A Re-Examination of Financial Analysts' Differential Earnings Forecast Accuracy*

Abstract. This research re-examines whether there are differences in the forecast accuracy of financial analysts through a comparison of their annual earnings per share forecasts. The comparison of analyst forecast accuracy is made on both an ex post (within sample) and an ex ante (out of sample) basis. Early examinations of this issue by Richards (1976), Brown and Rozeff (1980), O'Brien (1987), Coggin and Hunter (1989), O'Brien (1990), and Butler and Lang (1991) were ex post and suggest the absence of analysts who can provide relatively more accurate forecasts over multiple years. Contrary to the results of prior research and consistent with the belief in the popular press, we document that differences do exist in financial analysts' ex post forecast accuracy. We show that the previous studies failed to find differences in forecast accuracy due to inadequate (or no) control for differences in the recency of forecasts issued by the analysts. It has been well documented in the literature that forecast recency is positively related to forecast accuracy (Crichfield, Dyckman, and Lakonishok 1978; O'Brien 1988; Brown 1991). Thus, failure to control for forecast recency may reduce the power of tests, making it difficult to reject the null hypothesis of no differences in forecast accuracy even if they do exist. In our analysis, we control for the differences in recency of analysts' forecasts using two different approaches. First, we use an estimated generalized least squares estimation procedure that captures the recency-induced effects in the residuals of the model. Second, we use a matched-pair design whereby we measure the relative forecast accuracy of an analyst by comparing his/her forecast error to the forecast error of another randomly selected analyst making forecasts for the same firm in the same year on or around the same date. Using both approaches, we find that differential forecast accuracy does exist amongst analysts, especially in samples with minimum forecast horizons of five and 60 trading days. We show that these differences are not attributable to differences in the forecast issuance frequency of the financial analysts. In sum, after controlling for firm, year, forecast recency, and forecast issuance frequency of individual analysts, the analyst effect persists. To validate our findings, we examine whether the differences in the forecast accuracy of financial analysts persist in holdout periods. Analysts were assigned a “superior” (“inferior”) status for a firm-year in the estimation sample using percentile rankings on the distribution of absolute forecast errors for that firm-year. We use estimation samples of one- to four-year duration, and consider two different definitions of analyst forecast superiority. Analysts were classified as firm-specific “superior” if they maintained a “superior” status in every year of the estimation sample. Furthermore, they were classified as industry-specific “superior” if they were deemed firm-specific “superior” with respect to at least two firms and firm-specific “inferior” with respect to no firm in that industry. Using either definition, we find that analysts classified as “superior” in estimation samples generally remain superior in holdout periods. In contrast, we find that analysts identified as “inferior” in estimation samples do not remain inferior in holdout periods. Our results suggest that some analysts' earnings forecasts should be weighted higher than others when formulating composite earnings expectations. This suggestion is predicated on the assumption that capital markets distinguish between analysts who are ex ante superior, and that they utilize this information when formulating stock prices. Our study provides an ex ante framework for identifying those analysts who appear to be superior. When constructing weighted forecasts, a one-year estimation period should be used because we obtain the strongest results of persistence in this case.     

Systemic Risk and International Portfolio Choice

Returns on international equities are characterized by jumps; moreover, these jumps tend to occur at the same time across countries leading to systemic risk. We capture these stylized facts using a multivariate system of jump‐diffusion processes where the arrival of jumps is simultaneous across assets. We then determine an investor's optimal portfolio for this model of returns. Systemic risk has two effects: One, it reduces the gains from diversification and two, it penalizes investors for holding levered positions. We find that the loss resulting from diminished diversification is small, while that from holding very highly levered positions is large.     

HEALTH CARE IN THE UNITED STATES: WHY IS SUPPLY SO PRICE INSENSITIVE?

Health spending as a percentage of gross domestic product in the U.S. economy is growing, from 5% in 1960 to about 16% in the current period, and it is predicted to grow to as much as 30% in 2050. Then why is the supply of health care in the United States so insensitive to steeply rising prices? This paper conducts an econometric study to show that high health‐care costs have an adverse impact on labor productivity, causing a negative production externality in all industries. So, can the rising cost of health‐care affect the U.S. comparative advantage? The paper seeks answers to these questions in a general equilibrium model and finds that the labor productivity shock is responsible for the sluggish or declining supply of health care. Consumers are able to afford less health care due to a possible decline in real wages. U.S. comparative advantage becomes a nonissue, provided that the equilibrium is stable in spite of a negatively sloped health‐care supply curve. Negative externality, leading to market failure, may be addressed in two alternative ways. (JEL F11, I11, I12, I18)     

NON‐COOPERATIVE ENTRY DETERRENCE IN LICENSE AUCTIONS: DYNAMIC VERSUS SEALED BID*

We examine the impact of potential entry on incumbent bidding behavior in license auctions, in both dynamic and sealed bid formats. Unlike sealed bid auctions, dynamic auctions reveal information about the identities of potential winners and allow bidders to revise their bids. This helps incumbents to coordinate their entry deterrence efforts. If entry is sufficiently costly for each incumbent, only the dynamic auction has an equilibrium where entry is deterred for sure. Numerical calculations suggest that, regardless of how costly entry is for each incumbent, sealed bid auctions can generate a higher probability of entry as well as a more efficient allocation.     

