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Stock Prices that Go Public Together, Move Together

March 15, 2017

If companies do well, their stocks go up. If they do poorly, their stocks go down. Or do they? Recently research indicates stock prices aren't only based on the business fundamentals of a company.

Growing literature in behavioral finance shows different ways stock returns move that are not related to the underlying business of the company. For example, where the firm is located, a bank's underwriters and other outside factors can affect stock prices.

"The world of finance research is increasingly moving toward a view that behavioral finance and market frictions are really important, and it's important for us to understand these different ways that markets depart from perfect rationality," Shane Underwood, associate professor in the Finance, Insurance & Real Estate Department, said.

In particular, Underwood was intrigued by the effect investment banking networks have on the market. In his article "Comovement and Investment Banking Networks," which was co-written with Gustavo Grullon and James P. Weston, he examined how those networks similarly influence the stock prices of firms with the same underwriters. It was published in the Journal of Financial Economics.

Each investment banking company has a group of investors, also known as underwriters, on whom it depends to place shares when firms become public, so there are groups of investors who repeatedly take offers from the same bank. Because of the repetitive involvement, the researchers found the firms who use the same underwriters during equity offerings often move together in the market (referred to as comovement).

"We show that when firms come back to the market for a seasoned equity offering (SEO), especially if they switch banks, you see a big change in comovements," Underwood, who started at Baylor in fall 2016, said. "So, your stock returns start to move more like firms associated with the new bank rather than the old bank."

Essentially, if a company does an initial public offering (IPO) or SEO with a certain bank, its stock returns will move similarly to other firms the bank has taken public.

"This is one of many of these interesting real world issues that influence how prices behave differently from what your standard, rational financial model would say," he said. "At the same time, these results are also consistent with a rational model where we simply have different sources (the different investment banks) generating information about firms for their institutional clients, who then trade in a correlated fashion. This could lead to the excess comovement we observe."

Although the researchers expected to see the comovement, they were surprised by the strength of the results.

"We were sort of surprised…to see the strength, in spite of all the noise in the data, to see how strongly it linked up," Underwood said. "The change in comovement linking up to the changes in institutional ownership was a very strong result."

This study could have implications on how firms think about the importance of choosing banks when they go for their SEO. Based on the study results, it may be beneficial for companies to consider choosing an investment bank with the broadest possible network of institutional investors.

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