Ebook Do Financial Analysts Restrain Insiders’ Informational Advantage?
How does competition between sell-side analysts and firm insiders for price sensitive information affect market equilibrium and liquidity? In their theoretical papers, Fishman and Hagerty (1992) and Khanna, Slezak and Bradley (1994) predict that firm insiders and research analysts compete for price sensitive information. Without the presence of analysts, firm insiders have monopoly over information, allowing them to maximize the benefits from informational rents. This should have an impact on market equilibrium. As Holden and Subrahmanyam (1992) show, competition between informed agents wipes out any informational advantage, leading to deeper markets and more information revelation.
The empirical literature so far has focused exclusively on competition between analysts but has failed to investigate the competitive relationship between analysts and insiders and the resulting impact on market equilibrium. This paper aims to fill this gap in the literature. Unlike informed outsiders, insiders have access to better information about the firm’s prospects at no cost. This informational advantage should impact traders’ welfare and the trading process. The presence of an informed outsider should provide competition to insiders and reduce insiders’ trading profits. Most importantly, if the informed outsider’s information becomes public more rapidly relative to that of insiders, as Brennan and Subrahmanyam (1995) suggest, then analysts should create a more level-playing field for traders and generate a positive impact on liquidity and price discovery.
Fishman and Hagerty (1992) provide theoretical guidance in answering our research question. The presence of analysts and their interaction with insiders are crucial in reducing the informational advantage insiders have. Price efficiency increases as (i) the number of informed outsiders increases, and (ii) private information becomes more evenly distributed among traders. They show that the presence of insiders produces two adverse effects on trading: first, informed outsiders are less likely to acquire information, and second, informed outsiders have an informational disadvantage relative to insiders. In this scenario, we argue that liquidity traders can suffer along with informed outsiders from the monopolistic presence of insiders. Traders may defend themselves in different ways in such a scenario: spreads may widen in response and traders may ultimately leave the stocks, leading to lower liquidity and less efficient prices.
The effect of analysts depends on the quality of information they acquire. If sell-side analysts produce and disseminate valuable information, they should help lower insiders’ informational advantage and bring a consequent increase in benefits to liquidity traders. Even if analysts’ reports suffer from biased research and conflicts of interest (Michaely and Womack, 1999 and Agrawal and Chen, 2008) or if analysts simply re-package public information (Easley et al. (1998), Roulstone (2003), and Piotroski and Roulstone (2004)), they can still pose some level of competition to insiders as long as they contribute to the price discovery process.
In order to empirically investigate whether analysts restrain insiders’ informational advantage, we use a (quasi) natural experiment consisting of stocks in which firms’ insiders become monopolists over trade-related information following a complete loss of research coverage. These coverage terminations are publicized events. We look at years where market developments and new regulations, embodied by the Global Settlement, changed the sell-side research business. For the period 1999-2003, we found 558 firms that lost all research coverage for reasons other than (a) subsequent bankruptcy, delisting or takeover, (b) a decrease of institutional holdings, or (c) an increase in insiders’ presence or trading activity. The number of stocks dropped by analysts in our time period is unusually high (Khorana, Mola and Rau (2007))driven mainly by restructuring of research departments. Kelly and Ljungqvist (2008) also find evidence of exogenous coverage termination during our period that was the “result of brokerage firms downsizing their research operations in response to adverse changes in the economics of producing research in the early 2000s” (page 2). These unusually high rates of coverage termination, together with the various screens we apply, provide a good natural experiment to investigate our research question. A time-series research design like ours produces cleaner results than a cross-sectional design because the magnitude of insiders’ presence may determine analyst coverage in the first place, leading to severe endogeneity issues. The stocks used in our tests do not experience any change in insiders’ or institutional investors’ holdings or activity prior to coverage termination. Hence, there is no crowding-out effect from insiders or institutions.
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