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  • “ Independent Research means (i) a research report prepared by an unaffiliated person or entity, or (ii) a statistical or other survey or analysis of research reports (including ratings and price targets) issued by a broad range of persons and entities, including persons and entities having no association with investment banking activities, which survey or analysis has been prepared by an unaffiliated person or entity”
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    1. 1. Federal Reserve Bank of Atlanta Financial Markets Conference, April 2004 Which Types of Analyst Firms Make More Optimistic Forecasts? Amanda Cowen, Boris Groysberg, Paul Healy Harvard Business School
    2. 2. Agenda <ul><li>Motivation </li></ul><ul><li>Institutional background </li></ul><ul><li>Sample </li></ul><ul><li>Tests and results </li></ul><ul><li>Policy questions </li></ul>
    3. 3. Motivation <ul><li>NY State AG analyst investigation </li></ul><ul><ul><li>Focus on investment banking conflicts </li></ul></ul><ul><li>Settlement </li></ul><ul><ul><li>Mitigate investment bank conflicts </li></ul></ul><ul><ul><li>Increase quality & independent of research </li></ul></ul><ul><li>Yet limited understanding of financial analysts’ incentives in issuing forecasts </li></ul>
    4. 4. Investigation Findings: Investment Banking Effects on Research <ul><li>Affected initiation/continuation of coverage </li></ul><ul><li>Analysts performed investment banking functions </li></ul><ul><li>Investment bankers evaluated analyst performance </li></ul><ul><li>Inadequate controls over senior analysts </li></ul><ul><ul><li>Eg: Jack Grubman, Mary Meeker, Henry Blodget, Justin Baldauf, Kirsten Campbell, etc. </li></ul></ul><ul><ul><li>No system for reviewing senior analyst ratings </li></ul></ul><ul><ul><li>Lowest ratings unused </li></ul></ul>
    5. 5. Examples of Analyst Improprieties 1 3 2 ST Rating 1 “ this stock is a powder keg, given how aggressive we were on it earlier this year and given the ‘bad smell’ comments that so many institutions are bringing up” (ML06413) 07/13/00 InfoSpace (INSP) 1 Nothing interesting about company“except banking fees” (ML03806) 1/11/01 GoTo.Com (GOTO) 1 “ such a piece of crap” (ML51453) 06/03/00 Excite@home (ATHM) LT Rating Analysts’ Private Comments Date Company
    6. 6. Settlement <ul><li>Agreement between SEC, NY State AG, NASD, NYSE and 10 leading banks (April 28, 2003) </li></ul><ul><li>Mitigate investment banking/research conflicts </li></ul><ul><ul><li>Separate research and investment banking (reporting lines, budget, physical separation, compensation, evaluation, coverage, no soliciting I/B business) </li></ul></ul><ul><ul><li>Disclosure of analyst conflicts </li></ul></ul><ul><li>Improve overall research quality </li></ul><ul><ul><li>Increase transparency of analysts’ performance </li></ul></ul><ul><ul><li>Banks purchase & distribute third-party research on covered companies from Independent Research Providers (with no investment banking business) </li></ul></ul>
    7. 7. Settlement Fines ($ in millions) Firm Fine Independent Research Investor Salomon Smith Barney $300 $75 $25 $400 CSFB 150 50 0 200 Merrill Lynch 100 75 25 200 Morgan Stanley 50 75 0 125 Goldman Sachs 50 50 10 110 Bear Stearns 50 25 5 80 Deutsche Bank 50 25 5 80 J.P. Morgan Chase 50 25 5 80 Lehman Bros. 50 25 5 80 UBS Warburg 50 25 5 80 TOTAL $900 $450 $85 $1,435 Source: Reuters; SEC; New York Attorney General Education Total
    8. 8. Prior Research on Analyst Incentives <ul><li>Optimistic LT forecasts & recommendations by affiliated analysts </li></ul><ul><ul><li>Lin & McNichols, 1998; Michaely & Womack, 1999; Rajan & Servaes, 1997; Dechow, Hutton & Sloan, 2000; Lin, McNichols, O’Brien, 2003 </li></ul></ul><ul><li>Investment banking affects analyst promotions </li></ul><ul><ul><li>Hong and Kubik, 2003 </li></ul></ul><ul><li>No short-term earnings forecast optimism </li></ul><ul><ul><li>Hansen & Sarin, 1996; Ali 1996 </li></ul></ul><ul><li>Value Line forecasts more accurate than I/B/E/S forecasts </li></ul><ul><ul><li>Philbrick & Ricks, 1991 </li></ul></ul>
    9. 9. Research Questions <ul><li>How do incentives differ for analysts at different types of firms: </li></ul><ul><ul><li>Full service investment banks </li></ul></ul><ul><ul><li>Brokerage firms </li></ul></ul><ul><ul><li>Research firms </li></ul></ul><ul><li>How optimistic are analysts at these different types of firms? </li></ul>
    10. 10. Analyst Incentives: Sources of Research Funding <ul><li>Indirect funding of research. Primary sources: </li></ul><ul><ul><li>Institutional equities </li></ul></ul><ul><ul><li>Investment banking (42% of total for 8 leading banks) </li></ul></ul><ul><ul><li>Retail business </li></ul></ul><ul><ul><li>Fixed income </li></ul></ul><ul><li>Merrill Lynch ($578.7M in 2001) </li></ul><ul><ul><li>Funding sources: 72% Institutional Equities and Investment banking, 22% Retail business, and 6% Fixed Income </li></ul></ul><ul><li>Goldman Sachs ($321.1M in 2001) </li></ul><ul><ul><li>Funding sources: 50% Institutional Equities and 50% Investment banking </li></ul></ul>
