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Federal Reserve Bank of Atlanta Financial Markets Conference, April 2004
Which Types of Analyst Firms Make More Optimistic Forecasts?
Amanda Cowen, Boris Groysberg, Paul HealyHarvard Business School
Agenda
• Motivation• Institutional background• Sample• Tests and results• Policy questions
Motivation
• NY State AG analyst investigation – Focus on investment banking conflicts
• Settlement – Mitigate investment bank conflicts
– Increase quality & independent of research
• Yet limited understanding of financial analysts’ incentives in issuing forecasts
Investigation Findings:Investment Banking Effects on Research
• Affected initiation/continuation of coverage• Analysts performed investment banking functions• Investment bankers evaluated analyst
performance• Inadequate controls over senior analysts
– Eg: Jack Grubman, Mary Meeker, Henry Blodget, Justin Baldauf, Kirsten Campbell, etc.
– No system for reviewing senior analyst ratings
– Lowest ratings unused
Examples of Analyst Improprieties
Company Date Analysts’ Private Comments ST Rating
LT Rating
Excite@home (ATHM)
06/03/00 “such a piece of crap” (ML51453) 2 1
GoTo.Com (GOTO)
1/11/01 Nothing interesting about company“except banking fees” (ML03806)
3 1
InfoSpace (INSP)
07/13/00 “this stock is a powder keg, given how aggressive we were on it earlier this year and given the ‘bad smell’ comments that so many institutions are bringing up” (ML06413)
1 1
Settlement
• Agreement between SEC, NY State AG, NASD, NYSE and 10 leading banks (April 28, 2003)
• Mitigate investment banking/research conflicts– Separate research and investment banking (reporting lines, budget,
physical separation, compensation, evaluation, coverage, no soliciting I/B business)
– Disclosure of analyst conflicts
• Improve overall research quality– Increase transparency of analysts’ performance
– Banks purchase & distribute third-party research on covered companies from Independent Research Providers (with no investment banking business)
Settlement Fines
($ in millions)
Firm FineIndependent
ResearchInvestor
Salomon Smith Barney $300 $75 $25 $400 CSFB 150 50 0 200 Merrill Lynch 100 75 25 200 Morgan Stanley 50 75 0 125 Goldman Sachs 50 50 10 110 Bear Stearns 50 25 5 80 Deutsche Bank 50 25 5 80 J.P. Morgan Chase 50 25 5 80 Lehman Bros. 50 25 5 80 UBS Warburg 50 25 5 80
TOTAL $900 $450 $85 $1,435
Source: Reuters; SEC; New York Attorney General
Education Total
Prior Research on Analyst Incentives
• Optimistic LT forecasts & recommendations by affiliated analysts– Lin & McNichols, 1998; Michaely & Womack, 1999; Rajan &
Servaes, 1997; Dechow, Hutton & Sloan, 2000; Lin, McNichols, O’Brien, 2003
• Investment banking affects analyst promotions– Hong and Kubik, 2003
• No short-term earnings forecast optimism– Hansen & Sarin, 1996; Ali 1996
• Value Line forecasts more accurate than I/B/E/S forecasts – Philbrick & Ricks, 1991
Research Questions
• How do incentives differ for analysts at different types of firms:
– Full service investment banks
– Brokerage firms
– Research firms
• How optimistic are analysts at these different types of firms?
Analyst Incentives:Sources of Research Funding
• Indirect funding of research. Primary sources:– Institutional equities
– Investment banking (42% of total for 8 leading banks)
– Retail business
– Fixed income
• Merrill Lynch ($578.7M in 2001)– Funding sources: 72% Institutional Equities and Investment
banking, 22% Retail business, and 6% Fixed Income
• Goldman Sachs ($321.1M in 2001)– Funding sources: 50% Institutional Equities and 50%
Investment banking
How Does Research Funding Vary Across Firms?
