Does the Scope of the Sell‐Side Analyst Industry Matter? An Examination of Bias, Accuracy, and Information Content of Analyst Reports

• Date: 01 June 2017
• Published date: 01 June 2017
• Author: RONI MICHAELY,JOSEPH PACELLI,KENNETH MERKLEY
• DOI: http://doi.org/10.1111/jofi.12485

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 3 •JUNE 2017

Does the Scope of the Sell-Side Analyst Industry

Matter? An Examination of Bias, Accuracy, and

Information Content of Analyst Reports

KENNETH MERKLEY, RONI MICHAELY, and JOSEPH PACELLI∗

ABSTRACT

We examine changes in the scope of the sell-side analyst industry and whether these

changes impact information dissemination and the quality of analysts’ reports. Our

findings suggest that changes in the number of analysts covering an industry impact

analyst competition and have significant spillover effects on other analysts’ forecast

accuracy, bias, report informativeness, and effort. These spillover industry effects

are incremental to the effects of firm level changes in analyst coverage. Overall, a

more significant sell-side analyst industry presence has positive externalities that

can result in better functioning capital markets.

SELL-SIDE FINANCIAL ANALYSTS PLAY an important role in capital markets. Ana-

lysts facilitate the distribution of financial information, and their reports pro-

vide valuable information to market participants (e.g., Grossman and Stiglitz

(1980), Womack (1996), Kadan et al. (2009), Loh and Stulz (2011)). Further,

analysts help shape capital markets through their interactions with underwrit-

ers, brokers, institutional investors (IIs), and management. It is not surprising

therefore that the behavior of analysts has captured the attention of many

academic studies. These prior studies consider various aspects of analysts’ ac-

tivities such as their choice to cover particular firms (Jegadeesh et al. (2004))

and how the intensity of such coverage can influence firms’ information en-

vironments and financial policies (e.g., Hong and Kacperczyk (2010), Derrien

and Kecsk´

es (2013), Balakrishnan et al. (2014)).

Despite the significant interest in financial analysts, there is surprisingly

little empirical evidence examining the sell-side analyst industry as a whole.

∗Kenneth Merkley is at the Samuel Curtis Johnson School of Management, Cornell University.

Roni Michaely is at the Samuel Curtis Johnson School of Management and Cornell Tech. Joseph

Pacelli is at the Kelley School of Business, Indiana University. We thank Kristian Allee and

Matthew DeAngelis for assisting us with conference call data. We benefited from comments and

suggestions received from Joseph Comprix, Franc¸ois Degeorge, Franc¸ois Derrien, Janet Gao, Roger

Loh, Jay Ritter, Alex Tebay, and Richard Willis and seminar participants at the 2014 American

Finance Association annual meeting, Cornell University, Georgia State University, the Interdisci-

plinary Center (Herzliya, Israel), Singapore Management University, the University of Delaware,

the University of Kentucky, the 2014 Financial Accounting Reporting Section midyear meeting,

and the 2013 New York Accounting and Finance Forum. The authors have no conflicts of interest,

as identified by the Journal of Finance’s disclosure policy.

DOI: 10.1111/jofi.12485

1285

1286 The Journal of Finance R

In particular, we know little about which economic factors relate to changes

in the scope of sell-side analyst activity over time (aggregate number of ana-

lysts, number of reports, etc.). Perhaps more importantly, we know little about

whether changes in the scope of the sell-side analyst industry impact the over-

all information environment and have consequences for market participants.

Evidence on analyst activity from an aggregate perspective can provide impor-

tant insights into the nature of competition among analysts and can shed light

on questions that cannot be addressed simply by examining analysts’ activities

at the firm level.

This study attempts to fill the above gap in the literature. Specifically, we

examine how the scope of the sell-side analyst industry evolves over time and

how it varies with different economic factors. We find that changes in the scope

of the sell-side analyst industry have economic consequences for market partic-

ipants. Our findings suggest that a larger sell-side analyst industry encourages

more intensive competition that increases the quality and informativeness of

analysts’ reports. Importantly, our results suggest that changes in the scope of

the sell-side analyst industry produce spillover effects that relate to the unique

way in which analysts compete with each other within industries, as opposed

to within firms.

