Business strategy, stock price informativeness, and analyst coverage efficiency

• Date: 01 January 2021
• Author: Rongrong Zhang
• Published date: 01 January 2021
• DOI: http://doi.org/10.1002/rfe.1101

Rev Financ Econ. 2021;39:27–50. wileyonlinelibrary.com/journal/rfe

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INTRODUCTION

Business strategy is a set of guiding principles that, when communicated and adopted in the organization, generates a desired

pattern of decision-making (Watkins, 2007). Recent research shows that business strategy plays an important role in setting firm

policies and affecting firm risks, including financial reporting practices (Bentley, Omer, & Sharp, 2013), tax avoidance policies

(Higgins, Omer, & Philips, 2015), over- and under-investment decisions (Navissi, Sridharan, Khedmati, Lim, & Evdokimov,

2017), audit reporting quality (Bentley-Goode, Newton, & Thompson, 2017), stock price crash risk (Habib & Hasan, 2017),

information disclosures (Bentley-Goode, Omer, & Twedt, 2018), and annual report readability (Lim, Chalmers, & Hanlon,

2018). We complement and extend this line of research by showing that business strategy affects stock price informativeness

and analyst coverage efficiency.

One of the main roles of stock markets is the production and aggregation of information resulting from trading by specula-

tors, informed and uninformed traders. Stock prices convey traders' private information such as the demand for firms' products

and their investment opportunities. Managers can extract valuable information about the prospects of their own firms from

observing stock prices (Hayek, 1945) and use such information to guide corporate decisions. (Chen, Goldstein, & Jiang, 2007;

Received: 3 September 2019

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Revised: 31 January 2020

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Accepted: 12 February 2020

DOI: 10.1002/rfe.1101

ORIGINAL ARTICLE

Business strategy, stock price informativeness, and analyst

coverage efficiency

RongrongZhang

Department of Finance, Parker College of

Business, Georgia Southern University,

Statesboro, GA, USA

Correspondence

Rongrong Zhang, Department of Finance,

Parker College of Business, Georgia

Southern University, Statesboro, GA 30460,

USA.

Email: rzhang@georgiasouthern.edu

Abstract

We examine how business strategy affects stock price informativeness which in turn

influences analyst coverage efficiency. Using stock price synchronicity and the prob-

ability of informed trading as proxies for stock price informativeness, we show that

stock prices of prospectors are less informative than those of defenders. Next, we

explore two channels through which business strategy influences analyst coverage

efficiency. We first test and find support for an information transfer channel, i.e., the

higher stock price synchronicity of prospectors facilitates more information trans-

fer by analysts, resulting in higher analyst coverage efficiency of prospectors than

defenders. Next, we test and find support for an informed trading channel, i.e., the

higher probability of informed trading on stocks of defenders intensifies competition

between informed traders and analysts. Such competition adversely affects analyst

coverage efficiency, leading to lower analyst coverage efficiency of defenders than

prospectors. Our findings are robust to an array of robustness checks including 2SLS/

IV tests, differences-in-difference tests, and high-tech industry sensitivity analyses.

KEYWORDS

analyst coverage efficiency, business strategy, defender, prospector, stock price informativeness

JEL CLASSIFICATION

D82; G24; L21; L22

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De Cesari & Huang-Meier 2015). In this study, we adopt Miles and Snow (1978, 2003) business strategy classification which

defines three strategies, namely, defenders that focus on cost control and maintain stable market shares for a narrow set of

products, prospectors that seek high growth rates and constantly update their products and services through innovation, and

analyzers that blend the characteristics of defenders and prospectors. We hypothesize that business strategy is a key determinant

of stock price informativeness. Specifically, we argue that firms adopting a defender like strategy has more informative stock

prices than those adopting a prospector like strategy for the following reasons.

First, business strategy affects the quantity of firm disclosure. Bentley-Goode et al. (2018) report that prospectors make

more frequent voluntary disclosures (e.g., management earnings forecast) and attract greater analyst coverage than defenders.

