Investor response to sell-side analyst revisions in IPO recommendations: Do they correct expectations

This paper tests for investor optimism in IPO firms by examining excess returns around sell-side-analyst revisions of recommendations. I pose the corrections hypothesis and the learning hypothesis. According to the corrections hypothesis, if investors correct their initially optimistic expectations, they should react more negatively to analyst upgrades and downgrades of IPO firms relative to benchmark non-IPO firms. A competing hypothesis is the learning hypothesis, which posits that investors should respond more positively to upgrades and more negatively to downgrades of IPO firms relative to benchmark non-IPO firms, because they learn more from all information events about new, immature firms. Examining benchmark performance-adjusted-excess-returns around all revisions issued in the first 3 years after IPO issue, I find that investors do learn more from analyst revisions for IPO firms. However the magnitude of the response to upgrades and downgrades is asymmetric. The negative response around downgrades dominates the positive response around upgrades. Overall, the abnormal return from a typical 3-day period around all revisions is -1.80%. This correction is economically significant, and makes up 47.43% of the long-run underperformance of a typical IPO firm. This result is robust to different specifications of benchmark firms.