Financial analysts: Are they useful after all?
François Derrien and his co-author study the extent to which financial analysis impacts a firm’s decisions. They provide empirical evidence revealing a direct link between analyst coverage and the cost of capital, amounts invested, and financing capacity. Contrary to popular belief, it seems that financial analysts do indeed serve a real purpose.
Does coverage by financial analysts influence corporate decision-making? “It is an important question,” says François Derrien. “Some researchers think that analysts do not provide much information, that they all say the same thing, that they are subject to conflicts of interest, and that their analyses are biased. There is a general consensus that, essentially, they are not of much use.” To test this idea, Derrien and his co-author, Ambrus Kecskés, identified firms that had reduced analyst coverage (i.e. cut back on the number of analysts covering them) and studied the impact of that loss on financing and investment decisions. “It proved to be more complicated than we initially thought it would be,” explains Derrien.
“Simply analyzing the investment decisions of firms that have lost or gained an analyst is likely to result in erroneous conclusions. For example, the fact that a firm has reduced their investments after losing an analyst might seem to indicate that their decision to make fewer investments has resulted from that loss of the analyst, when in fact they lost the analyst because they reduced their investments.” To verify the causal relationship, the researchers tackled the problem of identifying exogenous shocks in analyst coverage – i.e. shocks that cannot be caused by anticipated changes in corporate policy. They focused on decreases in analyst coverage following the closure or merger of brokers. In either of those two events, some or all of a firm’s analysts are dismissed, with the firm losing some of its coverage.
RELATIVELY STRONG RESULTS IN TERMS OF ECONOMIC MAGNITUDE
The results of the study confirm that analysts generate important information that is used by market players, which impacts the cost of capital for firms and, consequently, the investments they agree to and their financing. In fact, after the loss of an analyst, companies reduce their investments by on average 2.4% of the total value of their assets. The three investment components that the researchers focused on (capital, research and development, and acquisitions) fall significantly in both the year prior to and following the loss of an analyst in comparison to similar firms that do no lose an analyst. Firms also considerably reduce their financing (on average by 2.6 % of their assets) when they lose an analyst. Amongst the three variables that the researchers were interested in (changes in long and short-term debts and equity issuance), only short-term debt does not decrease significantly, because it is less sensitive to uncertainty and, consequently, to analyst coverage. The greater the coverage, the more information there is available for investors, thus the lower the uncertainty regarding
When a firm loses an analyst, uncertainty about the firm’s value and the cost of its capital increases.
the value of the firm and, ultimately, the lower the cost of capital. As François Derrien explains: “When a firm loses an analyst, uncertainty about the firm’s value and the cost of its capital increases. And, while the cost of its financing increases, its investment opportunities become less attractive. In overall terms, the firm reduces its external financing (loans and share issues) and its investments.”
EFFECTS DEPEND ON INDIVIDUAL FIRMS
The effects vary enormously depending on a firm’s individual characteristics. They are highly significant for smaller companies that with less analyst coverage overall. By contrast, they are less significant for larger companies or companies that operate with several analysts, and for firms where investors have access to large amounts of information. In addition, the effects are more pronounced for firms with limited resources that have to rely on external financing to fund new projects. The results demonstrate the pivotal role played by financial analysts. As François Derrien concludes: “Not only do analysts influence the price of shares via their investment recommendations and reports, the information they provide also directly affects the cost of the capital of the firms they cover and, more indirectly, their financing and investment decisions.”
Based on an interview with François Derrien, professor of finance, and the article “The Real Effects of Financial Shocks: Evidence from Exogenous Changes in Analyst Coverage” by F. Derrien and A. Kecskés, scheduled for publication in the Journal of Finance.
APPLICATIONS IN THE WORKPLACE
The results of the study by François Derrien and Ambrus Kecskés show that the greater a firm’s analyst coverage, the easier it is for that firm to finance and invest. (Although this suggests that the number of analysts should be increased, in reality this may not be the case for every company.) “We increasingly find that many listed companies do not have analyst coverage”, explains Derrien. “After the scandals of the 2000s, brokers reduced the number of analysts and there are now fewer of them on average. This is not necessarily a good thing, especially for very small firms.” Derrien goes on to provide possible solutions, such as the approach in Spain, where stock market authorities make use of public analysts to provide coverage of firms that, at least in theory, is neutral.
The researchers analyzed 52 broker closures or mergers in America between 1994 and 2008 that resulted in 1,724 firms losing financial analysts. They then compared the changes in the investment and financing decisions of the firms (for the year before and after the loss) with those of similar companies that had not lost an analyst (in terms of market sector, total assets, cash flow, analyst coverage, and so on).