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26 September 2019 CFA Institute Journal Review

Firms’ Innovation Strategy under the Shadow of Analyst Coverage (Digest summary)

  1. Priyank Singhvi, CFA

This is a summary of “Firms’ Innovation Strategy under the Shadow of Analyst Coverage,” by Bing Guo, David Pérez-Castrillo, and Anna Toldrà-Simats, published in the Journal of Financial Economics, vol. 131, no. 2.

Equity analyst coverage affects the way firms innovate. An increase in analyst coverage leads to firms’ reducing allocations to internal R&D and preferring external channels of acquisitions and corporate venture capital for innovation. Analyst coverage also increases the efficiency of innovation efforts as measured by patents and citations.

What Is the Investment Issue?

The authors demonstrate the impact of analyst coverage on the way firms innovate and the effectiveness of the innovation strategy. Analysts influence firms’ innovation strategy primarily through two mechanisms:

  • The information effect, wherein the analyst provides reliable information and thus helps communicate to investors—particularly about difficult-to-evaluate, complex, and long-term initiatives regarding innovation
  • The pressure effect, wherein the analyst tracks and reports on financial performance quarterly

How Did the Authors Conduct This Research?

The authors look at all US public firms with more than $10 million in assets, excluding financials and utilities, between 1990 and 2012. Using such statistical methods as ordinary least-squares regression, instrumental variables, and difference-in-difference, they identify links between analyst coverage and innovation strategy and outcomes.

Analyst coverage, the key independent variable, is measured as the number of analysts covering the firm in a given period. The difference between actual earnings per share (EPS) and estimated EPS reflects the pressure effect. These results are regressed against the dependent variable of innovation strategy, as reflected by change in R&D spend, acquisitions for technology, and corporate venture capital programs. The authors use the number of patents and citations as well as the incremental or radical nature of innovation as indicators of the innovation outcomes.

A set of firm and industry characteristics from the financial literature that may affect the firms’ innovation strategy provides the control variables: firm size, R&D expenses, firm age, leverage, cash, return on equity, Tobin’s Q, fixed assets and capital expenditure, institutional ownership, an index of corporate governance, and industry structure as captured by the Hirschman–Herfindahl Index.

The authors use their methodology to address the potential endogeneity and reverse causality stemming from certain situations where the same firm-specific phenomenon affects both analyst coverage and the innovation strategy.

What Are the Findings and Implications for Investors and Investment Professionals?

Increased analyst coverage, through the close monitoring of earnings, leads to significant reduction in R&D spending one to two years ahead. The probability of a cut in R&D expenses when an additional analyst starts covering a firm originally covered by one analyst is 4.4%, and the average cut is ~0.5% of assets. An average company in the authors’ research has six analysts, and for that, an additional analyst increases the likelihood of cut in R&D by about 1%.

Decreased information asymmetry by increased analyst coverage leads to (1) a higher likelihood of acquisitions, (2) a higher number of acquisitions, and (3) increased innovation in the targets. If the number of analysts goes from one to two, the likelihood of the target firm acquiring other firms one year later increases by 4.1%, a significant number in the context of the average likelihood of acquisitions in the sample being 15.4%. Also, the average numbers of patents and citations of the target firms one year ahead increase by 23.5% and 23.8%, respectively, when coverage increases from one to two analysts.

Similarly, the likelihood of firms setting up a corporate venture capital (CVC) fund and making investments in startups in one to two years also increases with increased coverage. If the number of analysts increases from one to two, the probability of a firm setting up CVC funds and investing in startups increases by 0.6% and 2.2%, respectively.

The impact of analyst coverage on innovation strategy is more pronounced in high-tech firms, firms facing financial constraints, and firms with relatively poor corporate governance.

This research also shows that analyst coverage not only changes the way firms innovate but also makes it more effective:

“…We find that firms that cut R&D expenses after being followed by financial analysts produce more patents and citations. Similarly, firms’ investments in acquisitions and CVC funds have a positive and significant impact on the future patents and citations....”

This finding is intuitive because higher analyst coverage is expected to lead to increased pressure on management to demonstrate more efficient and successful innovation activity. The authors find, however, that internal innovation becomes less radical with increased coverage.

When applying the authors’ findings to business evaluation, one needs to be mindful that, although patents and citations are probably one of the best and most widely used proxies of innovation, not all innovation with business value is patented or is patentable.

At another level, this research acts as a reminder of the responsibility equity analysts carry. They not only report on and forecast about companies but also have a significant effect on shaping strategy for the companies they cover.

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