The long-run performance of initial public stock offerings that are recommended by their underwriters is dramatically worse than the performance of firms recommended by non-underwriters, shows new research from Cornell University's Johnson Graduate School of Management and Dartmouth's Amos Tuck School of Business Administration. "Our study found significant evidence of bias -- and possible conflict of interest -- between the analyst's responsibility to his investing clients and his incentive to market stocks underwritten by his firm," said Roni Michaely, assistant professor of finance at the Johnson School and co-author of the study. "Contrary to the conventional wisdom, we found that the market doesn't come close to recognizing the full extent of this bias."

Michaely and co-researcher Kent Womack, assistant professor of finance at Tuck, compared recommendations made by underwriters and non-underwriters of 391 companies that conducted initial public offerings (IPO) in 1990--1991. They tracked stock performance for up to two years after the IPO date.

"We found that not only were analysts' recommendations biased in favor of stocks of their firm's IPO clients, but stocks of companies which were recommended only by analysts from the underwriting firms were terrible performers," Womack said. As soon as six months after the offering date, IPOs recommended only by their own underwriter were underperforming the group recommended by only non- underwriters. After two years, the average difference was dramatic: the group recommended by only non-underwriters was outperforming the group recommended by their own underwriter by more than 55 percent.

"This phenomenon is not unique to a small subset of investment banks," Michaely said. "For 12 of the 14 major brokers making buy recommendations for both their own underwriting clients and for non-clients, their batting average was much better on their non-client recommendations." Michaely and Womack offer two possible explanations for production costs conflict of interest. "One possibility is that underwriter analysts genuinely believe that the firms they underwrite are better than the firms underwritten by other investment banks," Womack said. "Their forecasts are anchored on an 'insider's view,' scenarios of success and past plans rather than on results or the market's assessment. The second possibility is that analysts know that they are misleading the public but do so anyway because they have been directed to or because it is good for their compensation." The findings raise important policy questions about whether additional regulations are needed to protect investors and about the structure of the investment banking industry. "The investing public is not fully protected," Michaely said. "Investors do not understand the extent of this bias; the market does not adequately correct for it. It's time to consider whether to restrict, or at least monitor more closely, how analysts handle IPOs underwritten by their firm. "These findings should also raise questions for those who advocate lifting all, or most, restrictions on the banking industry," he said. "They clearly show that even in a restricted environment, there is still bias and, quite possibly, conflict of interest."