Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward: they exert buy pressure following strong buy recommendations, no reaction to buy recommendations, and selling pressure following hold recommendations. This "discounting" is even more pronounced when the analyst has an underwriter affiliation. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.

Why do security analysts issue overly positive recommendations? We propose a novel empirical strategy to assess the relative importance of the leading explanations: strategic distortion, which reflects incentives to trigger small-investor purchases and please management, and non-strategic distortion, which reflects genuine over-optimism, due to self-selection or credulity. We exploit the concurrent issuance of recommendations and earnings forecasts by the same analyst to distinguish those motivations. While non-strategic distorters express their positive view both in recommendations and in forecasts, strategic distorters issue overly positive recommendations but slightly more negative ("beatable") forecasts. We find that affiliated analysts who have the most positive recommendations outstanding make the most negative forecasts. The same does not hold for unaffiliated analysts. Affiliated analysts are also more likely to distort forecasts downwards just before earnings announcements, allowing management to beat the forecast. Our findings indicate widespread strategic distortion, though the heterogeneity across analysts is large. We show that strategic distortion is persistent within individual analysts, with potential forensic implications.* We would like to thank Sris Chatterjee,

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Traditional economic analysis of markets with asymmetric information assumes that uninformed agents account for the incentives of informed agents to distort information. We analyze whether investors in the stock market internalize such incentives. Stock recommendations of security analysts are likely to be biased upwards, particularly if the issuing analyst is affiliated with the underwriter of the recommended stock. Using the NYSE Trades and Quotations database, we find that large (institutional) traders account for the upward bias and exert no abnormal trade reaction to buy recommendations, and significant selling pressure in response to hold recommendations. Small (individual) traders do not account for the upward shift and exert significantly positive pressure for buys and zero pressure for hold recommendations. Moreover, large traders discount positive recommendations from affiliated analysts more than from unaffiliated analysts, while small traders do not distinguish between them. The naive trading behavior of small investors induces negative abnormal portfolio returns.

Abstract:Prior research on equity analysts focuses almost exclusively on those employed by sellside investment banks and brokerage houses. Yet investment firms undertake their own buy-side research and their analysts face different stock selection and recommendation incentives than their sell-side peers. We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts from mid-1997 to 2004. We find that the buy-side firm's analysts issue less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicate that annualized buy-side Strong Buy/Buy recommendations underperform those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings are driven by differences in the stocks recommended and their market capitalization. After controlling for these selection effects, we find no difference in the performance of the buy-and sell-side analysts' Strong Buy/Buy recommendations.JEL classification: M41, G14, G29