Do analysts add value when they most can? Evidence from corporate spin‐offs

Abstract

This article investigates how securities analysts help investors understand the value of diversification. By studying the research that analysts produce about companies that have announced corporate spin-offs, we gain unique insights into how analysts portray diversified firms to the investment community. We find that while analysts' research about these companies is associated with improved forecast accuracy, the value of their research about the spun-off subsidiaries is more limited. For both diversified firms and their spun-off subsidiaries, analysts' research is more valuable when information asymmetry between the management of these entities and investors is higher. These findings contribute to the corporate strategy literature by shedding light on the roots of the diversification discount and by showing how analysts' research enables investors to overcome asymmetric information. Draft, March 8, 2010We would like to thank Gabriel Natividad, Cynthia Montgomery, Felix Oberholzer, and seminar participants at HEC Lausanne for their comments. We thank Patrick Barton, Mercedes Boland, Qin Ding, Victor Doherty, Alexander Fisher, Michael Hauschild, Nick Hurley, Benjamin Istvan, Benjamin Kaufman, Patrick Lo, James Moran, George Saalouke, Michael Skey, Robert Steele, Jeremy Stone, Robert Tau, Huong Trieu, Lois Wang, and Jeff Wu for their assistance in collecting and coding the data from analyst reports, and Boris Groysberg for providing part of the data about analysts. We gratefully acknowledge the financial support of the Division of Research at the Harvard Business School. All errors are our own. When Do Analysts Add Value?Evidence from Corporate Spinoffs AbstractWe investigate the information content and forecast accuracy of 1,793 analyst reports written around 62 spinoffs--a setting in which analysts' ability to inform investors is potentially very high. We find that analysts pay little attention to subsidiaries about to be spun off even though these subsidiaries constitute a significant part of the parent company operations. Moreover, while the level of detail in analyst research about parent companies is significantly related to EPS and price forecast accuracy, the same is not true for the subsidiaries. We establish that this "forgotten child" phenomenon is linked to a "neglected parent" effect, whereby inaccuracy in subsidiary earnings forecasts is associated with inaccuracy in parent estimates. We conclude by showing that spinoffs may be a particularly complex setting for analysts to evaluate relative to other forms of corporate restructuring, such as IPOs, mergers, or bankruptcies, providing one potential explanation for our findings. 1The impact of financial analysts on capital market efficiency has been much debated in academia and in practice. A large body of academic research finds that analysts act as important information intermediaries, generating financial forecasts, stock recommendations and other fundamental research which helps investors form more precise estimates of stock prices, thereb...

Analyzing Analyst Research: A Review of Past Coverage and Recommendations for Future Research

“…The studies by Feldman, Gilson and Villalonga (2014) and Feldman (2016) further our understanding of the relationship between the extent and nature of analyst coverage and firm corporate strategy. To examine the potential cause of the "diversification discount " Feldman et al (2014) examine corporate spin-offs and find that analysts that "put more effort" into their reports by explaining the rationale for the spin-off are more accurate in their future earnings forecasts for diversified firms post-spin-off as compared to analysts that do not provide such detail.…”

“…To examine the potential cause of the "diversification discount " Feldman et al (2014) examine corporate spin-offs and find that analysts that "put more effort" into their reports by explaining the rationale for the spin-off are more accurate in their future earnings forecasts for diversified firms post-spin-off as compared to analysts that do not provide such detail. Further, Feldman (2016) theorizes and finds that so-called legacy spin-offs that involve a firm's original (core) business are associated with a particularly high likelihood of analyst coverage initiation and termination.…”

Corporate spinoffs and analysts' coverage decisions: The implications for diversified firms

“…For non‐legacy spinoffs, it is unclear whether the forecasts produced by the initiating analysts will be more or less accurate than those produced by the continuing analysts. On the one hand, analysts generally do not produce much research about the segments in diversified firms (Feldman et al, ), and they find it costly to change the models they use to value companies (Zuckerman and Rao, ). Both of these factors should make it more difficult for continuing analysts to produce accurate research about a firm that has undertaken a non‐legacy spinoff: they may not have a sufficient understanding of that firm's remaining operations, and they may not be able or willing to update their valuation models in response to the deal.…”

“…While it is unclear, for non‐legacy spinoffs, whether the initiating analysts' forecasts will be more or less accurate than the continuing analysts' forecasts, there are two reasons why the same is not true for legacy spinoffs. First, the psychological magnitude of the changes implied by legacy spinoffs suggests that analysts who continue covering these firms might be even more constrained by their pre‐spinoff valuation models or their failure to produce segment‐level research about these firms (Feldman et al, ; Zuckerman and Rao, ). Second, while continuing analysts might normally benefit from their accumulated experience covering a firm that undertakes a spinoff, the historical significance of a firm getting rid of a business for which it has been known since its inception, along with the organizational shifts that often accompany such a change (Feldman, ), should erode the value of the experience or connections that continuing analysts normally enjoy.…”

Which industries are served by online marketplaces for technology?

“…The data covered all publicly listed firms in US and non-US stock exchanges for 2002-2007 (e.g., Humphery-Jenner, 2013; Madhavan & Prescott, 1995;Rindova et al, 2010). We excluded observations for penny stocks (<1%) and extreme outliers from our analysis (e.g., Feldman, Gilson, & Villalonga, 2013). We were able to match about 4.3 million analyst estimates to a firm identifier (i.e., a firm's industry NAICS code from Compustat and its stock price from CRSP).…”