Analyst Coverage and the Glamour Discount

Abstract

We find that the value premium documented in the literature is actually a glamour discount. The difference in average returns between high book-to-market (value) and low book-to-market (glamour) stocks is driven by unusually low returns to glamour stocks. There is no significant difference in returns between high book-to-market and medium book-to-market stocks. Furthermore, the return discount exists only for glamour stocks with low analyst coverage. These findings suggest that low coverage stocks whose prices are bid well above book value become overpriced because investors have little information to rationalize their pricing. This inference is further supported by tests based on accounting measures of firm performance and earnings announcement returns. The return on assets (ROA) of glamour stocks with low analyst coverage in the two-year period after portfolio formation is significantly lower than the ROA of glamour stocks with high analyst coverage, and earnings announcement returns of the former group are much more negative than the insignificant returns of the latter group. These results suggest the prices of glamour stocks with low coverage are high because investors are overly optimistic about future performance, and investors are subsequently surprised by performance when earnings are announced. In sharp contrast, no difference in ROA or announcement returns exist between value stocks that have low versus high analyst coverage. These findings present a serious challenge to risk based explanations of the difference in returns between high and low book-to-market stocks.