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?