Michael J. Jung
New York University – Leonard N. Stern School of Business
M.H. Franco Wong
INSEAD; University of Toronto – Rotman School of Management
Yale School of Management
May 7, 2014
A large literature examines the link between firm fundamentals and future stock returns (e.g., Ou and Penman 1989; Bernard and Thomas 1990; Holthausen and Larcker 1992; Sloan 1996; Abarbanell and Bushee 1997, 1998; Piotroski 2000). Typically, the motivation for this line of research is that firm fundamentals are reflected in accounting data, which are informative about a firm’s future cash flows, and that investors do not fully impound this information into stock prices. But since financial statement numbers are backward looking in nature, it is beneficial for investors to identify early indicators of firm fundamental changes that have not yet been reflected in financial statements. In this paper, we examine whether an increase in analyst interest—defined as the onset of sell-side equity analysts who do not cover a firm but participate on that firm’s earnings conference call—serves as an early indicator of not only firm fundamental changes, but also future capital market activities and stock price movements.
Our focus on analyst interest stems from two observations. First, prior research shows that analysts are sophisticated industry experts (Mikhail et al. 1999; Asquith et al. 2005; Kadan et al. 2012). Given their deep industry knowledge, analysts are aware of firms’ shifting competitive positions due to new entrants, products, customers, and markets, well before such information is reflected in financial statements. Second, before an analyst initiates coverage of a firm, he or she must conduct due diligence on the firm. The concept of analyst due diligence has not been explored in the prior literature, which is one aspect of the analyst black box (Ramnath, Rock, and Shane 2008; Bradshaw 2011) we examine. In particular, we highlight that analysts regularly participate on firms’ earnings conference calls before they initiate coverage of the firms.1 This common practice occurs because listening to, and asking a question on, a firm’s conference call is part of an extensive, and sometimes lengthy, due diligence process. For example, Sanford C. Bernstein & Co., a top-ranked sell-side equity research firm in Institutional Investor’s annual All-American Research Survey, gives newly hired analysts up to one year to conduct due diligence on firms before initiating coverage of them (Koo 2012).
We posit that analyst conference call participation prior to coverage initiation captures early analyst interest, and thus, serves as an early indicator of improving firm fundamentals and capital market activities. Our proposition stems from two non-mutually exclusive theories. The first theory is from McNichols and O’Brien (1997), which shows that analysts allocate their effort toward firms in which they view future prospects to be favorable.2 This theory suggests that analyst interest—our measure of early analyst effort—predicts positive future reported firm fundamentals and stock returns. The second theory is from Merton (1987), which shows that greater investor recognition of a firm leads to lower cost of capital for the firm and higher demand and valuation for its stock. This theory suggests that analyst interest in a firm leads to greater recognition among institutional investors (through more frequent conversations with analysts), which in turn leads to greater capital market activities (i.e., trading) and valuation of the stock.
While we focus on analyst conference call participation prior to coverage initiation, we also examine whether covering analysts who are absent from the call is a possible early indicator of declining analyst interest. However, we note that while the concept of analyst due diligence suggests that analysts participate on a firm’s conference call before initiating coverage of that firm, it does not necessarily suggest that an analyst would be absent from a conference call before dropping coverage of that firm because the analyst could just as plausibly drop coverage before being absent from the call. In addition, covering analysts may not participate in every conference call, suggesting larger measurement errors in a measure of analyst disinterest. As a result, tests of analyst “absenteeism” are likely to be less powerful than that for analyst due diligence.