Here's one trick that investment experts have practiced for years: Buy new stocks 24 days after their initial public offering. Not 20 days after. Not 30 days after. But 24.
To Wall Streeters, the "25-day bounce" is a well-known phenomenon. It occurs because the investment banks that underwrite an initial public offering must wait 25 days before their analysts "initiate coverage" on a stock. "Initiating coverage" means issuing a formal report on the company's prospects and a recommendation to investors on whether to buy the stock.
The reason there is a bounce is because the recommendation is virtually always a "Buy." Friendly coverage following an initial public offering is part of the deal when the underwriters are chosen.
Take the case of Drugstore.com. The online drugstore, which went public on July 28 at an offering price of $18, closed on Aug. 20, after 23 days of trading, at $48.50 a share. Three trading days later, it closed last Wednesday at $56, a 15 percent rise. In the age of skyrocketing stock prices, that might not sound like much, but it's an awfully big profit for a couple of days.
What happened in between was that analysts at Donaldson, Lufkin & Jenrette and Thomas Weisel Partners recommended the stock. Early last Monday morning, DLJ set a target price of $65 a share, with Thomas Weisel making its recommendation on Tuesday. And the stock, naturally, started creeping upward.
Roni Michaely of Cornell University and Kent Womack have written a paper titled "Conflict of Interest and the Credibility of Underwriter Analyst Recommendations," forthcoming in the Review of Financial Studies, that analyzes the effectiveness of the underwriters' recommendations. They looked at 200 stocks and 14 major investment banks. Their conclusion is that underwriters' recommendations "show significant evidence of bias." That's academic speak for, "don't trust 'em."
DLJ and Thomas Weisel were part of the underwriters' syndicate -- the group of investment banks responsible for selling Drugstore.com's initial public offering. The offering price was $18 a share. The stock immediately skyrocketed after the IPO. Amazingly, the same investment bankers who sold the stock for $18 a share 25 days earlier, suddenly think it's worth $65. (Morgan Stanley, the lead underwriter on the deal, has not yet initiated coverage on Drugstore.com and the company's star Internet analyst, Mary Meeker, was on vacation and could not be reached.)
The reason all this is so important is because investment banks' recommendations about their clients stock are at best highly suspect.
Here are some stunning numbers from the Womkack and Michaely study:
The difference in two-year performance between new stocks recommended only by their underwriters and stocks recommended by other investment banks is huge. The median two-year return for companies whose stock is recommended only by their underwriters is negative 51.9 percent. For stocks recommended by other analysts, it's 23.1 percent. The total gap is thus 75 percentage points. That's about the same as the difference between putting your money in a savings account and trying your luck at slot machines.
According to the study, then, underwriters' recommendations are nearly useless -- but investors eat them up. That's why stocks like that of Drugstore.com jump after the underwriters' recommendations come out.
The problem is that, while investment bank analysts are paid to choose stocks for the banks' money management operations, they are also supposed to bring in new banking business. Rainmaking, in fact, is generally a bigger part of the analyst's job than analyzing the markets. Nobody is eager to bring their banking business to an investment house whose analysts will not return the favor with a plug. The net result is that analysts present a rosy story about the companies with which their banks are doing business.
Most of Wall Street has known that for a while. Now, thanks to Michaely and Womack, there's some proof.