ANN ARBOR—Wall Street analysts often provide biased research in response to investment banking pressures, according to a new study by a University of Michigan Business School researcher. “Sell-side analysts have long faced allegations that pressures to generate investment banking business compromise the soundness of their investment research,” said Richard Sloan, professor of accounting and finance at the U-M Business School. “Our evidence supports these allegations. We found that analysts routinely hype the stock of firms raising new financing so that these firms can issue securities at temporarily inflated prices.” Sloan and two of his former doctoral students, Mark Bradshaw of Harvard Business School and Scott Richardson of the Wharton School at the University of Pennsylvania, examined data from financial statements and stock returns from 1975-2000 for more than 100,000 firm-year observations. They found that the degree of overoptimism in sell-side analysts’ earnings forecasts, stock recommendations and target prices is systematically related to corporate financing activities—especially for firms that are issuing new securities. “The economic significance of our results is striking,” Sloan said. “For example, we find that target prices set by analysts are, on average, 80 percent too high for firms issuing securities versus only 20 percent too high for firms repurchasing securities.” The researchers say that the predictability of future stock returns—which historically have been unusually low in the three years following securities issuances and unusually high during the same time-frame for securities repurchases—is due to temporary mispricing rather than risk. “The predictable future stock returns are directly related to predictable biases in analysts’ earnings forecasts,” Sloan said. “It appears that investors initially buy into analysts’ biased earnings expectations and are subsequently surprised by the predictable forecast errors. “Further, we find that analysts set significantly higher future target prices for firms issuing securities than for firms repurchasing securities. If the lower future stock returns for issuing firms represent a lower risk premium, then we would expect analysts to set lower target prices for such firms.” The study also shows that analysts tailor their overoptimism to the type of security being issued. For example, analysts typically exaggerate short-term earnings prospects of debt issuers to reduce the perceived credit risk of these securities. In contrast, they overstate the long-term growth potential of equity issuers in order to sell securities at higher prices. Finally, Sloan and colleagues say that the primary driver of overoptimism is external financing activity, not, like prior research has shown, whether analysts work for firms that have investment banking ties to the companies they cover. Analysts with no ties often enjoy financial incentives to provide overly optimistic research on issuing firms as well, they add. “Our analysis shows that the relation between corporate financing activities and analyst research is pervasive,” Sloan said. “Sell-side analysts routinely manipulate their investment advice in response to investment banking pressures in order to temporarily inflate stock prices around securities issuances.” Related links:

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