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E-MailAllaudeen Hameed is a Professor of Finance at National University of Singapore. This post is based on an article authored by Professor Hameed; Randall Morck, Professor of Finance at the University of Alberta; Jianfeng Shen, Senior Lecturer in Finance at the University of New South Wales; and Bernard Yeung, Professor of Finance at National University of Singapore.
Stocks followed by more analysts should be priced more accurately, yet their returns are unusually prone to co-move with market and industry indexes. Stocks that co-move more are often thought to be related to herding. This is because more informed trading ought to make a firm’s stock price move with the changing fortunes of that specific firm, as well as with market and industry trends. More firm-specific price variation in less-followed stocks seems counterintuitive, yet this is what we observe.
In our paper, Information, Analysts, and Stock Return Comovement, forthcoming in The Review of Financial Studies, we resolve this seeming paradox. Stocks covered by more analysts co-move more precisely because they are priced more accurately and their price movements help investors update the prices of less-followed stocks. This “information spillover” makes most price movement in highly-followed stocks look like comovement with industry or market trends, but in fact investors are using information about highly-followed stocks to deduce how other stocks ought to move.
The intuition is compelling. High fixed costs of gathering and processing information (paying for data feeds, expert analysts, and other business costs) force analysts to focus on generating information with the broadest possible uses. Specifically, information useful for valuing many stocks generates more revenue than information useful for valuing only one stock. This suggests that more followed stocks might be more reliable industry bellwethers—information about them being helpful in valuing other stocks in the industry. Less-followed stocks might be more idiosyncratic, their information less helpful for valuing other stocks.
To test this, we first show that analysts disproportionately follow stocks whose fundamentals correlate more highly with those of other firms, after controlling for other firm characteristics known to attract analysts (e.g., market capitalization, trading volume, volatility, and institutional ownership). Following industry jargon, we label intensely-followed firms whose fundamentals correlate strongly with those of other firms in their industries as “bellwether firms.”
Statistical tests provide strong evidence of information spillovers from bellwether firms to other firms. Earnings forecast revisions for bellwether firms significantly affect the stock prices of their industry peers, especially those with low coverage, immediately or with a lag. Critically, these information spillovers are unidirectional: earnings forecast revisions for firms that are less intensely followed do not move the prices of heavily followed firms.
Further statistical tests use exogenous analyst coverage terminations due to brokerage firms closing their research departments. These show that coverage terminations appear to cause investors to rely more heavily on information about bellwether firms. In particular, when analyst coverage of already thinly-followed stocks decreases because of closure of research departments, these stocks co-move more with their industry bellwether stocks. Critically again, this is a one-way phenomenon.
Yet more robustness tests exclude alternative explanations. For example, bellwether effects cannot be explained by under-reactions associated with price or earnings momentum, or by delayed reactions to market-wide or industry-wide information. A final set of tests show institutions trading on this bellwether effect. Institutions disproportionately buy thinly-covered stocks on upward revisions to their industry bellwether firms’ earnings forecasts and potentially profit as the bellwether affects lifts those stocks.
The article’s bottom line is that bellwether firms are a pervasive feature of the stock market. Analysts’ information moves intensely covered bellwether firms’ stock prices quickly, and then spills over, sometimes with a lag, to move sparsely covered firms whose fundamentals generally move with their bellwether firms’ fundamentals. Analysts’ information about thinly-covered firms moves only their own stocks, and has no discernable spillover effect.
The full paper is available for download here.
