Previous research suggests that analyst recommendations are positively biased. These recommendations can either be strategically biased or nonstrategically biased. Nonstrategic distortions occur when positive recommendations and optimistic forecasts are present. Strategic distortions occur when positive recommendations and less optimistic forecasts are present. The authors find that affiliated analysts have a stronger tendency to distort strategically than nonaffiliated analysts.
The authors assume that analyst recommendations are positively biased. They believe this bias is motivated by strategic or nonstrategic reasons. Strategic motives result from misaligned incentives in analysts who want to induce investor purchases, generate investment banking business, or satisfy management. Nonstrategic distortions reflect genuine optimism in analysts who are convinced of positive expectations. The authors propose an approach to distinguish between strategic and nonstrategic biases.
How Is This Research Useful to Practitioners?
In general, analysts make recommendations and provide a forecast of future earnings. The authors define strategic distortions as positive recommendations accompanied by less optimistic forecasts. Nonstrategic bias is defined as an occasion when positive recommendations and optimistic forecasts are both present.
The authors find widespread and persistent strategic distortion because many recommendations are tilted toward buys and strong buys, but the related earnings forecasts often underestimate actual earnings. This distortion is more detrimental to small investors, who tend to act more on recommendations than on forecasts. The authors believe analysts would rather overstate recommendations, which small investors believe and react to but large investors tend to discount, than overstate earnings estimates, which large investors watch intently.
They also distinguish between affiliated and nonaffiliated analysts. Affiliated analysts work for an investment bank whereas nonaffiliated analysts make independent recommendations. The authors conclude that although affiliated analysts issue more positive recommendations than nonaffiliated analysts, affiliated analysts issue a similar or higher number of negative earnings forecasts. Affiliated analysts are also found to be slower to downgrade recommendations than nonaffiliated analysts.
Other factors are tested to determine whether those factors can predict the degree of strategic distortion. Institutional ownership and all-star analyst status are not predictive, but investment banking pressure and analysts’ past distortion are strongly predictive of future distortion.
It is important for investors to realize the potential for bias in analysts’ recommendations. The authors believe that analysts use their recommendations and earnings forecasts to “speak in two tongues” and that the existence of different audiences allows them to do so. Practitioners should know that it is important to understand both the recommendation and the earnings forecast portions of an analyst’s report. It is also useful to understand that recommendations may have a stronger influence on small investors whereas the earnings estimates have more influence on institutional investors.
How Did the Authors Conduct This Research?
Using I/B/E/S and CRSP data, the authors collect recommendations and earnings estimates for stocks on the NYSE, Amex, and NASDAQ from February 1994 to December 2008. The average distortion between recommendations and annual earnings forecasts is computed for this period. The authors then test the average distortion against potential predictors of strategic distortion.
The authors ask an important question about whether small investors are negatively affected by the strategic bias inherent in analysts’ buy recommendations. As the authors mention, this subject is topical because small investors are increasingly managing their own investments.