When Analysts Talk, Do Institutional Investors Listen? Evidence from Target Price Changes

• Published date: 01 May 2016
• Author: Shannon Lin,Zenan Zhang,Hongping Tan
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/fire.12102

The Financial Review 51 (2016) 191–223

When Analysts Talk, Do Institutional

Investors Listen? Evidence from Target

Price Changes

Shannon Lin

Dalhousie University

Hongping Tan∗

York University

Zenan Zhang

Jiangnan University

Abstract

We find that institutions trade in the same direction as target price changes based on

6,415 U.S. firms from 1999 to 2011, even after controlling changes in stock recommendations

and earnings forecasts. The impact of target price changes on institutional trading is more

pronounced for small firms, firms followed by few analysts, and illiquid firms, and is mainly

limited to transient institutions. We do not find any outperformance for institutions to follow

analysts’ target price forecasts, suggesting that institutions could find it easier to justify their

investment decisions by following analyst forecasts, although such trading does not result in

outperformance.

∗Corresponding author: Schulich School of Business, YorkUniversity, 4700 Keele Street, Toronto, M3J

1P3, Canada; Phone: (416) 736-2100, ext 30099; Fax: (416) 736-5687; E-mail: htan@schulich.yorku.ca.

The authors gratefully acknowledge helpful comments from an anonymous referee and the editor Srini

Krishnamurthy, as well as from conference and workshop participants at the Financial Management

Association 2011 Asian Conference, Northern Finance Association 2011 annual meeting, Financial Man-

agement Association 2011 annual meeting, Eastern Finance Association 2012 annual meeting, Nanyang

Business School, Wuhan University, and Zhongnan University of Economics and Law. We thank June

Woo Park and Changqiu Yu for excellent research assistance, and the Social Sciences and Humanities

Research Council of Canada for financial support. All errors are our own.

C2016 The Eastern Finance Association 191

192 S. Lin et al./The Financial Review 51 (2016) 191–223

Keywords: financial analyst, institutional trading, target price, recommendation, usefulness,

profitability

JEL Classifications: G11, G14, G29

1. Introduction

This paper examines the relationship between analyst research content and

institutional trading based on a large sample of analyst target price forecasts for 6,415

U.S. firms during 1999–2011. We investigate whether institutional investors trade on

the information contained in target prices, and identify firm and investor traits that

moderate the impact of target prices on institutional trading. Wealso examine whether

trading on target price information would be beneficial to institutional investors.

Target prices indicate the value assessment of underlying stocks by financial

analysts. They are typically included alongside earnings forecasts and stock recom-

mendations in analyst research reports but have largely been overlooked in the ana-

lyst literature until recently. An emerging literature investigates the determinants and

investment value of target price and its relation to earnings forecast and stock recom-

mendation, however,the claim in Brav and Lehavy (2003, p. 1933) that “their [target

prices’] role in conveying information to market participants and their contributionto

the formation of equity prices have remained largely unexplored” is still largely true

today (see, e.g., Bradshaw, 2002; Brav and Lehavy, 2003; Asquith, Mikhail and Au,

2005; Huang, Mian and Sankaraguruswamy, 2009; Gleason, Johnson and Li, 2013;

Bradley, Clarke, Lee and Ornthanalai, 2014).

The usefulness of analyst research in general, and that of target price in particular,

continues to be a widely debated topic among academics, investors, and regulators.

Despite a large literature that shows the informativeness of various components

of analyst research, there is concern over the objectivity and investment value of

analyst research given the conflicts of interest surrounding the securities research

industry. Essentially, analysts have been accused of biasing their research outputs to

attract investment banking business, to secure management access, and to generate

brokerage commissions (for a review on analyst forecast literature, see Ramnath,

Rock and Shane, 2008).

We examine the usefulness of target prices to presumably one of the most so-

phisticated investors and players in the stock market: institutional investors. A few

papers attribute institutional outperformance to the use of stock recommendations

by sell-side analysts (see, e.g., Chen and Cheng, 2006; Green, 2006; Oppenheimer

and Sun, 2009), leaving us to question whether analyst target prices also serve a

similar function. A casual reading of analyst reports reveals cases in which analysts

reiterate their stock recommendations but change their target price forecasts dramat-

ically, and instances in which they revise their stock recommendations but maintain

their previously issued target price forecasts. Since target prices can be implicitly

S. Lin et al./The Financial Review 51 (2016) 191–223 193

interpreted as analysts’ expectation of stock returns over the forecast horizon, they

should contain additional information beyond that conveyed by stock recommen-

dations. Earlier work by Brav and Lehavy (2003) demonstrates significant market

reaction to analysts’ target price revisions, even after controlling for contempora-

neously issued stock recommendation and earnings forecast revisions. Since both

Huang, Mian and Sankaraguruswamy (2009) and Da and Schaumburg (2011) offer

evidence that target price changes predict returns, we buildon these findings to further

investigate whether institutional investorsuse analyst target prices in their investment

decisions and how institutional investors respond to the information contained in

target prices in the presence of stock recommendations.

We find a positive relationship between institutional trading and target price

changes, consistent with the idea that institutions trade on target price changes.

Furthermore, the explanatory power of target price changes goes beyond that of

changes in recommendations and earnings forecasts, even after controlling for a host

of institutional trading determinants. Further analysis suggests that target prices and

stock recommendations might be capturing different sets of analysts’ information

that does not necessarily overlap. These results are robust to different measures of

target price changes and institutional trading. We also show that the positive relation

between target price change and institutional trading is more pronounced for small

firms, firms followed by feweranalysts, with lower liquidity, and with lower price-to-

earnings (P/E) ratio, and is limited to transient investors. Despite the implementation

of regulatory changes in the early 2000s targeting the conflicts of interest in the

securities research industry, we do not find institutional trading more sensitive to

target price changes in recent years. Finally, we do not find any outperformance for

institutions to follow analysts’ target price advice. Since institutions are governed by

the “Prudent-man rule,” they could find it easier to justify their investment decisions

by following analyst forecasts to trade, despite the fact that such trading does not

result in outperformance.

The rest of the paper proceeds as follows: Section 2 discusses the relevant

literature leading up to our hypotheses. Section 3 describes our sample and research

method. Section 4 illustrates empirical results. Section 5 is a returns analysis of

portfolios based on target price changes. Finally, section 6 concludes.

2. Literature review and hypotheses

Of the three major components of analyst research outputs (earnings forecasts,

stock recommendations, and target prices), much of the previous literature is limited

to the first two, focusing either on the cross-sectional differences and determinants

of performance among analysts, or on the market response to the issuance of these

forecasts.1A small but growing literature examines the determinants and investment

1See, for example, Stickel (1995), Barber, Lehavy, McNichols and Truman (2001), Bae, Stulz and Tan

(2008), Bradley, Chan, Kim and Singh (2008), Loh and Stulz (2011), and Bradley, Liu and Pantzalis

(2014).