Bridge over ocean
25 October 2018 CFA Institute Journal Review

Analyst Coverage and the Quality of Corporate Investment Decisions (Digest Summary)

  1. Nicholas Tan, CFA

The greater the corporate coverage of financial analysts, the higher the quality of corporate investment decisions, which can be measured by total factor productivity within firms. The positive effect of financial analysts comes from their role in distributing information and being an external monitor for more-opaque and financially constrained firms, as well as for firms with relatively weak investor protection.

How Is This Research Useful to Practitioners?

Financial analysts distribute firm-specific information across financial markets based on timely access to information, private knowledge, and analytical prowess. Previous research has shown that financial analysts help to reduce information asymmetries between management and investors but, on the negative side, they force managers to forgo valuable long-term investments in order to meet short-term expectations via a focus on quarterly profits.

The authors study the effect of financial analysts on the quality of corporate investments, first by analyzing the efficiency gains of firm investment decisions as proxied by total factor productivity (TFP), the difference between expected and actual output of the firm.

Baseline regression results indicate a positive relationship between analyst coverage and firm productivity, showing that greater analyst coverage leads to higher-quality corporate investments.

The authors identify channels through which financial analysts improve firm productivity, and the authors discover that the positive effect of analyst coverage on productivity is stronger in more-opaque firms, financially constrained firms, and firms at which investor protection is relatively weak.

They offer two major contributions to the existing literature on finance and productivity: that the information-dissemination role financial analysts play can directly help to stimulate the financing of productive corporate investments, and that financial analysts affect firms’ ability to finance productive-enhancing investments that can help to advance productivity growth.

How Did the Authors Conduct This Research?

Firm-specific financial variables are from Compustat, and analyst information is from I/B/E/S. The sample used to study the relationship between analyst coverage and one-year-ahead firm productivity consists of 35,280 firm-year observations between 1991 and 2013. Firms with missing values for TFP estimation and firms that face different productivity constraints (e.g., non-domestic firms, financial firms, and regulated firms) are excluded.

To assess how analyst coverage affects firm productivity, TFP measures are used as a proxy to capture firm productivity. The key inputs to estimating TFP are output (measured by sales minus materials used in production), capital (measured by property, plant, and equipment), and labor (measured by the total employee number).

Analyst coverage is calculated as the number of unique analysts issuing earnings forecasts for a firm during the 12-month period before its fiscal year-end.

TFP is regressed with the natural logarithm of the analyst coverage measure, and then the effects of year and industry are added. When studying the TFP measure one, two, and three years ahead, the authors find that the coefficient estimates of analyst coverage are positive and significant throughout, which suggests analyst coverage is associated with higher levels of firm productivity.

A major challenge the authors face is the potential endogeneity of analyst coverage, whereby unobservable firm heterogeneity correlated with both analyst coverage and firm productivity could lead to a biased result, and firms with higher productivity potential could simply be attracting more analyst coverage. The authors use identification strategies and performs robustness tests (a two-stage least squares estimation and a difference-in-differences estimation) to establish causality, and the results indicate that analyst coverage significantly enhances firm productivity.

Abstractor’s Viewpoint

The authors do a good job of highlighting the balance that financial analysts must find to improve productivity among firms they cover instead of supporting the perception that financial analysts force managers to focus on short-term returns at the expense of actions that accrue long-term benefits. They also suggest that future research could explore how to maximize the positive effect of financial analysts in countries that regulate analyst behavior differently.

The findings in the article could be used to create a useful addition to the usual fundamental analysis screeners, although it could penalize firms in developing countries, where analyst coverage may be poorer if analyst communities are less established.


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