidence suggests analysts have greater incentives to cover firms that are more likely to produce higher brokerage or investment banking income for the analyst's employer. Given the important role analysts play in transmitting firm information to investors, the reluctance of analysts to follow small firms potentially exacerbates the asymmetric information problem (between managers and outside shareholders) for these firms.2 In this paper we extend the literature on analyst behavior by examining the relationship between corporate governance and the degree of analyst following for small U.S. firms. We posit that, when considering which small U.S. firms to follow, analysts will prefer firms with superior shareholder rights. This preference is derived from analyst incentives and the likely consequences of poor corporate governance. Analysts have a well-documented incentive to provide coverage for firms that they view favorably.3 Firms with weak governance may be viewed unfavorably because of their perceived high agency costs and their perceived inferior information disclosure. Although prior research has examined the relationship between ownership structure and analyst following, to our knowledge this is the first study to test whether a comprehensive measure of shareholder rights is related to the number of analysts covering small U.S. firms. We sample 365 small firms (using the same size definition as that used in creating the S&P600 Small Cap Index) that have necessary I/B/E/S, Research Insight, and corporate governance data for the year 2002. We focus on small firms for two reasons. First, small firms have particular difficulty in attracting analyst coverage. Second, analyst coverage is probably more important in reducing information asymmetry for small firms, given the limited attention these firms receive in the financial press. We focus on the year 2002 because securities firms were cutting analyst positions at that time, forcing the shrinking population of professional analysts to make difficult choices regarding which firms to follow.4 As our measure of corporate governance, we use the corporate governance index and corporate governance data provided by Professor Andrew Metrick at the Wharton School. These data have been used in many earlier studies.5 We regress the number of analysts following a firm on the firm's corporate governance index and we control for several firm-specific factors potentially related to analyst following. Our main finding is that firms with superior shareholder rights are followed by a greater number of security analysts. This relationship is robust whether OLS regression or negative binomial regression is used. Although we hesitate to make strong claims regarding causality, our evidence is consistent with analysts having a preference for following firms with better corporate governance. …