Studying the scope of the sell-side analyst industry provides insights beyond

studying analysts at the firm level. Specifically,only when we examine analysts

at the level of the industries they cover (as opposed to the firms they cover) can

we study the spillover effects of competition. While firm-level studies show that

analyst competition (as measured by the number of analysts following a firm)

positively affects the quality of a firm’s analyst reports (Hong and Kacperczyk

(2010)), these studies miss an important factor that cannot be analyzed at

the firm level alone: analyst competition at the industry level. For example,

in a typical industry group, about 176 firms receive analyst coverage. While

analysts compete with each other in terms of their coverage of these firms, they

do not cover all of the firms in an industry. Typically, when an analyst leaves

an industry, about 15 firms in that industry are directly affected by the loss of

coverage. The spillover effect that we investigate, however, considers how the

loss of coverage for this small set of firms affects the other 161 firms in the

industry that are not directly affected by the analyst’s departure.

There are good reasons to suspect that industry-level competition is impor-

tant. Analysts compete at the industry level for II rankings and industry pres-

tige (Stickel (1992), Hong and Kubik (2003), Ljungqvist et al. (2007), Groysberg,

Healy, and Maber (2011)). Given that industry ranking selections and presti-

gious job positions are limited, competition among analysts for these accolades

should increase as the number of analysts in an industry increases. Industry-

level competition is also unique because it arises even when analysts do not

cover the same firms. This difference allows us to examine the spillover effects

of changes in the scope of the sell-side analyst industry. We hypothesize that

the spillover effects resulting from a loss of analyst coverage for a subset of

firms ultimately affects the quality of research produced in an entire industry

along dimensions such as aggregate forecast quality and informativeness.

Does the Scope of the Sell-Side Analyst Industry Matter? 1287

Because changes in the scope of the sell-side analyst industry (i.e., number of

analysts employed, number of brokers, and number of firms receiving coverage)

may have important economic consequences, we begin our analyses by exam-

ining the extent of these changes over time. Our data suggest that the number

of analysts has grown moderately over the 1990 to 2010 period and exhibits

differential growth patterns based on brokerage size.1Over the past decade,

larger brokerage houses have employed a smaller portion of the overall ana-

lyst population while smaller brokerage houses have substantially increased

their analyst presence. We also examine how the scope of the analyst indus-

try varies with economic factors including industry performance, investment

banking activity, trading commissions, regulatory change, and technological

change. Our analyses suggest that the total number of analysts in an indus-

try varies positively with industry initial public offering (IPO) activity and

changes in trading volume. Our results also suggest differential sensitivity of

analyst industry scope based on brokerage house size, with the largest bro-

kerage houses being most sensitive to IPO activity—a key component of their

business services. Overall, our evidence suggests that changes in the number

of analysts covering an industry are related to changes in economic conditions

and regulation.

We next consider the main questions of interest in this paper, namely,

whether changes in the scope of the sell-side analyst industry have economic

consequences and whether the effects of these changes at the industry level

are distinct from those at the firm level. We propose that one channel through

which industry-level changes in analysts’ scope can have spillover effects on the

quality of analyst research is through changes in industry-level competition.

Increased competition at the covered industry level can potentially enhance

the quality of analyst reports within an industry by increasing analyst effort

and in turn information quality. As analyst industry competition increases,

analysts try to distinguish themselves from other analysts by increasing their

effort in order to produce higher quality research for all stocks in their portfo-

lio. This increased effort can lead to greater information for other analysts in

the industry because analysts often use the reports of their industry peers to

construct their own reports (Clement, Hales, and Xue (2011)). If increased com-

petition positively affects the quality of some analysts’ reports, these reports

can in turn affect the quality of other reports as well as the informativeness

of market prices (Grossman and Stiglitz (1980)). In addition, if new analysts

1The growth in the sell-side analyst industry is significantly smaller than that for other finance

professionals during this period (Greenwood and Scharfstein (2013)), suggesting that the costs and

benefits of sell-side analyst activities likely differ from those of other finance-related activities.

Unlike investment bankers or traders, analysts are often a cost center, and attributing how much

they contribute to the overall bank activity is difficult even with the best data. Further, the

role and contribution of analysts has changed significantly over time. For example, the Global

Settlement weakened the connection between analyst activities and investment banking revenue,

and trading commissions have declined significantly in recent years. In addition, advances in

technology and increased corporate disclosure requirements have lowered the cost of independent

financial analysis.