Which types of analyst firms are more optimistic?

Research optimism among securities analysts has been attributed to incentives provided by underwriting activities. We examine how analysts’ forecast and recommendation optimism varies with the business activities used to fund research. We find that analysts at firms that funded research through underwriting and trading activities actually made less optimistic forecasts and recommendations than those at brokerage houses, who performed no underwriting. Optimism was particularly low for bulge underwriter firm analysts, implying that firm reputation reduces research optimism. There is also evidence that analysts at retail brokerage firms are more optimistic than those serving only institutional investors. We conclude that analyst optimism is at least partially driven by trading incentives.     

Internal control material weakness, analysts’ accuracy and bias, and brokerage reputation

The main purpose of this paper is to examine the impact of internal control material weaknesses (ICMW hereafter) on sell side analysts. We find that ICMW reporting firms have less accurate analyst forecasts relative to non-reporting firms when the reported ICMWs belong to the Pervasive type. ICMW reporting firms have more optimistically biased analyst forecasts compared than non-reporting firms. The optimistic bias exists only in the forecasts issued by the analysts affiliated with less-highly-reputable brokerage houses. The differences in accuracy and bias between ICMW and non-ICMW firms disappear when ICMW disclosing firms stop disclosing ICMWs. Collectively, our results suggest that the weaknesses in internal control increases forecasting errors and upward bias for financial analysts. However, a good brokerage reputation can curb the optimistic bias.     

Relationship Incentives and the Optimistic/Pessimistic Pattern in Analysts' Forecasts

We examine whether analysts' incentives to maintain good relationships with management contribute to the optimistic/pessimistic within‐period time trend in analysts' forecasts. In our experiments, 81 experienced sell‐side analysts from two brokerage firms predict earnings based on historical information and management guidance. Analysts' forecasts exhibit an optimistic/pessimistic pattern across the two timing conditions (early and late in the quarter), and the effect is significantly stronger when the analysts have a good relationship with management than when their only incentive is to be accurate. Debriefing results indicate that analysts are aware of this pattern of forecasts, and believe that this benefits their future relationships with management and with brokerage clients. The analysts most frequently cite favored conference call participation and information access when describing benefits from maintaining good relationships with management. Our results suggest the following: The optimistic/pessimistic pattern in forecasts is in part a conscious response to relationship incentives, information access is perceived to be a major benefit of management relationships, and recent regulatory changes may have lessened but have not eliminated this conflict of interest source.     

Additional Evidence on Analysts’ Decision to Issue Disaggregated Earnings Forecasts: Strategic Biasing

This study examines why analysts issue disaggregated earnings forecasts to I/B/E/S. Some recent studies suggest that analysts with superior forecasting ability issue disaggregated earnings forecasts to build reputation in the marketplace and stop forecast disaggregation once their reputation has been established. Based on an analysis of I/B/E/S forecast data for U.S. firms from 1998 to 2008, we find that, in a given year, about 20%–34% of analysts disaggregate for some, but not for all the firms that they follow. This evidence of selective disaggregation by analysts suggests that reputation building alone does not fully explain the decision to disaggregate forecasts. We hypothesize that the decision to disaggregate earnings forecasts is at the firm‐level as well and is systematically related to the analysts’ bias in the issued forecasts. Our findings are that (a) analysts’ overall optimistic bias and forecast errors decrease monotonically with the level of forecast disaggregation, and (b) analysts that selectively disaggregate their forecasts for some firms or who do not persistently disaggregate a given firm's forecasts exhibit more positive bias and larger forecast errors. Our findings are consistent with the notion that the analysts who issue biased forecasts, for example, to curry favour with the management, are less likely to provide disaggregated information as part of the forecast.     

ANALYST REPUTATION,DEALER AFFILIATION,AND MARKET MAKING

We investigate the effects of analysts' affiliation and reputation on dealers' market making activities. We find that for a given stock, dealers who have affiliated analysts covering the stock quote and trade more aggressively than those who do not have any affiliated analysts. More important, the reputation of affiliated analysts plays an additional role in the affiliated dealer's quote and trade behavior. Dealers with affiliated star analysts post more aggressive quotes and have larger market shares than dealers with affiliated nonstar analysts. Although dealers who post more aggressive quotes also induce affiliated star analysts to cover the stocks, the positive effect of analyst reputation on the affiliated dealers' quote aggressiveness remains significant and robust after controlling for potential endogenous and simultaneous problems.     

