Aug 1, 2010

When Secu­ri­ty Ana­lysts Talk, Who Real­ly Listens?

Large and small investors find dif­fer­ent results when fol­low­ing ana­lyst recommendations

Based on the research of

Michael B. Mikhail

Beverly Walther

Richard H. Willis

When it comes to invest­ing, it seems like a good idea to fol­low experts’ rec­om­men­da­tions. Real-world results gen­er­al­ly sup­port that intu­ition. How­ev­er not all rec­om­men­da­tions are equal­ly prof­itable, and when decid­ing how to act, indi­vid­ual investors should take a sec­ond look at both the ana­lyst reports and the cir­cum­stances under which the ana­lysts operate.

Small investors react­ing to a sell-side secu­ri­ty analyst’s rec­om­men­da­tions lose an aver­age of near­ly two per­cent on their trad­ing activ­i­ties in the five days after the rec­om­men­da­tion is issued, accord­ing to research by Bev­er­ly Walther, a pro­fes­sor of Account­ing and Infor­ma­tion Man­age­ment at the Kel­logg School of Man­age­ment. In con­trast, large traders react­ing to the same advice gain more than five per­cent in the same time peri­od. Walther says it appears that small investors react to the mere issuance of rec­om­men­da­tions, with­out look­ing at the under­ly­ing argu­ments in the report, assess­ing the cred­i­bil­i­ty of the infor­ma­tion, or con­sid­er­ing ana­lysts’ com­pet­ing interests.

An ana­lyst may have the incen­tive to issue a biased, over­ly opti­mistic report if he or she works at an invest­ment bank­ing house or a com­pa­ny that has done invest­ment bank­ing deals with the firm under review, Walther points out. Even ana­lysts who do not have these rela­tion­ships may have an incen­tive to be over­ly opti­mistic because they some­times rely on firm man­age­ment to try to get inside infor­ma­tion and do not want to alien­ate the firm’s management.

To pro­tect investors, in 2003 the Secu­ri­ties and Exchange Com­mis­sion adopt­ed Reg­u­la­tion AC. It requires stock ana­lysts and oth­ers that issue a report on a secu­ri­ty to cer­ti­fy that the views expressed are accu­rate reflec­tions of their per­son­al views. They must also dis­close whether they were com­pen­sat­ed for the views expressed.

Walther notes that despite the con­cerns expressed by reg­u­la­tors, it’s not real­ly clear that small investors — indi­vid­u­als — rely that much on ana­lyst reports to begin with and, if they do react, that they are harmed.” Work­ing with Michael B. Mikhail of Ari­zona State Uni­ver­si­ty and Richard H. Willis of Van­der­bilt Uni­ver­si­ty, Walther eval­u­at­ed how small and large investors respond to secu­ri­ty ana­lyst stock rec­om­men­da­tions and how their returns compare.

The researchers cat­e­go­rized investors based on the amounts of their trades: large” was defined as more than $30,000, and small” was defined as less than $7,000. Walther explains that, in gen­er­al, the size of the trade indi­cates the type of trad­er. If they’re plac­ing trades of $50,000 or $200,000 at a time, pre­sum­ably those are fun­da­men­tal­ly dif­fer­ent types of enti­ties than ones plac­ing a trade of $1,000,” she says. But the data avail­able do not allow us to defin­i­tive­ly clas­si­fy the trades we see as being placed by insti­tu­tions or individuals.”

Large Investors Look More Care­ful­ly at the Infor­ma­tion
Walther and her col­leagues used the Zacks Invest­ment Research data­base to obtain the dates and val­ues of rec­om­men­da­tions issued by indi­vid­ual ana­lysts dur­ing 1993 to 1999, pri­or to the imple­men­ta­tion of Reg­u­la­tion AC. If you look at one of these ana­lyst reports on a firm, you’ll see there’s a lot of head­line’ infor­ma­tion that the media very often pulls out,” Walther says. The ana­lyst will say, for exam­ple, that they are issu­ing a buy rec­om­men­da­tion. They give an earn­ings fore­cast or report what they expect the price to be some­time in the future for this firm.”

But Walther cau­tions that more often than not, fol­low­ing that head­line is a dis­cus­sion the ana­lyst writes, essen­tial­ly jus­ti­fy­ing the rec­om­men­da­tion.” The analyst’s report often con­tains infor­ma­tion such as what the ana­lyst expects the demand for the firm’s prod­ucts to be, indus­try trends, future expens­es — much more detailed infor­ma­tion that they use to come up with that sum­ma­ry recommendation.”

