Finding diamonds in the rough: Analysts’ selective following of loss‐reporting firms

• Date: 01 January 2018
• Author: Jangwon Suh,Donal Byard,Yao Tian,Masako Darrough
• DOI: http://doi.org/10.1111/jbfa.12269
• Published date: 01 January 2018

DOI: 10.1111/jbfa.12269

Finding diamonds in the rough: Analysts’ selective

following of loss-reporting firms

Donal Byard1Masako Darrough1Jangwon Suh2Yao Tian3

1Accounting,Baruch College – CUNY, One

BernardBaruch Way, New York, New York,

UnitedStates

2NewYork Institute of Technology,New York

City,New York, United States

3Departmentof Accounting and Finance, San

JoseState University, San Jose, California, United

States

Correspondence

DonalByard, Baruch College, Box B 12–225, One

BernardBaruch Way,New York City, NY 10010,

USA.

Email:Donal.Byard@baruch.cuny.edu

Abstract

Investors face greater difficulty valuing loss-reporting than profit-

reporting firms: losses may be due to very different reasons (e.g.,

poor operatingperformance or investments in intangibles, and finan-

cial accounting information is of more limited use for valuing loss-

making firms than profit-making firms. Because of increased uncer-

tainty about loss firms’ future financial and business viability, we

hypothesize that financial analysts will be more selective when

choosing to follow loss firms than profit firms, with the result that

“abnormal” analyst following will be more informative to investors

regarding the future performance of loss firms than profit firms. Con-

sistent with this prediction, we find that abnormal analyst coverage

is useful for predicting firms’ future prospects, and is more strongly

associated with future performance (stock returns and ROA)for loss

firms than for profit firms. The market, however, does not seem to

use this useful information when pricing loss firms: for loss firms a

portfolio investment strategy based upon abnormal analyst follow-

ing can generate positive excess returns over 1- to 3-year holding

periods. These results are stronger for persistent-loss firms than for

occasional-loss firms. We conclude that abnormal analyst following

contains useful information about firms’ future prospects, and even

more so for loss firms than for profit firms.

KEYWORDS

analyst following, future performance, loss firms, self-selection

1INTRODUCTION

The incidence of accounting losses reported by firms has increased overtime (Hayn, 1995; Joos & Plesko, 2005). More

than 40% of the firms in the Compustat database reported losses at some point in the last 10 years.1Some reported

losses reflect poor operational results, while others reflect investmentsin intangible assets, which are typically subject

to immediate expensing(Ciftci & Darrough, 2015; Darrough & Ye, 2007). Of course, the returns from such investments

are highly uncertain, and not all loss-reporting firms (hereafter “loss firms”) eventually become profitable. Thus, using

1Aloss is defined as negative earnings before extraordinary items.

140 c

2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:140–165.

BYARDET AL.141

publicly-available financial accounting information, investors would find it difficult to distinguish between loss firms

with bright future prospects and those with poor prospects. Given the increasing incidence of losses and their poten-

tially different underlying causes, it is particularly important for investorsto find additional sources of information they

can use to distinguish among loss firms – so theycan identify “diamonds in the rough.” This study proposes a new source

of such useful information for investors: “abnormal”analyst following.

Analysts are not randomly assigned to follow firms. While analysts may be assigned to follow certain industries and

firms (e.g., large and prominent firms in the industry they cover), they also havediscretion in selecting the firms they

follow. Ceterisparibus, analysts have incentivesto cover firms they are relatively optimistic about; that is, they are able,

to some degree, to select the stocks they cover(McNichols & O'Brien, 1997). Analysts are likely to be reluctant to issue

unfavorable (pessimistic) investment recommendations, earnings, and cash flow forecasts, etc. (hereafter collectively

referred to as “forecasts”). Unfavorable forecasts may limit analysts’ access to information from management (Ke &

Yu,2006; Lim, 2001), adversely affect future investment banking business (Doukas, Kim, & Pantzalis, 2005; Michaely &

Womack,1999; O'Brien, McNichols, & Lin, 2005), and limit trading commissions (Hayes, 1998).2Thus, analysts have an

incentive, ex ante, to initiate coverage of and follow firms about which they are relatively optimistic (compared to other

firms), and drop coverageof firms about which they are relatively pessimistic. We therefore expect that some firms can

haveabnormally high or low levels of analyst following compared with other firms with similar characteristics (e.g., size,

industry,etc.).

In this paper,we focus on this self-selection behavior of analysts and examine whether “abnormal analyst following”

can help investors distinguish firms with a bright future from those without. More specifically, we examinewhether

analysts’ selective coverageis more useful for distinguishing among loss firms than profit firms. If analysts have skills or

ability to identify stocks that will perform better in the future, then analyst following will be indicative of stocks with a

promising future. In addition to such self-selection, analysts’ coverage also depends on fundamental firm characteris-

tics, such as firm size (Hong, Lim, & Stein, 2000b), the degree of firm complexity,and the level of institutional ownership

(Bhushan, 1989), all of which determine investors’ demand for analysts’ services as information intermediaries. Toiso-

late the effect of analyst self-selection in their coverage decisions, we first control for the “normal” level of analyst

following as determined by firm fundamentals and, from this, we estimate the “abnormal”level of analyst following.

While there is scope for analysts’ abnormal following to provide more useful information to investors for loss firms

than profit firms, ex ante, it is unclear if this is the case. No prior study we are aware of specifically examines ana-

lysts’ coverage of loss firms. Of the three possible information intermediaries—credit rating agencies, financial ana-

lysts, and auditors—only financial analysts are likely to have an incentive to identify loss firms with possible bright

future prospects.3Everybody wants to find the next Genentech; the question is: Can financial analysts contribute to

identifying them?

Based upon analysts'self-selection in their coverage decisions, we expectthat abnormal analyst following will help

predict firms’ future performance. More specifically,we expect that analysts will be more careful in selecting loss firms

than profit firms to follow: for example,they may engage in more lengthy private (i.e., unobservable) information acqui-

sition prior to initiating coverageof loss firms than profit firms. As a result, we predict that abnormal analyst following

will be a stronger predictor of future firm performance for loss firms than for profit firms. Therefore, we examine the

following two specific research questions:

2Hayes (1998) argues that analysts haveincentives to provide optimistic rather than pessimistic forecasts to maximize trading commissions. Hayes’ model

shows that while more precise optimistic forecasts always generate more trades,more precise pessimistic forecasts do not (which is exacerbated by short

selling constraints). Faced with an asymmetric incentive to gather information, analysts exertmore effort to follow firms for which they can issue relatively

optimistic forecasts. Similar to McNichols and O'Brien (1997), Hayes'model predicts that analysts will initiate coverage of stocks they expectto perform

relativelywell, and drop coverage of stocks they expect will perform relatively poorly.

3Since credit ratingagencies cater to debt-holders rather than equity-holders, they do not have an incentive to cover firms that do not issue debt. Many loss

firmswith high growth prospects are likely to be all equity financed. Consistent with this conjecture, using a sample of Compustat firms with S&P credit ratings,

wefind that loss firms are less likely to have a credit rating than profit firms. Furthermore, we find that persistent loss-reporting firms are rarely assigned high

credit ratings. Auditor's going concern opinions are similarly uninformative in terms of differentiating between loss firms with bright future prospects and

thosewith poor future prospects: 85% of loss firms receive a clean audit opinion (Audit Analytic database).