The Effect of Issuing Biased Earnings Forecasts on Analysts' Access to Management and Survival

This study offers evidence on the earnings forecast bias analysts use to please firm management and the associated benefits they obtain from issuing such biased forecasts in the years prior to Regulation Fair Disclosure. Analysts who issue initial optimistic earnings forecasts followed by pessimistic earnings forecasts before the earnings announcement produce more accurate earnings forecasts and are less likely to be fired by their employers. The effect of such biased earnings forecasts on forecast accuracy and firing is stronger for analysts who follow firms with heavy insider selling and hard‐to‐predict earnings. The above results hold regardless of whether a brokerage firm has investment banking business or not. These results are consistent with the hypothesis that analysts use biased earnings forecasts to curry favor with firm management in order to obtain better access to management's private information.     

Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts

We examine security analysts' career concerns by relating their earnings forecasts to job separations. Relatively accurate forecasters are more likely to experience favorable career outcomes like moving up to a high-status brokerage house. Controlling for accuracy, analysts who are optimistic relative to the consensus are more likely to experience favorable job separations. For analysts who cover stocks underwritten by their houses, job separations depend less on accuracy and more on optimism. Job separations were less sensitive to accuracy and more sensitive to optimism during the recent stock market mania. Brokerage houses apparently reward optimistic analysts who promote stocks.     

Financial analysts and price discovery

We show that whether or not a bank/brokerage firm has top‐rated financial analysts and high Wall Street Search rankings for their research is significantly related to that firm's contribution to price discovery, the process by which information is incorporated into stock prices. Our study relates cross‐sectional characteristics of the quality of brokerage research, the asymmetric information environment, and order flow volume to a microstructure measure of price discovery developed by Granger and Gonzalo. We measure analysts’ research quality with an industry‐specific ranking by institutional investors, with an opinion survey of trading desk personnel, and with the number of top 3 analysts across all industries employed by the bank/brokerage firm.     

The Effects of Disclosure and Analyst Regulations on the Relevance of Analyst Characteristics for Explaining Analyst Forecast Accuracy

We posit and find an effect of disclosure and analyst reporting regulations implemented from 2000 through 2003 (including Regulation Fair Disclosure, the Sarbanes‐Oxley Act and the Global Settlement Act) on the importance of analyst and forecast characteristics for analyst forecast accuracy. Following the enactment of these regulations, more experienced analysts and All‐Star analysts do not maintain their superior forecast accuracy, and analysts employed by large brokerage houses perform worse than other analysts. In addition, we find a decrease in the importance of analyst effort, the number of industries and firms followed, days elapsed since the last forecast, and forecast horizon. While the importance of bold upward forecast revisions does not change, bold downward revisions lose their relevance for forecast accuracy after 2003. Finally, we find an increase in the importance of prior forecast accuracy. We find that the importance of these characteristics varies with the precision of publicly available information. Specifically, the decrease in the importance of most analyst and forecast characteristics and the increase in the importance of prior forecast accuracy are greater when the precision of publicly available information is low. Overall, our results suggest that the positive effects of experience, effort, brokerage house size and All‐Star status on forecast accuracy in the pre‐regulation period were because of the information advantages that these analysts enjoyed (rather than their ability to generate private information). In contrast, our results suggest that prior forecast accuracy is related to analysts’ ability to generate private information.     

Reputation and Performance Among Security Analysts

Members of the Institutional Investor All-American Research Team supply more accurate earnings forecasts than other analysts when forecasts are matched by the corporation followed and by the date of brokerage house issuance. This contemporaneous advantage is complemented by a timing advantage; All-Americans supply forecasts more often than other analysts. Stocks returns immediately following large upward forecast revisions suggest that All-Americans impact prices more than other analysts. However, there is virtually no difference in returns following large downward revisions. Nevertheless, the collective results suggest a positive relation between reputation and performance, and, assuming that All-Americans are better paid, pay and performance.     

