Inside the “Black Box” of Sell‐Side Financial Analysts

• Published date: 01 March 2015
• Author: MICHAEL B. CLEMENT,ANDREW C. CALL,LAWRENCE D. BROWN,NATHAN Y. SHARP
• DOI: http://doi.org/10.1111/1475-679X.12067
• Date: 01 March 2015

DOI: 10.1111/1475-679X.12067

Journal of Accounting Research

Vol. 53 No. 1 March 2015

Printed in U.S.A.

Inside the “Black Box” of Sell-Side

Financial Analysts

LAWRENCE D. BROWN,

∗ANDREW C. CALL,

†

MICHAEL B. CLEMENT,

‡AND NATHAN Y. SHARP

§

Received 7 March 2014; accepted 27 October 2014

ABSTRACT

Our objective is to penetrate the “black box” of sell-side financial analysts by

providing new insights into the inputs analysts use and the incentives they

face. We survey 365 analysts and conduct 18 follow-up interviews covering

a wide range of topics, including the inputs to analysts’ earnings forecasts

and stock recommendations, the value of their industry knowledge, the de-

terminants of their compensation, the career benefits of Institutional Investor

All-Star status, and the factors they consider indicative of high-quality earn-

ings. One important finding is that private communication with management

is a more useful input to analysts’ earnings forecasts and stock recommen-

dations than their own primary research, recent earnings performance, and

∗Temple University; †Arizona State University; ‡University of Texas at Austin; §Tex as A &M

University.

Accepted by Christian Leuz. We appreciate helpful comments from two anonymous re-

viewers, Mike Baer, David Bailey, Shuping Chen, Artur Hugon, Stephannie Larocque, Bill

Mayew, Lynn Rees, Kim Ritrievi, Debika Sihi, Nathan Swem, Michael Tang(FARS discussant),

Yen Tong, Senyo Tse, James Westphal, Richard Willis, Yong Yu, and workshop participants at

Colorado State University, Georgetown University, Indiana University, Texas Christian Uni-

versity, Tulane University, the 2013 Southeast Summer Accounting Research Conference

(SESARC), the 2013 Temple University Accounting Conference, and the AAA Financial Ac-

counting and Reporting Section 2014 Midyear Meeting. This paper was a finalist for the 2014

FARS Midyear Meeting best paper award. We are thankful for survey design assistance from

Veronica Inchauste of the Office of Survey Research at the Annette Strauss Institute, and

the excellent research assistance from John Easter, Alexandra Faulk, Emily Hammack, Ash-

ley Loest, Lauren Schwaeble, Sarah Shaffell, and Paul Wong. An online appendix to this

paper can be downloaded at http://research.chicagobooth.edu/arc/journal-of-accounting-

research/online-supplements.

1

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

2L.D.BROWN,A.C.CALL,M.B.CLEMENT,AND N.Y.SHARP

recent 10-K and 10-Q reports. Another notable finding is that issuing earn-

ings forecasts and stock recommendations that are well below the consensus

often leads to an increase in analysts’ credibility with their investing clients.

We conduct cross-sectional analyses that highlight the impact of analyst and

brokerage characteristics on analysts’ inputs and incentives. Our findings are

relevant to investors, managers, analysts, and academic researchers.

