, Crain News Service
Ponying up for a newly issued stock because an analyst for the underwriter says so can cost investors big bucks, a new study suggests.
Analysts for investment banks frequently turn into Pollyannas when they look at companies brought to market by their colleagues, shows the study, conducted by Kent L. Womack, a professor at the Tuck School of Dartmouth College, and Roni Michaely, a professor at Cornell University.
The study, based on data from 1990 and 1991, looks at the recommendations of analysts working for the lead underwriter vs. recommendations by other analysts within a year of the initial public offering.
One finding: On average, stocks recommended by outside analysts gain 13% on a buy-and-hold cumulative return basis over the next six months. Stocks recommended by underwriters decline 5%.
The findings also indicate investors take the recommendations of the underwriter with a shaker of salt. A favorable rating from the underwriter bumps up stocks' return 2.7%; recommendations from non-underwriters lift stocks 4.4%.
Perhaps objectivity counts: Analysts at 12 of 14 big firms got worse results recommending their own underwritings than they did recommending those handled by rivals.
The study should be a warning to consider the source of any recommendation. Blindly buying on the basis of an analyst's urging might work for the day trader, but could cost the longer-term investor dearly.
"There's long been a suspicion by investment managers that you don't get healthy information from the underwriters" of an IPO, Mr. Womack said. "We tested it by looking at data and how many recommendations were credible and how many were booster shots trying to make the underwriters look good. Not only is the analyst interested in recommending the best stocks, he's interested in keeping the firm looking good."
As evidence, Mr. Womack said his findings determined underwriters often issued "buy" recommendations when the stocks were doing poorly. "It fits with our hypothesis that they are somewhat intentionally doing this because they're taking stocks that have gone down and helping take them back up," he said.
Mr. Womack presented some of his findings last month at the annual meeting for the Association of Investment Management and Research in Orlando. The article will be published later this year in the Review of Financial Studies.
A spokesman for a major investment bank said the findings don't represent a conspiracy so much as the mechanics of the IPO process. Analysts are involved early in the process of weighing whether to take a company public. If the analyst doesn't like a business, the investment bank is unlikely to back it.
"By the very nature of the process, you're not going to take companies public that you don't think are good companies," said the spokesman, who spoke on condition of anonymity.
Investment advisers were less than shocked by the findings. It would be "untenable to find an analyst issue(ing) a negative report," said Timothy Schlindwein, who runs a firm in Chicago bearing his name.
Another possible factor is that analysts are "so close to the company they can't see objectively how good the company is," Mr. Womack said.