Form of funding Underwriter Syndicate Brokerage Research
Hard dollar $$
3rd party soft dollar $ $ $ $$
Directed commissions
$$ $$ $$
Underwriting $$ $
Types of firm
Analyst Incentives by Firm-Type
• Underwriting firms– Optimistic forecasts to attract new clients/sell new IPOs
– Limited by bank and analyst reputations
• Brokerage firms– Optimistic to encourage buys
– Institutional vs retail incentives
– Disintermediation
• Research firms
Research Tests
• Analyst forecast optimism and accuracy for– Earnings (1 quarter, 2 quarters, 3-5 quarters ahead)
– 3-5 year ahead earnings growth rates
– 12 month target prices
• Across different types of firms– Underwriters (bulge and non-bulge)
– Syndicate firms
– Brokerage firms (retail and institutional)
– Research firms
Sample Analyst Firm Types
Underwriters Syndicate Brokerage Research
ABN AMRO Sanford C. Bernstein
Standard & Poors JSA Research
William Blair & Company
Putnam, Lovell, Securities
First Dallas Securities
Emerald Research
Merrill Lynch H&R Block Financial Advisors
Beeson Gregory Shonstrom Research
Salomon Smith Barney
Chapin Davis Frith Brothers Investments
Red Chip Review
Sample Forecasts
• Earnings forecasts (Jan. 1996-Dec. 2002)– 809,552 forecasts, 6,755 companies, 6,483 analysts 370 firms
– 86% by underwriter analysts, 9% syndicate, 4.5% brokerage
• Long-term earnings growth forecasts (Jan. 1996-Dec. 2002)– 25,642 forecasts, 3,229 companies, 3,439 analysts, 198 firms
– 90% by underwriter analysts, 7% syndicate, 2.7% brokerage
• Target prices by analyst firms (Jan. 1999-Sept. 2002)– 91,994 forecasts, 3,637 companies, 3,954 analysts, 192 firms
– 90% by underwriter firm analysts, 8% syndicate, 1.6% brokerage
Measuring Forecast Optimism
• Relative earnings/price forecast optimism
Relative forecast optimism (RFOPT) controls for: – Company effects (i)– Time effects (t)– Horizon (t-k)
)( ktit
ktit
ktitjkt
itj FORECASTSTDEV
FORECASTFORECASTRFOPT
Relative Earnings Optimism by Analyst Firm
-0.02
0
0.02
0.04
0.06
0.08
0.1
0-90 dayhorizon
91-180 dayhorizon
181+ dayhorizon
Underwriter banks
Syndicate firms
Brokerage firms
Pure research firms
Relative LT Earnings Growth Optimism by Analyst Firm
-0.02
0
0.02
0.04
0.06
0.08
0.1
0.12
Underwriter banksSyndicate firmsBrokerage firmsPure research firms
Relative Price Optimism by Analyst Firm
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
UnderwriterbanksSyndicate firms
Brokerage firms
Pure researchfirms
• Dependent variables– Relative forecast optimism (earnings, LT earnings growth,
target price)
• Key independent variables– Analyst firm effect: underwriter, syndicate, brokerage,
pure research
– Analyst company experience: log quarters of coverage
– Analyst forecast accuracy: mean relative forecast accuracy
– Forecast horizon (for earnings sample)
Model Specification
Relative Optimism Tests
EPS
0-90 day
EPS 91-180
day
EPS
181+ day
LT EPS growth Price
Underwriter less optimistic than
Non-underwriter * * ** **
Underwriter less optimistic than
Syndicate * * *
Brokerage * * *
Research **
Optimism increasing in experience ** * * *
Additional Tests
• Effect of Stock Market Crash: Similar results before & after
• Low optimism by high status bulge firms does not explain brokerage optimism
• Retail brokerage firms more optimistic than institutional brokerage, but incomplete explanation
• Optimism pattern typically similar for firms that make new issues and those that do not
• Accuracy results consistent with optimism
Policy Questions
• Why are brokerage analysts so optimistic?– Focused trading incentives?
– Retail firm incentives?
• Will bank distribution of independent research improve quality?– Will brokerage firms continue to be optimistic?
– Will banks that use trading to fund research become more biased?
– Will banks devote less resources for research?
• Who will undertake retail research & how will it be funded?
• Will Reg FD reduce effect of length of company coverage on optimism?