Adds and Drops of Research Coverage-Analysts Pile In and Storm Out

Finally, some research analyst at a brokerage firm has added one of your holdings to his/her coverage list. You get a little excited that the analyst has discovered some jewel that you have treasured for some time and will finally revealed its merit to the rest of the planet. You feel a little smug, don't you?

Apparently, you shouldn't. A recent paper by Ambrus Kecskes at the University of Toronto and Kent Womack at Dartmouth says that perhaps you should worry a little.

Analysts strive to cover stocks that are institutional favorites...they have the greatest trading activity. High market capitalization, high trading volume, spells glamor in many cases. Initiation of coverage tends to prompt increased liquidity. Analysts score well with their research directors and especially with the heads of capital markets if they can get "it" on the tape.

Lesser known names which have potential as M&A candidates or other investment banking services also come front and center. Nothing impresses an investment banking client more than wheeling in the resident expert, the research analyst, and having him/her wax poetic about the industry. Of course, with Sarbanes-Oxley concerns, this performance now takes place in front of a securities lawyer who ensures that nothing inappropriate is said, no offerings of warrants or other favors to influence opinion are suggested. The production of a research report satisfies the analyst's need for recognition and the firm's need for commish and investment banking fees.

Typically, an analyst drops coverage when something untoward occurs...management becomes non-communicative, earnings become unpredictable, or a better opportunity comes along to earn commish or underwriting fees. Sometimes, the assigned investment banker has done something to muck up the relationship. After all, there is only a finite amount of time and earnings maximization requires an optimization of the coverage list.

What happens to the stock price when coverage is assumed or when coverage is dropped? What are the longer-term implications?

Interesting results according to K &W ! In the year before and the year of an increase in coverage, stock returns are relatively higher. In the year before and the year of a decrease in coverage, stock returns are relatively lower. Surprisingly, however, in the year after a change in coverage, returns reverse. Specifically, excess of market returns are -1.2 percent following adds of coverage and +3.5 percent following drops.

Therefore, the market does seem to react to analysts' coverage decisions and in the right direction, but judging by the return reversal the following year, the market's contemporaneous reaction seems to be excessive.

Two findings are striking. First, even when other factors were accounted for such as size,turnover, institutional ownership, momentum, valuation, or risk fixed, the stock performance of firms for which analysts add coverage is at least as good as, if not better, than the performance of drops in the year of the coverage decision. Hence, increased analyst coverage does have a positive effect in that year. Second, adds always have relative better stock performance than drops in the year after the change in coverage. In fact, the increase-decrease spread ranges from 1.9 to 9.2 percent.

If drops are clearer signals than adds, then the market's negative reaction to drops will be greater. Insofar as the market overreacts more, the subsequent positive reversal following drops of coverage will be greater.

Bottom-line, the market tends to over-react to changes in analyst coverage. Over the near term, go with the flow. A drop in coverage can be viewed as a sell signal over the near term. A pick-up in coverage, over the near term is generally positive. But look for bargains among the orphaned stocks without coverage a year later. Getting sent into the reject pile takes a near-term toll, but provides a great entry point later. The market reads too much into analysts' coverage decisions, misreads piling in or storming out, and subsequently corrects itself.