Firms’ Innovation Strategy under the Shadow of Analyst Coverage

Long-term growth in profits depends significantly on firms’ investment in innovation activities. However, firms may not invest in innovation in an optimal way. Some distortions arise because the decisions as to whether and how to invest in innovation are not only affected by their long-term expected benefits but also by other considerations. Among the factors that can distort firms’ incentives to innovate, the recent literature has highlighted the recommendations or reports issued by financial analysts.

There are two distinct effects through which analyst coverage influences firms’ innovation activity. On the one hand, there is an information effect. Analysts collect firms’ information and provide it to the investors, for instance, by writing reports about company activities. As a result, they reduce the information asymmetries and decrease the possibility of market undervaluation of the investments in innovation, which increase a CEO’s incentives to innovate. On the other hand, there is a pressure effect. Analysts discipline managers’ behavior through issuing periodic earnings forecasts. Missing the earnings forecasts is usually punished by investors. However, since investments in innovation do not usually generate short-term income, managers have an incentive to cut expenditures in innovation when they have the pressure to meet analysts’ earnings targets.

In our recent paper Firms’ Innovation Strategy under the Shadow of Analyst Coverage, we contribute to the understanding of the effect of financial analysts on firm innovation by isolating the information and pressure effects. We do so by studying three different channels through which firms can invest in innovation: research and development (R&D) expenditures— the traditional way of doing innovation, acquisitions of other innovative firms—a quick way to access innovation, and investments in corporate venture capital (CVC) funds—a window to learn about the latest innovative ideas. We show that each channel is affected differently by the information and pressure effects of financial analysts.

First, in terms of the information effect, the information about innovative acquisitions and CVC investments is more often verifiable, quantifiable, can more easily be compared with similar investments, or can more easily be inferred from the relevant decision-makers. In contrast, R&D expenses are less transparent, non-verifiable, and their impact on innovation productivity and firm value is difficult to quantify. This greater opaqueness of R&D with respect to external innovation channels reduces analysts’ ability to process information and provide valuable recommendations to the market. Therefore, the informational role of analysts can be stronger for external innovation activities than for R&D. Second, in terms of the pressure effect, based on generally accepted accounting principles (GAAP), all investments in R&D are expensed in the income statement, whereas acquisitions and CVC investments are usually capitalized. Thus, increased market pressure by analysts is more likely to distort investments in R&D because cutting R&D expenses immediately increases pretax earnings and can allow managers to achieve earnings targets. In contrast, it should have a smaller impact on acquisitions or CVC because capitalized investments do not affect earnings in every accounting period.

We analyze a sample of more than 3300 US public firms for the period 1990-2012, and measure the effects of financial analysts with the number of analysts covering a firm. To overcome the potential endogeneity problems in the coverage-innovation relationship, we employ two identification strategies. First, we use an instrumental variables approach in which we instrument for the number of analysts covering a firm with a measure capturing exogenous variation in analyst coverage due to changes in the number of analysts that work for brokerage houses over time. Second, we employ a difference-in-differences method, using brokerage house mergers as a source of an exogenous decrease in the number of analysts.

We find that firms with more analyst coverage significantly reduce R&D expenses. More interestingly, those firms are more active in the acquisition market, they acquire more innovative firms, and they invest more through their CVC funds. These results confirm our previous arguments that in terms of in-house R&D expenses, the pressure effect is stronger than the information effect, whereas for the external innovation channels, the information effect seems to dominate. Moreover, our results are stronger for firms with poor corporate governance, more financial constraints, and those in high-technology industries. The first part of those results implies that the information and pressure effects make financial analysts act as external governance mechanisms that compensate for the lack of governance in poorly governed firms.

To further understand firms’ change in innovation strategy due to analyst coverage, we study whether the increased investment in external innovation activities is due to a direct effect of analysts because of their ability to process and report information to the market, or to an indirect effect whereby firms increase external innovation to compensate for the reduction in in-house R&D (i.e., a substitution effect). In the latter case, the increase in external innovation would be the result of analyst pressure rather than a consequence of their informational role. We find a positive direct effect of coverage on both future acquisitions and CVC, providing further support for the information effect.

Since the changes in innovation strategy due to financial analysts have nonobvious consequences for the final innovation outcome, we test their influence on firms’ innovation outcome measured by the quantity and quality of future patents, as well as on the type of innovation, i.e., radical versus incremental innovation. Taking into account the changes in firms’ R&D expenses and the investments in innovative acquisitions and CVC funds, we find that the negative effect of analyst coverage on firms’ innovation output found in the previous literature turns out to be not significant. Especially for those firms that cut R&D spending when they are followed by more analysts, there is even an increase in their future patent and citation count. Hence, analyst coverage has a disciplining effect that induces more efficient investments in innovation and leads to better outcomes. Similarly, firms that acquire other innovative companies and engage in CVC investments when they are followed by more analysts see an increase in future innovation. Analysts help reducing information asymmetries between firms and the financial markets, which encourages firms to make better investments in innovation. In terms of the type of innovation, our results indicate that analyst pressure and changes in R&D spending lead to less radical innovation, while external acquisitions and CVC investments are related to more radical innovation.

Our work contributes to the understanding of the governance role of financial analysts in firms’ innovation strategy and outcomes by isolating the information and pressure effects of analysts in a unified framework, and considering both internal and external innovation channels. Our results put in perspective previous findings on the negative effect of financial analysts on innovation: while an increase in market pressure leads to more cuts in internal R&D, which could reduce innovation, the accompanying disciplining effect and reduction in information asymmetries encourage efficient investments in both internal and external innovation.

The complete article is available here.