Inside the “Black Box” of Sell‐Side Financial Analysts

Our objective is to penetrate the “black box” of sell‐side financial analysts by providing new insights into the inputs analysts use and the incentives they face. We survey 365 analysts and conduct 18 follow‐up interviews covering a wide range of topics, including the inputs to analysts’ earnings forecasts and stock recommendations, the value of their industry knowledge, the determinants of their compensation, the career benefits of Institutional Investor All‐Star status, and the factors they consider indicative of high‐quality earnings. One important finding is that private communication with management is a more useful input to analysts’ earnings forecasts and stock recommendations than their own primary research, recent earnings performance, and recent 10‐K and 10‐Q reports. Another notable finding is that issuing earnings forecasts and stock recommendations that are well below the consensus often leads to an increase in analysts’ credibility with their investing clients. We conduct cross‐sectional analyses that highlight the impact of analyst and brokerage characteristics on analysts’ inputs and incentives. Our findings are relevant to investors, managers, analysts, and academic researchers.     

When Analysts Talk,Do Institutional Investors Listen? Evidence from Target Price Changes

We find that institutions trade in the same direction as target price changes based on 6,415 U.S. firms from 1999 to 2011, even after controlling changes in stock recommendations and earnings forecasts. The impact of target price changes on institutional trading is more pronounced for small firms, firms followed by few analysts, and illiquid firms, and is mainly limited to transient institutions. We do not find any outperformance for institutions to follow analysts’ target price forecasts, suggesting that institutions could find it easier to justify their investment decisions by following analyst forecasts, although such trading does not result in outperformance.     

Do analysts who understand accounting conservatism exhibit better forecasting performance?

This study investigates the performance of analysts when they match the asymmetric timeliness of their earnings forecast revisions (i.e., asymmetric forecast timeliness) with the asymmetric timeliness of firms’ reported earnings (i.e., asymmetric earnings timeliness). We find that better timeliness‐matching analysts produce more accurate earnings forecasts and elicit stronger market reactions to their forecast revisions. Further, better timeliness‐matching analysts issue less biased earnings forecasts, more profitable stock recommendations and have more favorable career outcomes. Overall, our results indicate that analysts’ ability to incorporate conditional conservatism into their earnings forecasts is an important reflection of analyst expertise and professional success.     

Analysts’ stock recommendations,earnings growth and risk

A key output of sell‐side analysts is their recommendations to investors as to whether they should, buy, hold or sell a company's shares. However, relatively little is known regarding the determinants of those recommendations. This study considers this question, presenting results that suggest that recommendations are dependent on analysts’ short‐term and long‐term earnings growth forecasts, as well as on proxies for the analysts’ unobservable views on earnings growth in the more distant future and risk. Furthermore, analysts who appear to incorporate earnings growth beyond the long‐term growth forecast horizons and risk into their recommendation decisions make more profitable stock recommendations.     

Understanding analysts' use of stock returns and other analysts' revisions when forecasting earnings

We investigate analysts' use of stock returns and other analysts' forecast revisions in revising their own forecasts after an earnings announcement. We find that analysts respond more strongly to these signals when the signals are more informative about future earnings changes. Although analysts underreact to these signals on average, we find that analysts who are most sensitive to signal informativeness achieve superior forecast accuracy relative to their peers and have a greater influence on the market. The results suggest that the ability to extract information from the actions of others serves as one source of analyst expertise.     

Conflicts of Interest and Research Quality of Affiliated Analysts in the German Universal Banking System: Evidence from IPO Underwriting

The quality of equity research by financial analysts is a prerequisite for an efficient capital market. This study investigates the quality of earnings forecasts and stock recommendations for initial public offerings (IPOs) in Germany. The empirical study includes 12,605 earnings forecasts and 6,209 stock recommendations of individual analysts for the time period from 1997 to 2004. The focus of this study is on analysing the potential conflicts of interest that arise when the analyst is affiliated with the underwriter of an IPO. In a universal banking system these conflicts of interest are usually more pronounced and therefore interesting to investigate. The empirical findings for the German financial market suggest that earnings forecasts and stock recommendations of the analysts belonging to the lead-underwriter are on average inaccurate and biased, indicating some conflicts of interest. Moreover, the stock recommendations of the analysts that are affiliated with the lead-underwriter are often too optimistic resulting in a significant long-run underperformance for the investor. In contrast, unaffiliated analysts provide better earnings forecasts and stock recommendations that result in a superior performance for the investor.     

Analyst Pessimism and Forecast Timing

In this study, we show that on average relatively pessimistic analysts tend to reveal their earnings forecasts later than other analysts. Further, we find this forecast timing effect explains a substantial proportion of the well‐known decrease in consensus analyst forecast optimism over the forecast period prior to earnings announcements, which helps explain why analysts’ longer term earnings forecasts are more optimistically biased than their shorter term forecasts. We extend the theory of analyst self‐selection regarding their coverage decisions to argue that analysts with a relatively pessimistic view–compared to other analysts–are more reluctant to issue their earnings forecasts, with the result that they tend to defer revealing their earnings forecasts until later in the forecasting period than other analysts.     

