Financial analyst coverage for U.S. firms facing foreign competition: Evidence from trade liberalization

• Published date: 01 June 2020
• Author: Dongyoung Lee,He Wen
• Date: 01 June 2020
• DOI: http://doi.org/10.1111/jifm.12111

J Int Financ Manage Account. 2020;31:139–168.

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139

wileyonlinelibrary.com/journal/jifm

Accepted: 29 September 2019

DOI: 10.1111/jifm.12111

ORIGINAL ARTICLE

Financial analyst coverage for U.S. firms facing

foreign competition: Evidence from trade

liberalization

DongyoungLee1

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HeWen2

© 2019 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

1Desautels Faculty of Management, McGill

University, Montreal, QC, Canada

2College of Business Administration,

University of Missouri – St. Louis, St.

Louis, Missouri

Correspondence

Dongyoung Lee, Desautels Faculty of

Management, McGill University, 1001

Sherbrooke St. West, Montreal, QC H3A

1G5, Canada.

Email: dongyoung.lee@mcgill.ca

Abstract

This study examines financial analyst coverage for U.S.

firms following an increase in foreign product market com-

petition. To capture exogenous shocks to domestic firms'

competitive environments, we exploit a quasi-natural ex-

periment from large import tariff reductions over the 1984

to 2005 period in the manufacturing sector. Using data for

the years before and after large tariff reductions, our differ-

ence-in-differences analysis shows evidence of a significant

decrease in analyst coverage for incumbent U.S. firms when

they face greater entry threat from foreign competitors. We

also find that analysts with less firm-specific experience

and less accurate prior-period forecasts are more likely to

stop following the domestic firm when foreign competi-

tion intensifies. Overall, the findings suggest that foreign

product market competition from global trade liberalization

is an important determinant of financial analysts' coverage

decisions.

KEYWORDS

analyst characteristics, analyst coverage, difference-in-differences, foreign

product market competition, trade liberalization

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INTRODUCTION

This study examines financial analysts' coverage decisions for domestic firms in the United States

subsequent to an increase in foreign product market competition. While understanding the dynamics

140

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LEE and WEn

of competition is a fundamental topic in business research, few studies have examined the impact

of product market competition on financial analysts' behavior. Extant empirical studies are mostly

based on domestic competition, providing mixed evidence about analysts' behavior in response to

higher product market competition.1

Thus, whether foreign competition affects analysts' coverage

decisions is still an open empirical question. To the best of our knowledge, this study is the first

to investigate changes in analyst following subsequent to increased foreign competition from trade

liberalization.

Recently, UBS analysts in the semiconductor industry selected Texas Instruments and Micron

Technology as firms subject to heightened uncertainty from the U.S. trade war with foreign countries,

according to a 2018 report (Rapier, 2018). Historically, these two firms experienced a significant re-

duction in import tariff rates from 4.15% to 1.01% in 1986 when the U.S.–Japan semiconductor free

trade agreement (FTA) took place. Given that the U.S. semiconductor industry has been sensitive to

foreign trade policies over time (Baldwin, 1994), we infer that financial analysts in 1986 likely faced

severe uncertainty from the exogenous trade shock. In support of this notion, our data show that the

number of analyst following dropped from 56 to 38 for Texas Instruments and from 6 to 4 for Micron

Technology before and after the U.S.–Japan semiconductor FTA in 1986.

While this example of two well-known firms from the semiconductor industry seems to suggest

an analyst coverage loss subsequent to large import tariff reductions, it is not clear whether this phe-

nomenon is purely coincidental or systematically related to changes in U.S. trade policies across all

manufacturing industries after we control for known determinants of analyst coverage. Against this

backdrop, the main objective of this study is to provide empirical evidence for analysts' coverage

decisions in response to exogenous tariff shocks using the historical U.S. data on changes in import

tariff rates.

Using import tariff reductions, we focus on trade liberalization to capture exogenous shifts in

domestic firms' competitive environments for several reasons. First, from a policy perspective, it is

imperative to examine capital market consequences of the government's reduction in trade barriers

because relatively little is known about the impact of open trade on market participants' behavior. In

particular, although prior studies provide some evidence that import tariff reductions have an eco-

nomic impact on domestic firms, increasing leverage and decreasing both firm size and profits (Baggs

& Brander, 2006; Head & Ries, 1999), understanding of how capital market participants respond to

domestic firms facing entry threats from foreign rivals is limited. By examining financial analysts'

coverage decisions following trade liberalization, we aim to identify potential changes in the financial

market's interests and domestic firms' information environments.

Second, the import tariff reduction provides a unique setting by generating exogenous variation

in foreign product market competition. This allows us to identify rather exogenous shocks to product

market competition in domestic markets (Flammer, 2015; Xu, 2012). In doing so, this study helps

mitigate an endogeneity concern prevalent in archival-based empirical studies (Beyer, Cohen, Lys, &

Walther, 2010; Reeb, Sakakibara, & Mahmood, 2012). For example, firm managers tend to attract the

attention of financial analysts as part of corporate strategies to deal with product market competition

(Zuckerman, 2000). This makes analyst coverage endogenous to the competitive environment, and

as such, it is difficult to show a causal impact of competition on analysts' behavior. We aim to over-

come such difficulty by relying on the quasi-natural experimental setting provided by foreign trade

liberalization.

Finally, the government-imposed trade liberalization significantly increases the entry threat from

foreign competitors, offering a specific setting in which to capture the dynamic nature of changing

competition over time. Specifically, we are able to identify an increase in pre-entry competition from

potential entrants, as opposed to that in postentry competition from existing rivals. The nature of