Is analyst research valuable to Finance Directors and investors?
Academic research provides ample evidence that share prices are affected by information in analyst reports, which indicates that investors pay attention to what analysts have to say. However, this contrasts with other evidence both from insiders and academics that analysts face pressures to remain on good terms with management and avoid providing negative commentary to retain access to the company.
Analyst optimism bias results in an unwillingness to issue sell recommendations or significantly downgrade an earnings forecast. Institutional pressures mean analysts want to keep a good relationship with the financial director (FD), allowing access for their clients as well as retaining the potential to win investment banking mandates from the company for their employers.
In previous times, before legislation and rule changes, analysts and FDs would engage in frank and open discussions to allow analysts to develop accurate forecasts and write engaging insightful research which would attract clients to their employers. Rule changes and scandals have altered the environment but producing interesting and informative research remains an analyst’s key role. Earnings conference calls and meetings with groups of investors can now provide the forums where analysts can ask questions and direct discussions to get answers to their concerns and expectations of companies.
From the FD’s perspective, analysts can be vital allies for getting the company’s message out to a wider audience. Investor interest can help reduce the cost of raising external finance so analyst and media coverage is particularly important for companies looking to issue shares or borrow more. Coverage and media interest can be a particular problem for small firms which may struggle to get any analyst coverage.
Mid-cap and small-cap companies may have a different relationship with analysts if the FD is keen to retain any coverage to attract more investors. Inevitably, analysts covering small and mid-cap companies will have more companies to cover and get less help from those companies which may not have dedicated investor relations staff.
New rules in the UK this year limiting how client money can be used to pay for research and banning payments to equity analysts for facilitating meetings between investors and company management will increase these pressures. The number of analysts is expected to fall further despite significant cuts in response to the financial crisis in 2008. Smaller companies may be denied any research coverage reducing trading in their shares and tempting them to leave the stock market completely.
The investors’ view of analysts will differ from an FD’s perspective. Sceptical observers view analysts as being simply a conduit to provide commissions and investment banking mandates for their employers. Their independence is questioned as the research they produce may be influenced by the interests of their employers, for example, if their employer holds a short position in the stock. However, analysts who are entertaining to read, appear independent-minded and have a good track record of forecasting will still have influence on investors.
Research suggests that accurate equity analysts get paid more, generate more income for their employers and work for larger investment houses than those with less reliable track records.
Given this widely held view of analysts, our research looked at whether analysts’ behaviour reflected a lack of independence and a desire to put a positive spin on any news from companies. By focusing on how analysts responded to earnings announcements, we drew on psychological insights about how individuals react differently to good and bad news. Unexpected and/or disappointing news challenges people’s expectations and makes them seek more detailed explanations of what has happened. We found evidence that analysts behaved differently when companies delivered unexpected bad news compared to their reactions to expected good news from those same companies.
By looking at analysts’ research notes and the questions they asked in conference calls, we found that analysts asked more in-depth and critical questions and were more likely to produce negative commentary after unexpected bad news. At conference calls, analysts were much more likely to ask about threats to the company and challenge management’s comments after disappointing earnings news.
In research notes, negative comments about firm prospects and management more than doubled after bad news. We also found evidence of robust questioning and commentary when news was positive, albeit at lower levels. This evidence runs counter to the view that analysts lack independence from companies and will always sacrifice impartiality to keep friendly relationships with senior management.
Our evidence confirms what many FDs know - that good analysts will make up their own minds about companies and not issue optimistically biased commentary where the company has underperformed. Analysts who receive unexpected bad news often see this as evidence of deeper problems at the company and want to know whether their instincts are correct so they can downgrade their forecasts and recommendations.
Stock price falls after unexpected bad news are associated with senior management losing their jobs as investors lose faith in them. To counter these negative outcomes, FDs will often want to ensure that bad news is not unexpected by letting analysts and investors know when results are unlikely to meet expectations and more importantly, what the company plans to do to sort out any current problems.
Our results show that FDs can’t rely on analysts being uncritical cheerleaders for companies which disappoint. When bad news occurs, analysts are prepared to ignore pressures to remain positive and give investors an objective and often negative view of the company’s management and prospects.