Slow price reactions to analysts’ recommendation revisions

This study explores the reasons for the slow price reactions to analysts’ recommendation revisions. We predict that analysts’ recommendation revisions contain earnings-related information that is not incorporated in analysts’ earnings forecasts and that the slow price reaction is attributable to a gradual incorporation of this earnings-related information into stock prices. We find that, consistent with our prediction, stocks with recommendation upgrades subsequently experience more upward earnings forecast revisions than stocks with recommendation downgrades, and that the differences in subsequent stock returns between upgraded and downgraded stocks is attributable to differences between subsequent earnings forecast (especially, FY2 earnings forecast) revisions.     

Underwriting Relationships and Analyst Independence in Europe

This paper examines the accuracy of security analysts’ earnings forecasts and stock recommendations for firms in 13 European countries. We document at least three key findings. First, we find strong evidence that lead and co‐lead underwriter analysts’ earnings estimates and stock recommendations are significantly more optimistic than those provided by unaffiliated analysts. Second, we find that lead and co‐lead underwriter analysts’ earnings forecast and stock recommendations are significantly more optimistic for underwriter stocks than for those they provide for other stocks. Third, we also find evidence that these biases found within earnings forecasts and stock recommendations are not driven by one particular country. In short, these findings suggest that affiliated analysts are more optimistic perhaps to maintain investment banking relations.     

Stock index adjustments and analysts’ forecast optimism: A quasi-natural experiment on the CSI 300 Index

As stock index adjustments comprise a basic system of capital market, their potential influence on analysts’ earnings forecasts is worthy of research. Based on a research sample of 23 adjustments to the CSI 300 Index from June 2007 to June 2018 and the backup stocks announced during the same period, this study examines the impact of additions to stock index on analysts’ forecast optimism using a staggered difference-in-differences model. The research results show that after stocks are added to the stock index, analysts’ earnings forecast optimism about these stocks increases significantly. Cross-sectional analysis indicates that this increase is more significant when the market is bullish, institutional ownership is low, the ratio of listed brokerage firms is low, star analyst coverage is low, firms show seasoned equity offering activity, the ratio of analysts from the top five brokerage firms ranked by commission income is high, and the analysts’ brokerage firms are shareholders. However, analyst-level tests find that analysts’ ability helps to reduce the impact of additions to stock index on earnings forecast optimism. Furthermore, additions to stock index significantly increase analyst coverage and forecast divergence. Economic consequences tests find additions to stock index significantly increases stock price synchronization, which is partly mediated by analysts’ earnings forecast optimism. This study enriches the literature on the impact of basic capital market systems and analyst behavior. The findings suggest that investors should rationally evaluate analysts’ earnings forecasts for stocks added to the stock index and obtain further information from various channels to improve asset allocation efficiency.     

Information misweighting and the cross-section of stock recommendations

This paper provides evidence that analysts whose earnings forecast revisions showed signs of greater exaggeration in the past make recommendation changes that lead to lower abnormal returns than their peers. Interpreting stock recommendations as a forecast of future abnormal returns, I show that this evidence is consistent with the hypothesis that analysts who typically exaggerate or overstate the weight of their private information when issuing forecasts also do so when making recommendations. The paper also shows that past earnings forecasts provide incremental information about analysts' recommending behavior beyond that contained in past recommendations.     

Learning and incentive: A study on analyst response to pension underfunding

There is a long-standing debate on whether sell-side analysts learn from their experience to improve earnings forecast skills. This study shows that incentive is an important factor for understanding the “learning by doing” effect by analysts. We examine analysts’ response to a complex type of information – corporate pension underfunding. Pension underfunding negatively impacts future earnings and analysts on average underreact to such information in their earnings forecasts. More importantly, when there is a strong incentive for analysts to deliver accurate forecasts, analyst learning effectively reduces their underreaction to pension underfunding information. On the other hand, when such an incentive is absent, the analyst learning effect is not discernible in the data. Further evidence suggests that analyst learning and incentive jointly reduce stock market mispricing associated with corporate pension underfunding.     

Stock repurchases as an earnings management device

We investigate whether firms use stock repurchases to meet or beat analysts’ earnings per share (EPS) forecasts. We identify conditions under which repurchases increase EPS and document the frequency of accretive repurchases from 1988 to 2001. We find a disproportionately large number of accretive stock repurchases among firms that would have missed analysts’ forecasts without the repurchase. The repurchase-induced component of earnings surprises appears to be discounted by the market, and this discount is larger when the repurchase seems motivated by EPS management, although using the repurchase to avoid missing analyst forecasts appears to mitigate some of the negative stock price response.     

Do banks care about analysts' forecasts when designing loan contracts?