Self‐Selection and the Forecasting Abilities of Female Equity Analysts

This paper investigates whether there are systematic differences between the forecasting style and abilities of female and male analysts, and whether market participants recognize these differences. My key conjecture is that only female analysts with superior forecasting abilities enter the profession due to a perception of discrimination in the analyst labor market. Consistent with this conjecture, I find that female analysts issue bolder and more accurate forecasts and their accuracy is higher in market segments in which their concentration is lower. Further, the stock market participants are aware of the male–female skill differences. They respond more strongly to the forecast revisions by female analysts even though those analysts get less media coverage. The short‐term market reaction is incomplete, however, because it is followed by a strong post‐revision drift. The perception of abilities is similar in the analyst labor market, where female analysts are more likely to move up to high‐status brokerage firms, while their downward career mobility is lower. Collectively, these results indicate that female analysts have better‐than‐average skill due to self‐selection and market participants are at least partially able to recognize their superior abilities.     

Do analysts affect bad news timeliness?

I investigate the effect of analysts on the speed with which bad news is reflected in earnings. Intuitively, the more analysts that cover a firm, the more costly it will be for the firm to keep bad news suppressed. Thus, analyst coverage should positively affect bad news timeliness (BNT) (but not necessarily the differential timeliness of bad news over good news, or conditional conservatism). Using brokerage house mergers as a natural experiment with a difference-in-differences design, I find that an exogenous decrease in analyst coverage decreases BNT; that is, analysts positively affect BNT. The decrease in BNT is robust to controlling for unobserved firm heterogeneity, using a propensity score matched sample, persists for up to three years after the brokerage house merger, and is stronger for firms with relatively low analyst coverage before the merger. The result improves our understanding of how analysts affect a firm's information environment.     

Hedge funds and their prime broker analysts

Are sell-side analysts reluctant to go against the investment views of their hedge funds when these hedge funds are their prime brokerage clients? We show that prime broker analysts tend to upgrade stocks recently bought by their clients. For stocks with upgraded recommendations, post-announcement cumulative abnormal returns are significantly lower for those purchased by the prime brokerage clients. Our results are stronger with high-dollar-turnover clients who generate more trading commissions. We also find that a hedge fund with a large bet on a stock has a stronger incentive to pressure the fund’s prime brokers to issue a favorable recommendation on the stock. Results are not driven by stocks of firms with low analyst coverage or small size.     

On the Determinants of Optimism in Financial Analyst Earnings Forecasts: The Effect of the Market's Ability to Adjust for the Bias

This paper examines whether the documented bias in analyst earnings forecasts is intentional by examining whether it is related to the market's ability to adjust for this bias. For intentional bias to exist it is not enough for analysts to face incentives but rather, analysts should also be willing to respond to these incentives. As the market's ability to adjust for the bias increases, its market effects decrease while analyst reputation costs increase reducing analyst willingness to bias their forecasts. The paper utilizes a firm‐specific design that allows for both the bias component of the forecast error and the market's ability to adjust for the bias to be computed at the firm level. Results suggest that even though forecast error is positive in the latter part of the period under review reflecting overall analyst pessimism, the bias embedded in the forecasts is optimistic throughout the period. More importantly, I find that analyst forecast bias is decreasing in the market's ability to adjust for it. This result provides further evidence that analysts knowingly bias their forecasts and provides support for the existence of reporting bias, in particular. Thus, the evidence provides justification for recent regulatory efforts to increase the objectivity of analyst research reports.     

The Client Is King: Do Mutual Fund Relationships Bias Analyst Recommendations?

