The activities of buy-side analysts and the determinants of their stock recommendations

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Abstract

We survey 344 buy-side analysts from 181 investment firms and conduct 16 detailed follow-up interviews to gain insights into the activities of buy-side analysts, including the determinants of their compensation, the inputs to their stock recommendations, their beliefs about financial reporting quality, and the role of sell-side analysts in buy-side research. One important finding is that 10-K or 10-Q reports are more useful than quarterly conference calls and management earnings guidance for determining buy-side analysts׳ stock recommendations. Our results also suggest that sell-side analysts add value by providing buy-side analysts with in-depth industry knowledge and access to company management.

Introduction

Buy-side analysts play an important role in equity markets because their research directly impacts the investing decisions of portfolio managers (Cheng et al., 2006, Frey and Herbst, 2014, Rebello and Wei, 2014). These analysts usually work for an investment firm (e.g., mutual fund, hedge fund, pension fund), and they perform their research activities exclusively for the firm that employs them. In contrast to sell-side analysts whose stock recommendations are distributed widely to their clients and who often receive coverage in the business press, buy-side analysts׳ stock recommendations are not available to anyone outside their own firm. Thus, although buy-side analysts are much closer than sell-side analysts to the ultimate investing decision, they are rarely the subject of academic research. The purpose of this study is to expand our understanding of the activities of buy-side analysts and their role in the capital markets.

We survey 344 buy-side equity analysts employed by 181 institutional investment firms and conduct 16 detailed follow-up interviews on a wide range of topics. We examine the factors that determine their compensation, their motivation to issue profitable stock recommendations, the inputs to their stock recommendations, the frequency and value of their interactions with company management, and their assessments of financial reporting quality. Further, because buy-side analysts are an important consumer of sell-side research, we examine the nature and frequency of their interactions with sell-side analysts and the attributes of sell-side analysts they find most important.

One important takeaway of our paper relates to the role of sell-side analysts in buy-side research. Specifically, although we find that buy-side analysts have strong financial incentives to produce profitable stock recommendations, fewer than 3% of them indicate sell-side stock recommendations are a very useful input for their own stock recommendations. Nevertheless, we find that sell-side analysts add value to buy-side analysts in other ways. For example, buy-side analysts typically follow more companies spread across more industries than do sell-side analysts, so they often rely on the sell side to quickly get up to speed on a particular industry. Further, buy-side analysts indicate that industry knowledge is the most useful input to their stock recommendations, which are the primary determinants of their compensation. Our findings help explain why institutional investors consistently rate industry knowledge so highly in Institutional Investor׳s (II) annual rankings of sell-side services.

Relatedly, buy-side analysts indicate that private communication with senior management is an important input into their stock recommendations, and that sell-side analysts play a pivotal role in facilitating access to management. Collectively, our findings suggest buy-side analysts rely on sell-side analysts for raw information (e.g., industry knowledge) and access to company management, which help inform their own stock recommendations; however, buy-side analysts do not look to sell-side analysts when translating this information into their own stock recommendations.

Despite prior research suggesting that sell-side analysts employed by large brokerages have more resources (Clement, 1999, Clement and Tse, 2003, Hong and Kubik, 2003), and that II All-Stars are superior sell-side analysts (Asquith et al., 2005, Leone and Wu, 2007, Stickel, 1992), fewer than 3% of the buy-side analysts say brokerage size and All-Star status are important attributes of sell-side analysts when deciding whether to use information they provide. In contrast, sell-side analysts׳ experience following a company and the frequency of their communication with senior management are the two most important determinants of buy-side analysts׳ decisions to use information sell-side analysts provide.

Concerns that financial reports lack timeliness and suffer from information overload have grown in recent years (White, 2013). Despite these concerns, nearly half (48%) of the buy-side analysts indicate that the recent 10-K or 10-Q report is very useful for determining their stock recommendations. These financial reports are more useful to them than quarterly conference calls, management earnings guidance, and recent earnings performance. Buy-side analysts also believe the most important attribute of high-quality earnings is that earnings are backed by operating cash flows. When we asked about “red flags” of management effort to intentionally misrepresent financial results, many “red flags” identified by prior research received strong support, including internal control weaknesses and weak corporate governance, suggesting buy-side analysts are concerned about the integrity of financial reports.

We make several contributions to the literature. Prior research documents that buy-side analysts play an important role in institutional investment decisions (Cheng et al., 2006, Crawford et al., 2014, Frey and Herbst, 2014, Rebello and Wei, 2014). However, the determinants of buy-side analysts׳ stock recommendations remain unclear, so our findings represent an important step forward for the literature. Further, institutional ownership has grown from around 5% of U.S. equities in 1945 to over 67% in 2010 (Blume and Keim, 2012); thus, buy-side analysts play an increasingly important role in equity markets. We also add to the literature׳s limited understanding of the working relationship between buy-side and sell-side analysts. Lastly, because buy-side analysts have strong incentives to identify attributes of high-quality earnings and “red flags” of misreporting, their views about the value of financial statements and the determinants of financial reporting quality bring important insights to the literature (Nelson and Skinner, 2013).

Section snippets

Subject pool

We used Thomson One to identify our subject pool of buy-side equity analysts.1 For each firm in the S&P 100 index as of September 10, 2012, we identified the 100

Empirical results, interview responses, and cross-sectional findings

After presenting demographic characteristics of the survey respondents, we present survey results organized into four sections. These sections address (i) the incentives buy-side analysts face and the determinants of their stock recommendations; (ii) their interactions with sell-side analysts; (iii) their interactions with company management; and (iv) their assessments of financial reporting quality. Collectively, our findings facilitate a better understanding of the factors that influence

Internal validity of survey responses

One concern when evaluating survey data is the internal validity of responses. If respondents are distracted or otherwise not engaged in the survey, their responses are less reliable. One common way to assess internal validity is to examine whether individual participants responded similarly to common questions asked in different places in the survey.

We assess the internal validity of buy-side analysts׳ survey responses in the following way. First, for each responding analyst we calculate the

Conclusion

Buy-side analysts play an important role in the capital markets by performing research and providing stock recommendations for their portfolio managers (Cheng et al., 2006, Frey and Herbst, 2014, Rebello and Wei, 2014), placing them much closer to the ultimate investment decision than sell-side analysts and giving them “skin in the game.” However, due to the private nature of their stock recommendations, academic research about buy-side analysts has been limited, especially compared with the

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    We appreciate helpful comments from Mike Baer, Mark Bradshaw, Jeff Cohen, Kurt Hallead, Amy Hutton, Alina Lerman, Sugata Roychowdhury, Phil Shane (FARS discussant), Nathan Swem, Chris Tocci, Youfei Xiao (CFEA discussant), Sunny Yang, Paul Zarowin, Kenneth Zuckerberg, and workshop participants at National University of Singapore, the University of Alberta, Boston College, the University of British Columbia, the University of Pennsylvania, the 2014 Conference on Financial Economics and Accounting, the Temple University 2014 Accounting Conference, the Yale University 2014 Summer Accounting Research Conference, the 2015 FARS midyear meeting, and the 2016 Penn State Accounting Research Conference. We received excellent research assistance from Jennifer Aubuchon, Michael Bryan, Mark Chessher, Allison Norton, Lauren Pellino, and Paul Wong. This paper was a finalist for the 2015 FARS midyear meeting Best Paper award.

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