After devel­op­ing mea­sures of how much infor­ma­tion was in each report, the researchers found that large traders’ reac­tions were asso­ci­at­ed with how much infor­ma­tion was avail­able. If there was a lot more infor­ma­tion in the report, large traders trad­ed more. If there was not as much infor­ma­tion in the report, large traders trad­ed less,” Walther sum­ma­rizes. Small investors seemed to react to the occur­rence of a rec­om­men­da­tion rather than to the infor­ma­tion con­tained in the more detailed report.

Thus, both large and small investors react­ed to rec­om­men­da­tion revi­sions, but their reac­tions dif­fered. While large investors trade more in response to the infor­ma­tion con­veyed by the analyst’s rec­om­men­da­tion and earn­ings fore­cast revi­sion, small investors trade more in response to the occur­rence of a rec­om­men­da­tion,” the researchers write in a paper based on their research.

The arti­cle also reports that small investors trad­ed more than large investors fol­low­ing upgrade and buy rec­om­men­da­tions, and they trad­ed more fol­low­ing upgrade and buy rec­om­men­da­tions than they did fol­low­ing down­grade and hold/​sell rec­om­men­da­tions. The researchers cite evi­dence that the mar­ket reac­tion to upgrades/​buy rec­om­men­da­tions is typ­i­cal­ly less pro­nounced than the reac­tion to downgrade/​sell rec­om­men­da­tions, and they argue that as a result, upgrade/​buy rec­om­men­da­tions are less cred­i­ble than down­grade or hold/​sell rec­om­men­da­tions. It seems that small investors do not take this into con­sid­er­a­tion when react­ing to ana­lysts’ recommendations.

Large Traders Earn More than Small Traders
Sur­pris­ing­ly, small traders tend­ed to be net pur­chasers fol­low­ing rec­om­men­da­tion revi­sions, regard­less of the direc­tion of the rec­om­men­da­tion revi­sion. Con­verse­ly, large traders tend­ed to be net sell­ers fol­low­ing down­grades and sells. As a con­se­quence of the dif­fer­ences in trad­ing pat­terns, small traders tend to lose mon­ey and large traders tend to make mon­ey. This find­ing pro­vides some sup­port for reg­u­la­tors’ con­cerns that ana­lysts may eas­i­ly mis­lead small investors, Walther and her col­leagues con­clude in their paper.

The researchers’ analy­sis shows that large traders tend­ed to make mon­ey regard­less of the type of rec­om­men­da­tion. Con­verse­ly, small traders lost mon­ey over­all, as well as after down­grades and sells. Large traders earned an aver­age of 5.1 per­cent com­pared with a 0.9 per­cent loss for small traders fol­low­ing strong buys/​buys. The dif­fer­ence was even larg­er for the trad­ing peri­od fol­low­ing hold/​sell rec­om­men­da­tions, when large traders earned 5.2 per­cent and small traders lost 3.1 percent.


Fig­ure 1. Esti­mates of how much mon­ey was made or lost by large and small investors in the five trad­ing days fol­low­ing the issuance of a recommendation.

In addi­tion, even though small traders bought more than large traders did fol­low­ing upgrade and strong buy/​buy rec­om­men­da­tions, small traders made less mon­ey from these trades. Large traders earned 5.4 per­cent fol­low­ing an upgrade rec­om­men­da­tion, com­pared with earn­ings of 0.4 per­cent for small traders. This find­ing is sur­pris­ing giv­en that returns sur­round­ing these rec­om­men­da­tions are, on aver­age, pos­i­tive,” the researchers write. One pos­si­bil­i­ty is that large traders are able to dis­cern which rec­om­men­da­tions are asso­ci­at­ed with more prof­itable returns while small traders are not.”

Walther and her col­leagues con­clude that their research pro­vides pre­lim­i­nary evi­dence sup­port­ing reg­u­la­tors’ con­cerns that small investors do not prop­er­ly con­sid­er the effects of ana­lyst incen­tives on report cred­i­bil­i­ty when react­ing to rec­om­men­da­tions.” They note that because their analy­ses are based on ana­lyst rec­om­men­da­tions issued pri­or to the pas­sage of Reg­u­la­tion AC, it remains an open ques­tion whether these dis­clo­sures are effec­tive in mit­i­gat­ing small investors’ appar­ent­ly sub­op­ti­mal invest­ment decisions.”

Featured Faculty

Beverly Walther

Professor of Accounting Information and Management, Department Chair of Accounting Information & Management

About the Writer

Beverly A. Caley, JD, is a freelance writer based in Corvallis, Ore.

About the Research

Mikhail, Michael B., Beverly R. Walther, and Richard H. Willis. 2007. “When security analysts talk, who listens?” The Accounting Review, 82: 1227-1253.

Read the original

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