Additionally, knowledge diffusions and information sharing along supply chains are important to innovation success (Azadegan

& Dooley, 2010; Isaksson, Simeth, & Seifert, 2016; Primo & Amundson, 2002). As such, we predict that innovation centric

prospectors exchange more information with their product market partners than defenders do. These activities increase the pro-

portion of related industry information absorbed into stock prices, resulting in higher stock price synchronicity of prospectors

compared with defenders.

Second, business strategy also affects the type of information available to the public. For example, Habib and Hasan (2017)

argue that a greater tendency to hoard negative news by prospectors results in a higher probability of experiencing future crash

risks by prospectors than defenders. Moreover, business strategy affects the content of firm disclosures. Lim et al. (2018) argue

that business strategy influences the wording, context, and scope of firm disclosure. Consistent with this view, they report that

the readability of 10-k reports is lower for prospectors than defenders. Financial markets aggregate firm information into stock

prices. Collectively, the above discussions suggest that business strategy might influence stock price informativeness by affect-

ing the quantity and type of firm information available in financial markets.

Third, as growth and innovation-focused firms, prospectors tend to attract more media coverage and analysts following,

resulting in higher visibility in stock markets of prospectors compared with defenders. Stock market visibility directly affects

stock returns (Lehavy & Sloan, 2008; Merton, 1987). We propose that differences in market visibility between defenders and

prospectors results in differences in their stock price informativeness.1

Fourth, Bentley et al. (2013) show that firms following a prospector strategy are more likely to experience financial report-

ing irregularities despite the greater auditor efforts compared with those following a defender strategy. This finding reveals that

information processing costs are higher for prospectors than defenders. All else being equal, we expect stock price informative-

ness to be inversely related to information processing cost, therefore, stock price informativeness of defenders should be higher

than that of prospectors.

To test the above predictions, we operationalize the Miles and Snow (1978, 2003) business strategy typology by constructing

a business strategy index (Sindex) following Bentley et al. (2013). This index takes on a value between 6 and 30 with high num-

bers indicating a prospector like strategy and lower numbers indicating a defender like strategy. For robustness, we construct two

indicator variables, defender for firms with Sindex in the bottom quartile distribution and prospector for firms with Sindex in

the top quartile distribution. Using quartile distribution cutoffs produce sufficient contrasts between defenders and prospectors.

To measure stock price informativeness, we compute stock price synchronicity by extracting the coefficient of determination

from the regression of firm-specific stock returns on industry and market returns following Morck, Yeung, and Yu (2000). High

stock price synchronicity suggests low stock price informativeness. Controlling for other firm-specific characteristics that are

associated with stock price synchronicity, our OLS regressions reveal that business strategy index has a positive and significant

effect on stock price synchronicity. Further, defenders (prospectors) have significantly lower (higher) stock price synchronicity

than analyzers. Collectively, these results support our prediction that business strategy affects stock price informativeness.

For robustness, we repeat the above regression estimations using the probability of informed trading (hereafter, Pin) and

its asymmetric component Adjusted Pin as alternative measures of stock price informativeness.2

As firm-specific information

in stock prices rises, informed trading activities increase and stock price synchronicity decreases. Our OLS panel regressions

reveal that business strategy index has a negative and significant effect on the probability of informed trading. Additionally,

defenders (prospectors) have significantly higher (lower) Pin and Adjusted Pin than analyzers, which is our reference group.

Next, we explore how business strategy affects analyst coverage efficiency via stock price informativeness. Extant analyst

literature largely focuses on the impact of analyst coverage on firm information asymmetry and has paid little attention to analyst

coverage portfolio. We attempt to fill this gap by examining the relation between business strategy and the breadth of analyst cov-

erage, i.e., the average number of firms under analyst coverage. We postulate that by way of affecting stock price informativeness,

business strategy affects analyst coverage efficiency. Empirically, we measure analyst coverage efficiency using analyst coverage

breadth, computed as the ratio of total number of firms followed by the focal firm's analysts scaled by the number of analysts.

We propose two channels through which business strategy affects analyst coverage breadth, namely, an information transfer

channel and an informed trading channel. Hilary and Shen (2013) show that analysts are capable of transferring information