Informed or speculative: Short selling analyst recommendations

Christophe et al. (2010) find evidence of abnormal short activity prior to analyst downgrades and argue that short sellers may be violating SEC insider-trading laws by trading on information obtained from analysts about upcoming downgrades. However, observing abnormal shorting prior to downgrades is not tantamount to determining that short sellers are trading on tips from analysts unless shorting is abnormally low prior to upgrades. This paper revisits this issue. While we observe abnormal shorting prior to downgrades, we also find markedly higher shorting prior to upgrades. In fact, the short-selling patterns surrounding both downgrades and upgrades are remarkably symmetric indicating that short sellers during the pre-recommendation period are not unusually informed about the direction of upcoming recommendation changes. If anything, our findings indicate that short selling prior to analyst recommendations is more likely speculative than informed.     

The impact of sell-side analyst research coverage on an affiliated broker’s market share of trading volume

Using NASDAQ reported individual stock level trading volume, we find that analyst research coverage on a stock increases the level of an affiliated broker’s market share of trading volume in that stock by 0.8 percent, on average, which corresponds to an additional annual volume of about one million shares in an average stock. Optimistic recommendations increase the level of market share by an additional 0.3 percent, on average, which is consistent with the notion that analysts have an incentive to issue optimistic recommendations. Also, a broker’s market share of volume increases on average when an affiliated analyst changes his/her recommendation, and decreases with the length of time during which an analyst maintains the same recommendation on a stock. The latter findings suggest that sell-side institutions are rewarded for providing new information to the market and for ongoing research services.     

INVESTORS ADJUST EXPECTATIONS AROUND SELL-SIDE ANALYST REVISIONS IN IPO RECOMMENDATIONS

In this article I compare investor response to sell-side analyst recommendation revisions of initial public offering (IPO) firms in the first three years after issue with that of a benchmark control sample of firms that have been public longer. I test whether investors in IPO firms adjust their initially optimistic expectations as information about new issues is released and uncertainty is resolved. In support of my hypothesis that investors adjust expectations downward, I find abnormally negative returns around analyst revisions of IPO firm recommendations. Additionally, I find the effect of analyst revisions on long-run performance of IPO firms is economically significant.     

ANALYST BEHAVIOR SURROUNDING TENDER OFFER ANNOUNCEMENTS

We examine the usefulness and credibility of analyst recommendations by focusing on their behavior surrounding tender offer announcements. For our 1998–2001 sample, we find analysts did not identify takeover targets through their recommendations nor did they distinguish between wealth‐increasing and wealth‐decreasing tender offers. We find some evidence of conflicts of interest in analyst recommendations, but it is confined to the 1999–2000 dot‐com period. However, the long‐run performance following recommendations suggests that these conflicts have little ultimate cost to investors.     

Are All Security Analysts Equal?

We examine the extent to which security analysts are homogeneous in their effect on firm valuation as measured by Tobin's Q. Earlier research documents a significant and positive relation between analyst coverage and firm valuation. We identify three classes of equity analysts and examine their differential effect on firm valuation associated with their coverage and their information production. We find that equity analysts are not homogeneous in their effect on firm valuation. The presence of analysts at national securities firms have the strongest effect on firm valuation followed by analysts at regional securities firms and finally analysts at nonbrokerage, or research, firms. We attribute this result to the differential monitoring and information dissemination function rendered by the analysts. Information produced by analysts, however, does not share the same credibility. Specifically, we find brokerage firms' buy recommendations are discounted by the market and have a weak effect on firm valuation. The results can be supported by arguments that brokerage firm analysts' recommendations are contaminated by their firms' investment banking relations with corporations.     

Analyst forecasts and European mutual fund trading

This paper addresses the questions whether European mutual fund managers rely on sell-side analyst information and whether this behavior impacts fund performance. Results show that mutual funds significantly increase (decrease) their holdings in stocks when any of the consensus forecast measures increases (decreases) within the quarter prior to the observation period. Furthermore, mutual fund managers primarily attribute high information value to consensus forecast revisions that contain positive information, that are based on a sufficiently high number of inputs, and with more unanimous inputs to the consensus. Finally, following sell-side research seems to be beneficial for mutual fund managers since our results show that stock trades that are in line with analyst forecast revisions significantly outperform trades that are contrary to analyst research.     