We investigate whether banks rely on the information content in equity analysts’ annual earnings forecasts when assessing the risk of potential borrowers. While a long literature finds that analysts provide useful information to market participants, it is not clear that banks, which have access to privileged information, would benefit from publicly available analysts’ forecasts. If, however, banks do rely on this information, then more precise private information in earnings forecasts may inform banks. We focus our analysis on the requirement of collateral because it is a direct measure of default risk, whereas other loan terms such as interest spread and debt covenants can also protect against other risks, such as asset misappropriation. The direct link between collateral and default risk allows us to examine whether information from analysts is relevant to banks when designing loan contracts. Consistent with our predictions, we find that higher precision of the private information in analysts’ earnings forecasts is associated with a lower likelihood of requiring collateral, and this effect is larger when a borrower does not have a prior relationship with the lender or their accounting or credit quality is low. We also find that this association disappears after the implementation of Regulation FD, consistent with this regulation reducing analysts’ access to private information.     

Analysts’ earnings forecasts: coexistence and dynamics of overconfidence and strategic incentives

This paper formulates a two-stage model to capture the decision process of financial analysts when issuing earnings forecasts. Our model extends the model of Chen and Jiang [(2005). Analysts’ weighting of private and public information. Review of Financial Studies, 19 (1), 319–355], by allowing for a distortion of forecasts independent of whether an analyst has private information. Using quarterly earnings forecasts, we provide empirical evidence on the coexistence of overconfidence and strategic incentives. Financial analysts overweight their private information and at the same time strategically inflate their forecast.     

When do stock analysts find bond rating changes informative?

Credit rating agencies (CRAs) have considerable privileged access to corporate management and are therefore a potentially important source of information to the equity market. We study how stock analysts incorporate bond ratings in their earnings forecasts. We develop an economic framework to explain why equity analysts might look to CRAs as an information source, especially after Regulation Fair Disclosure. Using this framework, we characterize the association between ratings changes and earnings forecast revisions surrounding these changes. We examine whether the extent to which equity analysts glean information from ratings changes is related to the extent and importance of information conveyed in the ratings change and analysts’ information uncertainty. We find that characteristics we examine are strongly related to stock analysts’ use of information in rating downgrades.     

Analyst reputation and management earnings forecasts

Prior studies show that analysts with high reputation are influential in the market. This paper examines whether managers consider analyst reputation in shaping their voluntary disclosure strategy. Using Institutional Investor magazine’s All-American (AA) rankings as a proxy for analyst reputation, we find that the coverage of AA analysts is positively associated with the likelihood of quarterly management earnings forecasts (MEFs). We also find that AA analysts’ forecast optimism is more positively associated with the likelihood of MEFs than non-AA analysts’ forecast optimism when the firm is covered by AA analysts. Analyses based on AA analyst coverage changes and AA status changes confirm the relation between analyst reputation and MEFs. We further find that analyst reputation influences other MEF properties, such as forecast news, bias, and revisions, and that our results are robust to alternative measures of analyst reputation. Further analyses show that market reactions at quarterly earnings announcements are more positive (negative) when firms meet/beat (miss) AA analysts’ forecasts than when firms meet/beat (miss) non-AA analysts’ forecasts. Collectively, our findings suggest that managers strategically provide voluntary forecasts by taking into account the reputation of individual analysts following their firms.     

Capitalized intangibles and financial analysts

We examine whether firms that capitalize a higher proportion of their underlying intangible assets have higher analyst following, lower dispersion of analysts’ earnings forecasts and more accurate earnings forecasts relative to firms that capitalize a lower proportion. Under Australian generally accepted accounting principles, capitalization of intangible assets has become increasingly ‘routine’ since the late 1980s. It is predicted that this experience leads Australian analysts to expect firms with relatively more certain intangible investments to signal this fact by capitalizing intangible assets. Our results are consistent with this. We find that capitalization of intangible assets is associated with higher analyst following and lower absolute earnings forecast error for firms with a stock of underlying intangible assets. Our tests suggest a weaker association between capitalization and lower earnings forecast dispersion. We conclude that there are benefits for analysts, for management to have the option to capitalize intangible assets. These findings suggest that IAS 38 Intangible Assets and AASB 138 Intangible Assets reduce the usefulness of financial statements.     

Chaebol-affiliated analysts: Conflicts of interest and market responses

Some Korean business groups, or chaebols, have a large stake in securities firms that issue analysts’ reports on their member companies. This structure is unique in that industrial companies and securities firms are affiliated and operate within the same group. We investigate the informational content of earnings forecasts, stock recommendations and target prices made by the chaebol-affiliated analysts, using data collected between 2000 and 2008. The chaebol analysts tend to make more optimistic earnings forecasts for the member companies. The mean EPS forecast error (5.36%) of the affiliated analysts for the same chaebol company are significantly larger than that (3.23%) of other chaebol and independent analysts. The chaebol analysts also assign better recommendations by almost one level and set target prices 2.5% higher to the member companies after controlling for company and analyst characteristics. These results are consistent with the hypothesis that chaebol analysts’ reports are biased by conflicts of interest. Stock market reactions do not differ in response to announcements of stock recommendations issued by affiliated vs. non-affiliated analysts. This suggests that capital markets do not recognize the conflicts of interest inherent in chaebol analysts’ reports.