JEL codes: G20; G23; G24; G28; M40; M41

Keywords: sell-side analysts; analyst inputs; analyst incentives; private com-

munication; analyst compensation; industry knowledge

1. Introduction

Sell-side financial analysts are of significant interest to academic researchers

because of their prominent role in analyzing, interpreting, and disseminat-

ing information to capital market participants. While early research on an-

alysts focused on the statistical properties of their earnings forecasts and on

improving analysts’ expectations models (Fried and Givoly [1982], O’Brien

[1988], Lys and Sohn [1990], Brown [1993]), later research investigated

the investment value of analysts’ earnings forecasts and stock recommenda-

tions (Womack [1996], Francis and Soffer [1997], Clement and Tse [2003],

Howe, Unlu, and Yan [2009]). Starting with Schipper [1991] and Brown

[1993], however, researchers have suggested the literature should focus

more on the context within which analysts make their decisions. More re-

cently, Ramnath, Rock, and Shane [2008] and Bradshaw [2011] conclude

that research on the “black box” of analysts’ decision processes is required

for the literature to progress. We penetrate this “black box” by surveying

365 analysts and conducting 18 follow-up interviews to gain insights into

the inputs they use and the incentives they face.1

The inputs we investigate include the determinants of analysts’ earnings

forecasts and stock recommendations; the frequency, nature, and useful-

ness of their communication with senior management; the valuation mod-

els they use to support their stock recommendations; their beliefs about

what constitutes high-quality earnings; and, their perceptions of possible

“red flags” of financial misrepresentation. With respect to incentives, we in-

vestigate the determinants of analysts’ compensation, their motivation for

generating accurate earnings forecasts and profitable stock recommenda-

tions, and the consequences of issuing unfavorable earnings forecasts and

stock recommendations. While prior research has generally focused on an-

alysts’ incentives to please company management or generate underwriting

business, our findings highlight the strong incentives analysts face to satisfy

their investing clients.

1Surveys have limitations, such as the potential for response bias, small sample sizes, social

desirability biases, and construct validity issues. However, surveys enable researchers to ask

questions that would be difficult to address with archival data.

INSIDE THE “BLACK BOX”OF SELL-SIDE FINANCIAL ANALYSTS 3

We summarize our main findings here and discuss our detailed results in

section 3. Our findings shed light on the value of private communication

with management as an input to analysts’ decision processes. Soltes [2014]

finds that private communication with management is a valuable source of

information for analysts. We extend Soltes [2014] by providing evidence

that over half of the analysts we survey report that they have direct contact

with the CEO or CFO of the typical company they follow five or more times

a year. We also find that private communication with management is a more

important input to analysts’ earnings forecasts and stock recommendations

than primary research, recent earnings performance, and recent 10-K and

10-Q reports. Further, analysts rate private phone calls as one of the most

useful types of direct contact with management for purposes of generat-

ing their earnings forecasts and stock recommendations. Our follow-up

interviews reveal that some analysts avoid asking questions during public

conference calls and use private phone conversations to check the assump-

tions of their models, to gain qualitative insights into the firm and its in-

dustry, and to get other details not explained on public calls. Our findings

provide a deeper understanding of analysts’ communication with manage-

ment in the post–Regulation Fair Disclosure (Reg FD) environment and

suggest analysts incorporate pieces of nonpublic information from man-

agement into a broader “mosaic.”

Institutional Investor (II) surveys regularly find that sell-side analysts’ indus-

try knowledge is extremely valuable to their buy-side clients. We provide ev-

idence that industry knowledge is a very important determinant of sell-side

analysts’ compensation, suggesting brokerage houses provide analysts with

incentives to satisfy their clients’ demand for industry knowledge (Brown

et al. [2014]). We also find that industry knowledge is the single most useful

input to analysts’ earnings forecasts and stock recommendations.

We asked analysts about their perceptions of earnings quality and

their beliefs about potential “red flags” of intentional misreporting. Al-

though Dichev et al. [2013] asked similar questions of the CFOs they

surveyed, users of financial accounting information (analysts) are likely

to have more informative views on financial reporting issues than pre-

parers (CFOs). Specifically, analysts are an important source of infor-

mation for their investing clients and have incentives to recognize

attributes of high-quality earnings because incorrect assessments of earn-

ings quality could result in economic losses for their clients and have

an adverse effect on their own reputation and compensation. Con-

versely, CFOs face incentives to manage earnings, which could cre-

ate a preference for low-quality earnings and bias their responses to

questions about earnings quality (Dechow et al. [2010], Nelson and

Skinner [2013]). In addition, CFOs have other reporting incentives that are

not always consistent with those of investors (Nelson and Skinner [2013]).

For example, Dichev et al. [2013] find that CFOs rate the avoidance of long-

term estimates as an important feature of high-quality earnings. However,

the analysts we survey do not believe this factor is an important earnings