This paper investigates whether the business relations between mutual funds and brokerage firms influence sell‐side analyst recommendations. Using a unique data set that discloses brokerage firms’ commission income derived from each mutual fund client as well as the share holdings of these mutual funds, we find that an analyst's recommendation on a stock relative to consensus is significantly higher if the stock is held by the mutual fund clients of the analyst's brokerage firm. The optimism in analyst recommendations increases with the weight of the stock in a mutual fund client's portfolio and the commission revenue generated from the mutual fund client. However, this favorable recommendation bias toward a client's existing portfolio stocks is mitigated if the stock in question is highly visible to other mutual fund investors. Abnormal stock returns are significantly greater both for the announcement period and, in the long run, for favorable stock recommendations from analysts not subject to client pressure than for equally favorable recommendations from business‐related analysts. In addition, we find that, subsequent to announcements of bad news from the covered firms, analysts are significantly less likely to downgrade a stock held by client mutual funds. Mutual funds increase their holdings in a stock that receives a favorable recommendation but this impact is significantly reduced if the recommendation comes from analysts subject to client pressure.     

Sell-side analysts’ career concerns during banking stresses

We propose a new approach to examine sell-side analysts’ career concerns by relating their forecast boldness to their employers’ news flows. Specifically, we use banking sector news to proxy for the severity of career concerns. Analysts follow more closely the consensus forecast when the prospects of the banking sector are negative (and vice versa). The effect is both economically and statistically significant after controlling for various firm, analyst, brokerage house, and forecasting characteristics, as well as sector and economy wide effects. The more established analysts, in terms of reputation and experience, are generally unaffected by banking sector news. In contrast, their less established peers tend to cluster their forecasts near the consensus after a sequence of negative news flows for banks. Collectively, our results support the notion that during banking stresses when job security is low analysts’ tendency to imitate others increases.     

The impact of all-star analyst job changes on their coverage choices and investment banking deal flow

Using a sample of all-star analysts who switch investment banks, we examine (1) whether analyst behavior is influenced by banking relationships and (2) whether analyst behavior affects investment banking deal flow. Although the stock coverage decision depends on the relationship with the client firms, we find no evidence that analysts change their optimism or recommendation levels when joining a new firm. Investment banking deal flow is related to analyst reputation only for equity transactions. For debt and M&A transactions, analyst reputation does not matter. There is no evidence that issuing optimistic earnings forecasts or recommendations affects investment banking deal flow.     

Analyst reputation and the issuance of disaggregated earnings forecasts to I/B/E/S

Although sell-side analysts privately forecast revenues and expenses when producing earnings forecasts, not all analysts choose to provide I/B/E/S with earnings forecasts disaggregated into revenues and expenses. We investigate the role of reputation in explaining this decision. We find that analysts without established reputations are more likely than reputable analysts to issue disaggregated earnings forecasts to I/B/E/S, consistent with I/B/E/S exposure benefits accruing to analysts seeking to establish a reputation. Among less reputable analysts, those with high ability are more likely to disaggregate, consistent with this group reaping greater benefits from the exposure I/B/E/S provides. Additional tests support our primary hypotheses. Among less reputable analysts, those who disaggregate are more (less) likely to be promoted (demoted or terminated). The stock market responds similarly, with more weight assigned to earnings forecast revisions provided by analysts who disaggregate their earnings forecasts.     

Do Opinions on Financial Misstatement Firms Affect Analysts’ Reputation with Investors? Evidence from Reputational Spillovers

We examine whether opinions on firms subsequently revealed to have misstated earnings affect analysts’ reputation with investors. We find that positive opinions by bullish analysts hurt their reputation, leading investors to react less to their research on non‐misstatement firms after the misstatement revelation (i.e., negative spillovers). We also find that bearish analysts issuing more negative opinions gain reputation and experience positive spillovers. Finally, for analysts who dropped coverage of the misstatement firm before the misstatement revelation, we find no spillovers, which suggests that analysts experience limited reputational gains when they did not issue a public negative opinion.     

Brokerage M&As and the peer effect on analyst forecast accuracy

We examine whether the impact of a change in the number of analysts a brokerage firm employs has an asymmetric effect on the forecasting ability of superior and inferior analysts. Specifically, we show that following brokerage M&As only superior analysts benefit from a rise in having a larger number of peers. In addition, we find that the market does not account for the improved performance among superior analysts, and argue that this creates an opportunity for investors to capitalize on this.