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 attitude
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 the value of the firm and, ultimately, the lower the cost of capital.
When a firm loses an analyst, uncertainty about the firm’s value and the cost of its capital increases.
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.”