Are small investors naive about incentives?

Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward. While they exert buy pressure following strong buy recommendations, they display no reaction to buy recommendations and selling pressure following hold recommendations. This “discounting” is even more pronounced when the analyst is affiliated with the underwriter. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.     

Information content of analyst recommendations in the banking industry

We investigate whether analyst recommendations about banks become more valuable in periods when the information environment for banks is more uncertain. The degree of uncertainty in the information environment for banks is time-varying because of time-varying changes in information asymmetry for banks and in bank regulations. Based on a sample of 23,632 analyst recommendations of 1106 banks, we find that analyst recommendations are more informative for banks that are riskier and subject to a higher degree of information asymmetry. Furthermore, regulations that reduce the information asymmetry (Sarbanes-Oxley Act) or the risk (Dodd-Frank Act) of the banking industry also reduce the information content of analyst recommendations, while regulations that increase the risk of the banking industry (Gramm-Leach-Bliley Act) increase the information content of analyst recommendations. Our results suggest the role of an analyst is more valuable when the information environment is more uncertain.     

Loan loss accounting and procyclical bank lending: The role of direct regulatory actions

I provide evidence that loan loss accounting affects procyclical lending through its impact on regulatory actions. Regulators are more likely to place banks with inadequate loan loss allowances under enforcement actions that restrict lending, leading these banks to lend less during downturns. Further, I find that banks with lower regulatory ratings lend less when they have more timely provisions, consistent with research theorizing that timely provisions increase transparency and inhibit regulatory forbearance. This regulatory action mechanism expands on prior research that has focused on the effect of loan loss recognition on regulatory capital adequacy during economic downturns.     

Analyst firm parent–subsidiary relationship and conflict of interest: evidence from IPO recommendations

We uncover a new source for the conflict of interest in analyst coverage existed before the Regulation FD period by examining whether recommendations within the parent–subsidiary (PS) relationship are more optimistic and whether they have better investment value than non‐PS recommendations. We find evidence consistent with the conflict of interest: PS analysts on average issue more optimistic recommendations, but their recommendations have worse or no better investment value in the calendar‐time portfolio analysis. Analyst firm PS relationship is another source for the conflict of interest in analyst coverage that has not been identified before.     

A comparison of buy‐side and sell‐side analysts

There is very little research on the topic of buy-side analyst performance, and that which does exist yields mixed results. We use a large sample from both the buy-side and the sell-side and report several new results. First, while the contemporaneous returns to portfolios based on sell-side recommendations are positive, the returns for buy-side analysts, proxied by changes in institutional holdings, are negative. Second, the buy-side analysts' underperformance is accentuated when they trade against sell-side analysts' recommendations. Third, abnormal returns positively relate to both the portfolio size and the portfolio turnover of buy-side analysts' institutions, suggesting that large institutions employ superior analysts and that superior analysts frequently change their recommendations. Abnormal returns are also positively related to buy-side portfolios with stocks that have higher analyst coverage, greater institutional holding, and lower earnings forecast dispersion. Fourth, there is substantial persistence in buy-side performance, but even the top decile performs poorly. These findings suggest that sell-side analysts still outperform buy-side analysts despite the severe conflicts of interest documented in the literature.     

Limited investor attention,relative fundamental strength,and the cross-section of stock returns

We explore the underlying reasons for the apparent mispricing of firms based on fundamental information. We document that a relative fundamental strength strategy that buys (sells) firms with strong (weak) fundamentals is highly profitable for up to three years. The results cannot be explained by either price or earnings momentum, are robust to risk adjustments based on standard asset pricing models, and survive a battery of robustness tests. The strategy also works better among small firms, as well as firms with low analyst coverage and a high probability of informed trading. Our empirical findings support the hypotheses of limited investor attention and informed trading.     

A new approach to predicting analyst forecast errors: Do investors overweight analyst forecasts?

