Analysts' Reinitiations of Coverage and Market Underreaction

Abstract

Do analysts add value and can they discover new information? I study the informativeness of reinitiations of coverage, which are defined as the resumption of coverage of a stock by a broker after more than six months of interruption. Reinitiations are associated with a significant short-term market response, in particular when the same analyst is assigned to the stock. Moreover, this market response is incomplete, and I document the existence of a six-month drift. The anomaly is sizeable, and a trading strategy delivers significant positive abnormal returns after transaction costs with a six-month horizon. These characteristics clearly differentiate reinitiations from other recommendations like initiations or upgrades. The results are consistent with an informed analyst hypothesis: the analyst who resumes the coverage of a firm benefits from his prior knowledge of the company and its sector, which helps him discover information that had been neglected by investors in an inefficient market, and time the issuance of his recommendation. Indeed, reinitiations coincide with future improvements in firms' profitability. Besides, when I test the implications of gradual information diffusion models, it appears that firms that were initially subject to a lower level of initial attention experience stronger cumulative abnormal returns after the reinitiation takes place.