Aurora Borealis
1 November 2013 CFA Institute Journal Review

The Dark Side of Analyst Coverage: The Case of Innovation (Digest Summary)

  1. Sridhar Balakrishna

Financial analysts have been thought to reduce information asymmetry, but the authors offer evidence of a previously underexplored outcome of analyst coverage. They examine the correlation between analyst coverage, institutional ownership, and innovation (measured in patents and citations) within firms and argue that analyst coverage does more harm than good to firm innovation in the long term.

What’s Inside?

The authors’ objective is to highlight the role of financial analysts in motivating firm innovation, which is important to driving economic growth. Innovation involves a lengthy gestation period with an uncertain outcome and high probability of failure. The authors challenge the existing literature, which suggests that the role of analysts is to reduce information asymmetry. They provide insight into the negative outcome that analyst coverage may have on a firm’s intent to invest in innovation and the short-term myopic view of managers driven by short-term performance.

How Is This Article Useful to Practitioners?

The adverse relationship between analyst coverage and firm innovation has been underexplored, a problem the authors aim to correct. Using an alternative hypothesis (the pressure hypothesis), they argue that analysts exert pressure on managers of listed firms to perform consistently—in effect, forcing them to focus on short-term goals. The authors refer to a 2005 survey of 401 US chief financial officers to support this view.

A byproduct of firm investment in innovation is information asymmetry because firms are forced to make only partial disclosure, fearing negative reporting by analysts and/or downgrades to their stock ratings. Research and development reap uncertain benefits and even have a high probability of failure. The authors also argue that information asymmetry can cause a reduction in analyst coverage, which results in increased institutional ownership of firms by dedicated investors.

This research is of particular interest to institutional investors who want to identify firms that exhibit financial asymmetry in their disclosures and have the propensity for more research and development activities that could catapult them to the growth path. Dedicated institutional investors provide a platform for these listed firms to incubate their ideas and focus on innovation for future growth, avoiding the noise caused by analysts with a focus on short-term results. Also, the results of this research, if fully adopted, could affect the pattern of investment holdings within listed innovative firms. The research may also help retail investors with a value investing mindset to focus on innovative firms with higher institutional holdings that could potentially provide them with attractive long-term returns.

How Did the Authors Conduct This Research?

Initially, the authors focus on the existing hypothesis (information hypothesis), which emphasizes the role played by analysts as transmitters of information from firms to investors. But the main theme of this research is to highlight the other view, the pressure hypothesis, which argues that analysts impose the pressure of short-term performance on firm managers and thereby exacerbate the myopic strategy and impede investment in research and development.

Using two observable innovation outputs—namely, the number of patents granted to a firm and the number of future citations received for each patent—the authors assess the success of long-term investment in innovation. Two strategies help them rule out any endogenous factors affecting analyst coverage and innovation: the difference-in-differences (DiD) and two-stage least-squares (2SLS) approaches.

To measure innovation levels and their relationship with analyst coverage, the authors use data from various sources, such as the National Bureau of Economic Research US Patent Citation database and Harvard Business School patent database (for the number of patents granted), I/B/E/S database (for the analyst coverage of firm earnings), and the Securities Data Company merger and acquisition (M&A) database (for brokerage house merger information). They obtain financial statement data and intraday quotes from various sources. They examine the impact on analyst coverage and firm innovation of such other underlying economic mechanisms as institutional ownership, stock illiquidity, and accrual-based earnings management.

One of the limitations of this study is the study period (1993–2005), although it does include the peak of the software boom (1998–2001). Another factor that could potentially affect the results, albeit to a smaller extent, is the authors’ method of establishing analyst coverage of firms by reviewing brokerage closures and brokerage M&As.

Abstractor’s Viewpoint

The authors concur that analysts play a vital role in improving capital market efficiency and reducing financial information asymmetry. But analysts review firm performance based on quarter-on-quarter financial results, which pressures firms into allocating their capital and labor toward short-term prospects at the risk of shunning long-term strategic growth opportunities.

During the period under study, a significant number of brokerage firms may have been incapacitated by the lack of specialized knowledge in such fields as technological research and development, mining and resources, chemical engineering, and automobiles. The ability to evaluate projects and their impact on a firm’s business and growth may require expert knowledge of the industry and the individual key success factors.

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