The Dark Side of Analyst Coverage

The following post comes to us from Jie (Jack) He of the Department of Finance at the University of Georgia and Xuan Tian of the Department of Finance at Indiana University.

In our paper, The Dark Side of Analyst Coverage: The Case of Innovation, forthcoming in the Journal of Financial Economics, we examine the effect of analyst coverage on firm innovation and test two competing hypotheses. We find that firms covered by a larger number of analysts generate fewer patents and patents with lower impact. To establish causality, we use a difference-in-differences approach and an instrumental variable approach. Our identification tests suggest a causal effect of analyst coverage on firm innovation. The evidence is consistent with the hypothesis that analysts exert too much pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative projects. Finally, we discuss possible underlying mechanisms through which analysts impede innovation and show a residual effect of analyst coverage on firm innovation even after controlling for such mechanisms. Overall, our study offers novel evidence of a previously under-explored adverse consequence of analyst coverage, namely, its hindrance to firm innovation.

While we show a negative effect of analyst coverage on firm innovation, one must be cautious in drawing a normative (as opposed to a positive) inference from our results. Since a firm’s optimal level of investment mix (short term versus long term) is usually firm-specific and unobservable, it is virtually impossible to determine whether firm managers, in the absence of analyst coverage, overinvest in the long-term innovative projects. If financial analysts prevent firm managers from investing sub-optimally by squandering too many resources on long-term activities, then they could be performing a good deed for the shareholders. In that case, our results would be consistent with the “bright” side of analyst coverage. To take one step further toward a normative conclusion, we rely on two findings. First, Hall, Jaffe, and Trajtenberg (2005) find that patent citations are significantly positively related to a firm’s market value, measured by its Tobin’s Q. Specifically, they show that an extra citation per patent boosts a firm’s market value by 3%. Second, we repeat the tests in Hall, Jaffe, and Trajtenberg (2005) with an augmented set of control variables and find that both the number of patents and the citations per patent have a significantly positive effect on firm value. Overall, these two pieces of evidence suggest that the financial market appreciates firms’ innovative activities and rewards successful innovation outcomes (such as high-impact patents) with a higher valuation. Together with the main finding of our paper that analysts impede firm innovation, the above evidence seems to reveal one possible “dark” side of financial analysts: their negative impact on firm value by discouraging innovative activities.

However, we need to bear in mind two important caveats when interpreting or generalizing our results. First, while our findings are consistent with the pressure hypothesis, we cannot rule out the possible positive role played by financial analysts in motivating firm innovation, as suggested by the information hypothesis. This is because our evidence reflects only the net effect of analyst coverage on firm innovation. Analysts could play both a positive role (by reducing innovative firms’ information asymmetry) and a negative role (by imposing short-term pressure on managers) in motivating firm innovation, but in practice the former is dominated by the latter, so that we observe a net negative effect of analyst coverage on firm innovation. Second, while we demonstrate one particular “dark” side of financial analysts, we are agnostic about how analyst coverage affects firm value in many other ways (some of which might be positive). Hence, it is inappropriate to conclude, if based solely on the evidence provided by our study, that analysts are detrimental to shareholder value or social welfare. Further, although financial analysts are a key ingredient of the public financial market and our paper examines their influence on individual firms’ incentives to innovate, a proper evaluation of the overall impact of the financial and capital investment system on a nation’s innovativeness and competitive advantage is beyond the scope of this study and calls for more future research.

The full paper is available for download here.

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