IPO UNDERPERFORMANCE PUZZLE: WHAT DO ANALYSTS RECOMMEND?

Abstract

This study examines a sample of 3,596 firms that completed their initial public offerings (“IPO”) in the U.S. market during the period of 1994-2006. At the end of the first trading day, their shares jumped an average of 18.84% above the price at which they offered the IPO. Yet, these firms underperform the market and non-IPO firms in similar industries with similar market capitalization and book-to-market value over the next three years. Can research analysts help us understand the documented “IPO underperformance puzzle” better? This paper provides a unified analysis of the IPO long-run underperformance anomaly and analyst recommendations by examining the information content and implications of buy/sell recommendations. We find that the IPO underperformance puzzle is driven by the firms in which analysts ascribed a low proportion of ‘buy’ in the contemporaneous period. In a dynamic information environment surrounding analysts and management of firms, simple ‘buy’ and ‘sell’ recommendations appear to be reliable sources of information on the long-run performance of IPO firms. However, consistent with the literature, we find some evidence that analysts might be overly-optimistic on IPO firms in their first year of going public. For an investor buying the shares of “analysts’ darlings” at the end of the first year and holding them for the next two years, these firms significantly underperform the market and similar non-IPO firms. Our results indicate that while analysts are accurate about informing the market about the contemporaneous performance of IPO firms, they might be clueless in forecasting their future performance. This study also finds compelling evidence of the neglect-firm effect when IPO firms receive little or no analyst coverage. These firms exhibit a significant returns premium.