Financial analysts play a key role as information intermediaries in the capital market. Analysts gather and evaluate information from public and private sources, write research reports, produce corporate earnings forecasts, and make recommendations that lead to the buying or selling of a company’s securities. Among financial analysts’ outputs, stock recommendations are the most direct and unequivocal way for analysts to express opinions about likely future stock returns.
Ideally, recommendations should help investors by reducing informational asymmetries, allowing investors to more accurately value companies and thereby profit from trading. Indeed, the short-term price and volume impacts of revisions in analysts’ recommendations reveal that they influence investment decisions of both institutional and retail investors. In turn, researchers have shown that, on average, such investor responses are well-founded: for example, Womack (1996) and Barber et al. (2001) uncover evidence that the cross-section of recommendations has forecasting power for future returns, while Jegadeesh et al. (2004) documents the profitability and informativeness of consensus recommendation levels and consensus recommendation changes, and Ivkovic and Jegadeesh (2004) evaluate the informativeness of recommendation revisions over the earnings announcement cycle.
This research highlights the benevolent side of analysts. Other research highlights less benevolent aspects, documenting how recommendations are influenced by factors other than analysts’ assessments of value. For instance, Lin and McNichols (1998), Ljungqvist et al. (2007) show that sell-side analysts with investment banking relationships are more likely to issue optimistic recommendations; O’Brien, McNichols and Lin (2005) find that affiliated analysts are slower (faster) to downgrade (upgrade) recommendations; while Jackson (2005), Cowen, Groysberg, and Healy (2006) and Ljungqvist et al. (2007) show that bullish recommendations generate more trades for their brokerage houses because investors face implicit or explicit short sale constraints; and Lim (2001) highlights how incentives to curry favor with management leads to upward biases.
Offsetting these less benign incentives, analysts who provide timely and accurate recommendations and forecasts generate additional trading business for their firms (see Cowen, Groysberg, and Healy, (2006) or Jackson (2005)), and are rewarded for it with higher compensation and employment by larger brokerage houses (see e.g., Hong and Kubik (2003)), while less accurate analysts are more likely to be fired (Mikhail, Walther, and Willis, (1999)). Indeed, Ljungqvist et al. (2007), using longitudinal data, find that the presence of more institutional investors induces investment banking affiliated analysts to dampen overly-enthusiastic recommendations, suggesting that career concerns and reputation management alleviate bias. So too, Fang and Yasuda (2006) argue that reputation concerns of analysts should ameliorate the consequences of adverse incentives for recommendations.
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Hazardous Analysts: Reputation Management and the Duration of Recommendations