    11. 11. How Does Research Funding Vary Across Firms? Types of firm $ $$ Underwriting $$ $$ $$ Directed commissions $$ $ $ $ 3rd party soft dollar $$ Hard dollar Research Brokerage Syndicate Underwriter Form of funding
    12. 12. Analyst Incentives by Firm-Type <ul><li>Underwriting firms </li></ul><ul><ul><li>Optimistic forecasts to attract new clients/sell new IPOs </li></ul></ul><ul><ul><li>Limited by bank and analyst reputations </li></ul></ul><ul><li>Brokerage firms </li></ul><ul><ul><li>Optimistic to encourage buys </li></ul></ul><ul><ul><li>Institutional vs retail incentives </li></ul></ul><ul><ul><li>Disintermediation </li></ul></ul><ul><li>Research firms </li></ul>
    13. 13. Research Tests <ul><li>Analyst forecast optimism and accuracy for </li></ul><ul><ul><li>Earnings (1 quarter, 2 quarters, 3-5 quarters ahead) </li></ul></ul><ul><ul><li>3-5 year ahead earnings growth rates </li></ul></ul><ul><ul><li>12 month target prices </li></ul></ul><ul><li>Across different types of firms </li></ul><ul><ul><li>Underwriters (bulge and non-bulge) </li></ul></ul><ul><ul><li>Syndicate firms </li></ul></ul><ul><ul><li>Brokerage firms (retail and institutional) </li></ul></ul><ul><ul><li>Research firms </li></ul></ul>
    14. 14. Sample Analyst Firm Types Salomon Smith Barney Merrill Lynch William Blair & Company ABN AMRO Underwriters Red Chip Review Frith Brothers Investments Chapin Davis Shonstrom Research Beeson Gregory H&R Block Financial Advisors Emerald Research First Dallas Securities Putnam, Lovell, Securities JSA Research Standard & Poors Sanford C. Bernstein Research Brokerage Syndicate
    15. 15. Sample Forecasts <ul><li>Earnings forecasts (Jan. 1996-Dec. 2002) </li></ul><ul><ul><li>809,552 forecasts, 6,755 companies, 6,483 analysts 370 firms </li></ul></ul><ul><ul><li>86% by underwriter analysts, 9% syndicate, 4.5% brokerage </li></ul></ul><ul><li>Long-term earnings growth forecasts (Jan. 1996-Dec. 2002) </li></ul><ul><ul><li>25,642 forecasts, 3,229 companies, 3,439 analysts, 198 firms </li></ul></ul><ul><ul><li>90% by underwriter analysts, 7% syndicate, 2.7% brokerage </li></ul></ul><ul><li>Target prices by analyst firms (Jan. 1999-Sept. 2002) </li></ul><ul><ul><li>91,994 forecasts, 3,637 companies, 3,954 analysts, 192 firms </li></ul></ul><ul><ul><li>90% by underwriter firm analysts, 8% syndicate, 1.6% brokerage </li></ul></ul>
    16. 16. Measuring Forecast Optimism <ul><li>Relative earnings/price forecast optimism </li></ul><ul><li>Relative forecast optimism ( RFOPT ) controls for: </li></ul><ul><ul><li>Company effects (i) </li></ul></ul><ul><ul><li>Time effects (t) </li></ul></ul><ul><ul><li>Horizon (t-k) </li></ul></ul>
    17. 17. Relative Earnings Optimism by Analyst Firm
    18. 18. Relative LT Earnings Growth Optimism by Analyst Firm
    19. 19. Relative Price Optimism by Analyst Firm
    20. 20. <ul><li>Dependent variables </li></ul><ul><ul><li>Relative forecast optimism (earnings, LT earnings growth, target price) </li></ul></ul><ul><li>Key independent variables </li></ul><ul><ul><li>Analyst firm effect: underwriter, syndicate, brokerage, pure research </li></ul></ul><ul><ul><li>Analyst company experience: log quarters of coverage </li></ul></ul><ul><ul><li>Analyst forecast accuracy: mean relative forecast accuracy </li></ul></ul><ul><ul><li>Forecast horizon (for earnings sample) </li></ul></ul>Model Specification
    21. 21. Relative Optimism Tests * EPS 181+ day * * ** Optimism increasing in experience ** Research * * * Brokerage * * * Syndicate Underwriter less optimistic than ** ** * * Non-underwriter Underwriter less optimistic than Price LT EPS growth EPS 91-180 day EPS 0-90 day
    22. 22. Additional Tests <ul><li>Effect of Stock Market Crash: Similar results before & after </li></ul><ul><li>Low optimism by high status bulge firms does not explain brokerage optimism </li></ul><ul><li>Retail brokerage firms more optimistic than institutional brokerage, but incomplete explanation </li></ul><ul><li>Optimism pattern typically similar for firms that make new issues and those that do not </li></ul><ul><li>Accuracy results consistent with optimism </li></ul>
    23. 23. Policy Questions <ul><li>Why are brokerage analysts so optimistic? </li></ul><ul><ul><li>Focused trading incentives? </li></ul></ul><ul><ul><li>Retail firm incentives? </li></ul></ul><ul><li>Will bank distribution of independent research improve quality? </li></ul><ul><ul><li>Will brokerage firms continue to be optimistic? </li></ul></ul><ul><ul><li>Will banks that use trading to fund research become more biased? </li></ul></ul><ul><ul><li>Will banks devote less resources for research? </li></ul></ul><ul><li>Who will undertake retail research & how will it be funded? </li></ul><ul><li>Will Reg FD reduce effect of length of company coverage on optimism? </li></ul>

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