Analysts' Selective Coverage and Subsequent Performance of Newly Public Firms

This study examines the ability of analysts to forecast future firm performance, based on the selective coverage of newly public firms. We hypothesize that the decision to provide coverage contains information about an analyst's underlying expectation of a firm's future prospects. We extract this expectation by obtaining residual analyst coverage from a model of initial analyst following. We document that in the three subsequent years, initial public offerings with high residual coverage have significantly better returns and operating performance than those with low residual coverage. This evidence indicates analysts have superior predictive abilities and selectively provide coverage for firms about which their true expectations are favorable.     

Common Failings: How Corporate Defaults Are Correlated

We test the doubly stochastic assumption under which firms' default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time‐series properties of default intensities. The data do not support the joint hypothesis of well‐specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities.     

Nonlinearity in the Returns-Earnings Relation: Tests of Alternative Specifications and Explanations*

Abstract. Several authors recently challenged the linearity of the returns-earnings relation. In this article, we test the adequacy of alternative nonlinear specifications and examine the validity of various explanations put forth for the returns-earnings nonlinearity. Our main findings are (1) that the nonlinearity persists even when the returns-earnings relation is estimated on annual data (most previous studies used quarterly data) and by a nonparametric procedure that does not impose a specific functional form on the relation; (2) that some nonlinearity exists in the relation between stock returns and earnings levels (previous studies have considered earnings surprises), although it is much less pronounced than the returns-earnings surprise nonlinearity; (3) that the main nonlinear estimation methods used in previous studies and in the current one appear to characterize equally well the underlying returns-earnings relation; predictions of subsequent stock returns based on each of the three specifications the authors examined are largely indistinguishable with respect to their accuracy; (4) that although “special items,” usually identified as transitory by the accountants, appear to contribute to the nonlinearity, there are probably additional contributing factors; the authors find that when all extraordinary items and “special items” are removed from earnings, the returns-earnings relation still exhibits nonlinearity, (5) that the inclusion of cash flow or accrual information also does not eliminate the nonlinearity; and (6) that the returns-cash flow relation is also nonlinear. The authors conclude that nonlinearity of the returns-earnings relation is quite robust across several alternative specifications. However, the candidate explanations they examined do not fully explain the observed nonlinearity. The search for the underlying cause of nonlinearity must therefore continue. Résumé. Plusieurs auteurs remettaient récemment en question la linéarité de la relation rendements-bénéfices. Les auteurs de l'article qui suit vérifient, pour leur part, si les formes non linéaires envisageables sont appropriées et examinent la validité de diverses explications mises de l'avant pour éclairer la non-linéarité de la relation rendements-bénéfices. Leurs principales observations sont les suivantes: (1) la non-linéarité persiste même lorsque la relation rendements-bénéfices est estimée à partir de données annuelles (la plupart des études précédentes s'appuyaient sur des données trimestrielles) et au moyen d'un procédé non paramétrique qui n'impose pas de forme fonctionnelle précise à la relation; (2) une certaine non-linéarité existe dans la relation entre le rendement des actions et les niveaux de bénéfice (les chercheurs avaient, jusque-là, pris en considération les bénéfices inattendus), bien que cette non-linéarité soit beaucoup moins accentuée que la non-linéarité des rendements-bénéfices inattendus; (3) les principales méthodes d'estimation non linéaire utilisées dans les études précédentes et dans la présente étude semblent définir tout aussi bien la relation sous-jacente rendements-bénéfices; les prédictions relatives aux rendements subséquents des actions en fonction de chacune des trois formes que les auteurs ont examinées sont, dans la majorité des cas, impossibles à différencier en ce qui a trait au degré d'exactitude; (4) bien que des éléments ? exceptionnels ?, habituellement définis comme étant provisoires par les comptables, semblent contribuer à la non-linéarité, d'autres facteurs y contribuent probablement aussi; selon les auteurs, lorsque tous les éléments extraordinaires et les ? éléments exceptionnels ? sont exclus des bénéfices, la relation rendements-bénéfices demeure non linéaire; (5) la relation demeure aussi non linéaire si l'on tient compte de l'information relative aux flux de trésorerie ou aux engagements; et (6) la relation rendements-flux de trésorerie est également non linéaire. Les auteurs concluent que la non-linéarité de la relation rendements-bénéfices, envisagée sous plusieurs formes différentes, résiste assez bien à l'analyse. Toutefois, les causes possibles qu'ils ont choisi d'examiner n'expliquent pas entièrement la non-linéarité observée, et les recherches doivent se poursuivre.