The Relationship between Analyst Coverage and Overinvestment, and the Mediating Role of Corporate Governance. Evidence From China

Abstract

This study applied a quantile analysis to test the relationship between analyst coverage and overinvestment in Chinese firms and further sought to demonstrate the mediating effect of corporate governance on overinvestment. The empirical results show that analyst coverage causes overinvestment across all quantiles; however, corporate governance can diminish the effect of firm overinvestment in the higher quantile analysis. Additionally, the difference-in-differences method was used to explore the effectiveness of the Chinese government’s 2013 corporate governance reform, with the results confirming that that governance reform has been effective in inhibiting a firm’s overinvestment. The findings of this study indicate that analysts act as market supervisors in the Chinese capital market, improving corporate governance; however, their coverage does not appear to benefit firms or shareholders. This research highlights the need to review the role of analysts in the market to ensure they can reduce information asymmetry between managers and shareholders without causing overinvestment behavior.

Keywords:

• Analyst coverage
• Corporate governance
• Overinvestment
• Difference-in-differences
• Propensity score matching

Acknowledgement

The authors would like to thank the anonymous referees for their constructive comments that helped to substantially improve the final version of this paper.

Notes

1 http://www.nasd.com/RegulatoryEnforcement/NASDEnforcementMarketRegulation/GlobalSettlement/index.htm and Kadan et al. have shown that Global Analyst Research Settlements, 2003, is an executive agreement between the U.S. Securities and Exchange Commission, the financial industry regulatory authority, and the New York Stock Exchange and major U.S. investment banks. The core issue of the judgment is the conflict of interest between the 10 largest investment banks and analysts in the United States. The settlement amount of US$1.435 million shows that analysts have issued false research reports for their own trading commission and investment banking business, thus damaging their investment research quality and credit.

2 China adopts a dual board of directors, which is formed by an executive board (all executive directors) and an independent board of supervisors (all non-executive directors).Company law in China stipulates that a limited liability firm shall set up a board of directors and a board of supervisors, and, according to Article 51 of the Company Law of the People's Republic of China, a limited liability company shall set up a board of supervisors with no less than three persons. A limited liability company with a small number of shareholders or a small amount of capital may set up one or two supervisors, and no board of supervisors is required.

3 The Third Plenary Session formulated policies to determine the orientation of China’s economic and institutional reforms in subsequent years. Hu, Tang, and Yan indicate that the Third Plenary Session, 2013, introduced the overall goal of comprehensively deepening reform, which required comprehensively promoting reform in economic, political, cultural, and social systems. The specific goal was to improve the socialist economy, socialist democracy, socialist culture, social management, and ecosystems.

4 Yu (2008) indicated that the change in securities firms’ revenue or profit are related to the number of analysts employed rather than a firm’s characteristics and investment strategies, which are instrumental variables to capture the change in analyst coverage. This means that the instrumental variable affects the independent variable but not the dependent variable, which satisfies the exclusive restriction. Thus, we adopt the instrumental variable to solve the endogeneity problem in this study. Moreover, the base year in this study is 2011–the middle year during the sample period–and firms within the base year must have at least one analyst coverage before it can be used to estimate instrument variables.

Additional information

Funding

This research was supported by Ph. D. followship of the Guangxi University of Finance and Economics (K5-21-15-00-019).