Stanford University
Graduate School of Business
June, 1997
For information, contact Janet Zich, [email protected], or
415/723-9193
The Trouble with Good News
STANFORD - The securities research analysts who advise your broker on the
best stock market picks may not be trying to mislead you deliberately, but
beware of their rosy attitudes. Maureen McNichols and Patricia O'Brien have
done some research of their own, turning up evidence that equity analysts'
earnings forecasts are persistently overoptimistic.
McNichols and O'Brien, associate professors of accounting at Stanford
Business School and London Business School, respectively, cast a broad net:
Their study included 523 analysts covering 3,774 different companies at 129
different brokerage firms listed in a Standard & Poor's database. McNichols
and O'Brien found that as a group, analysts are less likely to report bad
news than good because they self-select what they cover. That is, they add
coverage of stocks when their information is favorable and drop coverage
when their information is unfavorable. As a result, the bad news is rarely
reflected in their last forecast report or recommendation about the issue.
The researchers also found that return on equity was greater for stocks the
analysts had just added to their coverage than for stocks with previous
coverage. Not surprisingly, return on equity was lower for stocks that are
dropped, probably because the stock was abandoned after an analyst became
disillusioned with its performance. Return on equity was lower still for
stocks not covered at all by sample analysts.
McNichols suggests several possible explanations for these trends. First,
if the stock analyst identifies hot stocks that benefit the brokerage
firm's clients, the analyst enhances his or her reputation for picking
winners and providing timely information. Second, a good story is easier to
sell than a bad one. When the brokerage mails out its research reports,
good news is relevant to a broader audience and will get a higher hit rate
of revenue-producing trades executed by the firm. Any investor is
potentially interested in trading a hot stock. Only a smaller group of
investors already holding the stock would be interested in selling it.
Third, analysts prefer to maintain good relationships with corporate
management because management is a potential client for investment bank
services and a big source of information.
McNichols and O'Brien discovered that analysts also drag their feet when
they deliver bad news. They found the median number of days between upgrade
ratings of a stock was 98. By contrast, the number of days between
downgrades was 127. One possible explanation is that when analysts get
preliminary negative information, they sit on it awhile to see if the next
spurt of information about the company will be positive. Others may detect
initial negative signals, such as product quality problems, but not wishing
to jeopardize their relations with the company's senior management, will
wait until someone else puts out the bad news-and then hop on the bandwagon.
Of course, says McNichols, equity analysts have a strong incentive to
maintain their credibility. Without it, they cannot survive for long.
Analysts must sometimes advise clients of impending doom. One critical
constituency is made up of fund managers who invest millions of dollars in
money pools. McNichols speculates that analysts may advise fund managers by
phone of upcoming corporate trends that may be negative, allowing the fund
managers to rearrange their portfolios and look smart before the bad news
hits the street in official earnings announcements. In some cases, analysts
may simply drop such a stock from their coverage.
By Barbara Buell
-30-
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