STAR‐ANALYSTS' FORECAST ACCURACY AND THE ROLE OF CORPORATE GOVERNANCE

• Published date: 01 March 2015
• DOI: http://doi.org/10.1111/jfir.12053
• Date: 01 March 2015

STAR-ANALYSTS’FORECAST ACCURACY AND THE ROLE OF

CORPORATE GOVERNANCE

Alexander Kerl and Martin Ohlert

University of Giessen, Germany

Abstract

In this article we examine whether star-analysts have better forecasting abilities than non-

star-analysts. Our results reveal that star-analysts’earnings forecasts outperform their

peers’forecasts. Because the level of corporate governance plays an important role for the

general level of forecast accuracy, we furthermore investigate whether star-analysts

benefit from higher levels of governance. Our findings suggest that forecast accuracy of

star-analysts increases with the level of both country- and company-specific corporate

governance. Investors in capital markets do not seem to be aware of this fact because they

do not react differently to forecasts issued by star-analysts compared to those of non-star-

analysts.

JEL Classification: G14, G15, G18, G24, G32

I. Introduction

There is consensus that financial analysts contribute to the reduction of existing

information asymmetries in capital markets, particularly between the company and

outside investors (Hall and Tacon 2010). For this purpose, analysts provide detailed

company analyses to numerous market participants via research reports. Among other

information, such reports contain three key summary measures: an earnings forecast, a

stock recommendation, and a target price (Asquith, Mikhail, and Au 2005; Gleason,

Johnson, and Li 2013). Because following such forecasts is only beneficial for investors if

stock prices perform as expected, it is crucial to identify those analysts whose forecasts are

highly accurate. Often sell-side analysts’rankings that claim to identify so-called star-

analysts are used for this purpose. Nevertheless, it is important to analyze, first, if such

star-analysts really outperform non-star-analysts in forecast accuracy and, second, to what

extent this depends on the prevailing market environment.

With respect to the question “if ”star-analysts’forecasts outperform non-star-

analysts’forecasts, previous research offers evidence that sophisticated analysts indeed

provide more accurate forecasts (see, e.g., Stickel 1992; Leone and Wu 2007) and that

following the advice of these analysts increases returns for investors (see, e.g., Fang and

Yasuda 2013). With regard to the influence of the prevailing market environment on

forecast accuracy, the literature shows that the quality of analysts’information increases

with the quality of corporate governance settings (e.g., Byard, Li, and Weintrop 2006).

Following Gillan and Starks (1998), we understand the term “corporate governance”as

the influence and control of operations at a company through the system of laws, rules,

The Journal of Financial Research Vol. XXXVIII, No. 1 Pages 93–120 Spring 2015

93

© 2015 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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and other factors. Corporate governance, in general, can be measured on both country and

company levels. On the country level, the country-specific strength of accounting

standards (see Hope 2003) leads to a higher quality of mandatory and voluntary firm

disclosures, which are ultimately associated with greater forecast accuracy. On the

company level, analyst accuracy is related to the presence of institutional investors (see

Ljungqvist et al., 2007). The differences in forecast accuracy might be the result of high-

quality firm disclosures and the moderating effects of institutional investors in such

settings.

1

This article contributes to the literature by combining both streams of research in

the field of analysts’forecast accuracy. First, we analyze whether earnings forecasts are

more accurate when issued by star-analysts. Second, we are among the first to link star-

analysts’forecast accuracy to both country- and company-level corporate governance.

And finally, we analyze whether markets react differently to forecasts issued by star-

analysts because they consider such forecasts as more valuable.

We hypothesize that star-analysts issue more accurate forecasts within strong

governance settings following the line of argumentation by Barniv, Myring, and Thomas

(2005). Within strong corporate governance environments, there is an increased demand

for valuable earnings information because forecasted earnings play an important role for

investment decisions. Consequently, analysts experience economic incentives to provide

highly correct earnings forecasts because of the market-based reward structure (see

Schipper 1991). Ultimately, analysts with superior characteristics in terms of ability,

effort, experience, or resources succeed most in providing this information. On the

contrary, Francis, Khurana, and Pereira (2003) argue that in weaker corporate governance

settings, financial accounting systems are less likely to represent the true situation of a

company. Because investors therefore focus not as much on earnings information within

such countries, there is less incentive for star-analysts to come up with outstanding

earnings forecasts (Barniv, Myring, and Thomas 2005). Based on the trade-off between

cost of collecting and interpreting information and financial merits for correct earnings

forecasts, star-analysts outperform non-star-analysts primarily in strong corporate

governance environments. Relative to Barniv, Myring, and Thomas, we not only proxy

corporate governance by a split between common and civil law countries but,

additionally, use country-level governance measures such as the anti-self-dealing index

alongside two types of a country’s law enforcement capability and, as company-level

governance measure, the company-specific institutional ownership share.

Based on the FactSet database, we examine approximately 36,000 analyst reports

published between January 2005 and June 2010 that contain forecasts for the capital

markets in the United States, France, Germany, Italy, Spain, the United Kingdom,

Switzerland, and Japan. Contrary to prior research that has primarily used survey-based

rankings as issued by the Institutional Investor magazine or the Wall Street Journal to

identify so-called star-analysts in the U.S. capital market (see, e.g., Stickel 1992; Ertimur,

Mayew, and Stubben 2011), we use the annual Thomson Reuters’StarMine awards that

1

Please note that both country- and company-level corporate governance measures are, within this study, not

the choice of the companies themselves but are exogenously given.

94 The Journal of Financial Research