Sell-Side Research Analysts Are Destroying America, Apparently

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Here's sort of a pleasing paper on equity research analysts. The background is basically that there's this constellation of questions that reduce to "do public markets make companies Bad?," and one of the main mechanisms by which that might happen would be if markets make companies focus on short-term earnings and shareholder distributions rather than long-term value creation for all stakeholders through sustainable innovation. So you try to find ways to measure (1) how public a company is and (2) how innovative it is, more or less, and then see how they interact. Analyst coverage is sort of a proxy for, like, intensity of public-ness,1 while patents are sort of a proxy for innovation.2 So does more research coverage make companies more or less innovative?

In terms of economic significance, our analysis suggests that an exogenous average loss of one analyst following a firm causes it to generate 18.2% more patents over a three-year window than a similar firm without any decrease in analyst coverage.

Note the "exogenous": if you just look at raw analyst coverage versus patents, you get "a positive raw association between analystcoverage and the firm’s innovation output," which is sort of obvious; Google and Apple have more analyst coverage and more patents than, say, Yummy Flies, Inc.3 When you control for things like company size, etc., though, fewer analysts goes with more and more influential patents. The authors also look at some quasi-natural experiments - like: if two brokerage firms merge and fire one of your analysts, your analyst count goes down for no real reason - and find that these no-real-reason analyst changes significantly correlate with future innovation. Which suggests there's some sort of causal relationship between coverage and innovation. Then there's a lot of regressions and stuff.

If you believe these regressions, it's a fun result for those in the public-markets-are-evil, let's-ignore-shareholders camp. It might, for instance, make you a little more sympathetic to Michael Dell's argument that no long-term good can be done at Dell as long as he's gotta wake up and check the stock price every day. On the other hand, one of the explicit purposes of the JOBS Act, and of the proposed JOBS Act 2.0, was to make it easier for small newly public companies to attract research coverage. These results might suggest that those little newly public companies should be left alone to develop in peace, away from the prying eyes of sell-side research coverage. Research coverage might be a mixed bag.

Why? The paper looks at a couple of causal mechanisms for how analysts might stifle innovation, and find first of all "that an exogenous decrease in analyst coverage due to brokerage closures or mergers increases a firm’s equity ownership by dedicated institutional investors and decreases that by non-dedicated institutional investors."4 More analysts really does mean more hot-money short-term speculative etc. etc. investors and fewer long-term buy-and-hold fundamentally committed etc. etc. investors. The translation from that to "slash R&D and focus only on meeting quarterly earnings targets" is straightforward. There are also a perhaps slightly less straightforward stories about how a drop in coverage makes a takeover less likely (less publicity = less attention from acquirers), which frees management to focus on long-term value creation rather than short-term takeover protection via padding the stock price,5 about how coverage leads to liquidity leads to short-termism, and about how analysts make "accrual-based earnings management techniques" more difficult.6

But in the end they find that these "economic mechanisms are able to explain about 40% of the total effect of analyst coverage on firm innovation measured by patent counts," and 28% by patent quality. The rest, they don't know. They have a guess about the negative consequences of missing earnings.7

One other thing comes to mind which is that if you're a company you've got to talk to your analysts. There they are, calling you up, asking for the scoop, getting excited about strong earnings trends, and being pretty cynical when you give them your usual blather about investing in innovation and the long-term health of your company even at the cost of its short-term earnings. Also they're constantly bringing investors by to meet with you, which adds to your total quantity of interaction with markets people. Markets people tend to like good earnings and worry about vague long term promises. And people tend to like to make the people they're dealing with happy.

What do research analysts do if not translate a company's thinking to the market, and the market's thinking to the company? Sometimes the market expresses its thinking directly - through, like, a takeover or an activist campaign - but it's not implausible to think that it sometimes expresses its thinking through the words of equity research analysts. The more analysts you have, the more time you tend to spend hanging out with analysts - and the more you get socialized into the world of Wall Street rather than the world of whatever it is you're getting patents on.

Jie He & Xuan Tian: The Dark Side of Analyst Coverage: The Case of Innovation [SSRN via Harvard Law]

1.I mean, publicness is kind of a binary, but the various ills of being public - shareholder pressure and short-term focus on the bottom line and just, y'know, publicity - do seem to correlate with research coverage.

2.I know, I know.

3.I have not fact-checked that claim. Yummy Flies, Inc., is just my current favorite public-ish company, or maybe second-favorite behind Crazy Woman Creek Bancorp Inc.


Kelly and Ljungqvist (2012) find that an exogenous reduction in analyst coverage leads to a higher degree of information asymmetry among investors, which in turn results in an increase in institutional ownership and a decrease in retail ownership. Their rationale is that institutional investors have access to private information that is unavailable to retail investors who mainly rely on public sources of information such as analyst reports. Therefore, the increase in information asymmetry due to an exogenous drop in analyst coverage “crowds out” the demand by retail investors. To the extent that this argument also applies to different types of institutional investors, we expect that after an exogenous drop in analyst coverage there will be an increase in holdings from dedicated institutional investors, who actively collect information about firm fundamentals, concentrate their portfolios in a few firms, and thus have access to more private information. In contrast, an exogenous reduction in analyst coverage should lead to a decrease in holdings by non-dedicated institutional investors, who chase short-term profits instead of collecting information about firms’ fundamental values, hold highly diversified portfolios with small stakes in many companies, and thus have less access to private information. Meanwhile, the model of Aghion, Van Reenen, and Zingales (2013) implies that dedicated institutional investors encourage firm innovation to a greater extent than non-dedicated ones. Thus, the equity ownership by different types of institutional investors could be an underlying economic mechanism through which analyst coverage impedes firm innovation.

5.More specifically:

The DiD analysis reported above shows that an exogenous drop in analyst coverage decreases a firm’s exposure to takeovers. The model of Stein (1988) implies that reduced takeover exposure encourages firm innovation because takeover exposure imposes short-term pressure on managers to boost current stock price and thus prevents them from investing in longterm innovative projects. In line with their arguments, our finding suggests that takeover exposure is another plausible underlying economic mechanism through which analyst coverage impedes firm innovation.

6.That's a fun one: basically, you gotta make your earnings every month, which you can do either through fraud or through cutting back on long-term investing, and maybe fraud is preferable:

Yu (2008) argues that financial analysts serve as external monitors to managers and shows that firms followed by more analysts use discretionary accruals (as an earnings management method) less frequently. Given managers’ enhanced pressure to meet near-term earnings targets and their reduced abilities to adopt accrual-based earnings management techniques when they are followed by more analysts, a natural alternative way of handling the increased pressure is to manipulate earnings through real earnings management, which involves changing the timing or structure of operations, investments, and/or financing activities that have cash flow consequences. Previous studies, such as Cohen, Dey, and Lys (2008), show that accrual-based earnings management and real earnings management are substitutes. Cutting investments in innovation (e.g., cutting R&D expenditures or other unobservable inputs) is one of the major real earnings management tools that managers often use to raise their firms’ probability of meeting near-term earnings targets. Hence, analyst coverage can impede firm innovation through its impact on managers’ abilities to implement accrual-based earnings management techniques.

7.The guess:

We show that the cumulative abnormal returns (CARs) upon a negative earnings surprise (i.e., missing analysts’ consensus forecast targets) are larger in magnitude (i.e., more negative) when a firm is covered by a larger number of financial analysts, which could lead to a reduction in the manager’s compensation and a loss of his reputation.