I provide evidence that investors overweight analyst forecasts by demonstrating that prices do not fully reflect predictable components of analyst errors, which conflicts with conclusions in prior research. I highlight estimation bias in traditional approaches and develop a new approach that reduces this bias. I estimate characteristic forecasts that map current firm characteristics into forecasts of future earnings. Contrasting characteristic and analyst forecasts predicts analyst forecast errors and revisions. I find abnormal returns to strategies that sort firms by predicted forecast errors, consistent with investors overweighting analyst forecasts and predictable biases in analyst forecasts influencing the information content of prices.     

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.     

Analyst following,staggered boards,and managerial entrenchment

We use agency theory to explore how analyst coverage is influenced by the managerial entrenchment associated with the staggered board. The evidence suggests that firms with staggered boards attract significantly larger analyst following. We also document that firms with staggered boards experience less information asymmetry. Staggered boards insulate managers from the discipline of the takeover market. Entrenched managers are well-protected by the staggered board and have fewer incentives to conceal information, resulting in less information asymmetry. The more transparent information environment facilitates the analyst’s job. As a consequence, more analysts are attracted to firms with staggered boards. We also document the beneficial role of analyst coverage in improving firm value. Our results confirm the notion that analysts, as information intermediaries, provide oversight over management and thus help alleviate agency conflicts. The positive effect of analyst coverage, however, is severely reduced when the firm has a staggered board in place.     

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.     

Do investment banks listen to their own analysts?

To what extent conflicts of interest affect the investment value of sell-side analyst research is an ongoing debate. We approach this issue from a new direction by investigating how asset-management divisions of investment banks use stock recommendations issued by their own analysts. Based on holdings changes around initiations, upgrades, and downgrades from 1993 to 2003, we find that these bank-affiliated investors follow recommendations from sell-side analysts in general, increasing (decreasing) their relative holdings following positive (negative) recommendations. More importantly, these investors respond more strongly to recommendations issued by their own analysts than to those issued by analysts affiliated with other banks, especially for recommendations on small and low-analyst-coverage firms. Thus, we find that investment banks “eat their own cooking,” showing that these presumably sophisticated institutional investors view sell-side recommendations as having investment value, particularly when the recommendations come from their own analysts.     

The Governance Effect of the Media's News Dissemination Role: Evidence from Insider Trading

We investigate whether the media plays a role in corporate governance by disseminating news. Using a comprehensive data set of corporate and insider news coverage for the 2001–2012 period, we show that the media reduces insiders’ future trading profits by disseminating news on prior insiders’ trades available from regulatory filings. We find support for three economic mechanisms underlying the disciplining effect of news dissemination: the reduction of information asymmetry, concerns regarding litigation risk, and the impact on insiders’ personal wealth and reputation. Our findings provide new insights into the real effect of news dissemination.     

Behavioural Bias and Conflicts of Interest in Analyst Stock Recommendations

Abstract:  This paper tests whether sell-side analysts are prone to behavioural errors when making stock recommendations as well as the impact of investment banking relationships on their judgments. In particular, we analyse their report narratives for evidence of cognitive bias. We find first that new buy recommendations on average have no investment value whereas new sell recommendations do, and take time to be assimilated by the market. We also show that new buy recommendations are distinguished from new sells both by the level of analyst optimism and representativeness bias as well as with increased conflicts of interest. Successful new buy recommendations are characterised by lower prior returns, value stock status, smaller firms and weaker investment banking relationships. On the other hand, successful new sells do not differ from their unsuccessful counterparts in terms of these measures. As such, we provide evidence that analysts are prone both to behavioural bias as well as potential conflicts of interest in their new buy stock recommendation decisions. We also show that these two explanations of analyst behaviour are to a great extent independent of each other. Consequently, the recent attempts by regulators to address potential conflicts of interest in analyst behaviour may have only limited impact.     

The Predictive Content of Aggregate Analyst Recommendations

Using more than 350,000 sell‐side analyst recommendations from January 1994 to August 2006, this paper examines the predictive content of aggregate analyst recommendations. We find that changes in aggregate analyst recommendations forecast future market excess returns after controlling for macroeconomic variables that have been shown to influence market returns. Similarly, changes in industry‐aggregated analyst recommendations predict future industry returns. Changes in aggregate analyst recommendations also predict one‐quarter‐ahead aggregate earnings growth. Overall, our results suggest that analyst recommendations contain market‐ and industry‐level information about future returns and earnings.