Analyst Bias and Stock Recommendations: A Critical Review

Introduction

Following the Great Recession of 2008, the volatility of the stock market became a topic of increasing interest due to its collective impact on the global economy. In their study "Analyst quality, optimistic bias, and reactions to major news," Cao and Kohlbeck (2011) sought to determine whether the characteristics associated with superior analysts are also related to reductions in the asymmetric response to stock recommendations. To this end, Cao and Kohlbeck (2011) revisited previous research in this area to identify analyst and brokerage-firm characteristics indicative of superior ability to generate accurate stock recommendations. This paper reviews Cao and Kohlbeck's (2011) study concerning analyst quality, optimistic bias, and reactions to major news, followed by a critical analysis of the authors' conclusions. Finally, a summary of the research and its salient findings are presented in the conclusion.

Analyst Quality, Optimistic Bias, and Reactions to Major News

According to Cao and Kohlbeck (2011), studying the quality of financial analyses provided by analysts is an important and timely enterprise because such characteristics are closely associated with the asymmetric response of stock recommendations to public information shocks. Mokoaleli-Mokoteli, Taffler, and Agarwal (2009) similarly report that, "Although research attests to the importance of financial analysts for the efficient functioning of the capital markets, in the recent past strong doubts have been expressed about the credibility and objectivity of their stock recommendations" (p. 385). Moreover, a number of concerns have been raised about sell-side analysts' recommendations that were almost Panglossian in their predictions yet did not appear to mirror their honest views about the reported stocks. Indeed, Mokoaleli-Mokoteli et al. (2009) report that, "By mid-2000, the percentage of buy recommendations had reached 74% of total recommendations outstanding while the percentage of sells had fallen to 2%" (p. 385).

Cao and Kohlbeck (2011) also confirm that previous researchers have identified a degree of asymmetry between analysts' responses to large positive versus large negative information shocks. According to these researchers, "Analysts respond much more strongly to large negative price shocks and effectively do not respond to large positive price shocks" (p. 502). Previous research concerning revisions of analysts' earnings forecasts supports analyst optimism as indicated by their propensity to underreact to prior bad news; the precise cause of the optimistic bias in analysts' reactions to major news, however, remains understudied (Cao & Kohlbeck, 2011). What is known is that "Overoptimism is the tendency to overestimate the likelihood of desired outcomes and underestimate the frequency of unfavorable events and is one of the most cited biases in the literature on analysts' forecasts and recommendations" (Mokoaleli-Mokoteli et al., 2009, p. 386).

Asymmetric Responses and Superior Analyst Characteristics

To help fill this gap in the body of knowledge concerning asymmetrical responses, Cao and Kohlbeck (2011) investigated whether financial analysts' characteristics are associated with their asymmetric response of stock recommendations between positive and negative information shocks. These researchers also speculated that those attributes differentiating superior analysts from their less adept counterparts are positively related to the timely dissemination of bad news about a company. Consequently, Cao and Kohlbeck (2011) predicted that the asymmetric response would be less pronounced among superior analysts.

Based on their analysis of the stock return and recommendation-changes relationship, Cao and Kohlbeck confirmed that asymmetric reactions were less pronounced for analysts possessing superior attributes. Furthermore, the reduction in asymmetric reactions was more accentuated for analysts in the top decile, but the reduction was only discernible when such analysts reported negative private information about a company (Cao & Kohlbeck, 2011). Based on their preparatory analyses, Cao and Kohlbeck offered two fundamental reasons why the asymmetric response is less pronounced for superior analysts:

First, superior analysts have a reputation advantage in attracting new banking clients. As a result, other analysts are more likely to avoid negative views in order to attract new business. A sufficiently large negative shock permits these other analysts to downgrade while still maintaining an optimistic bias. Second, superior analysts have incentives to reveal their negative private information to the market. Compared to analysts identified as providing no upgrade, superior analysts can offer a relative upgrade while still being relatively less optimistic in reaction to a negative price shock.

Conclusion

The research showed that the findings obtained by Cao and Kohlbeck (2011) are consistent with previous research demonstrating that asymmetry was associated with a general information-processing bias among analysts deemed of lower quality. Significantly, this type of bias has a lesser potential to adversely affect analysts deemed superior based on their proven track records of translating earnings forecasts into recommendations. The findings by Cao and Kohlbeck were also consistent with the body of knowledge confirming the ability of superior analysts to differentiate stock picking compared to their less qualified counterparts. Analysts deemed superior were shown to be less likely to postpone the release of bad news about companies — a factor that is important for investors who concentrate on downside risk and trade on security analysts' stock recommendations. Finally, the research demonstrated that these types of studies are important because analyzing the specific characteristics of financial analyst recommendations carries particular value, given that prior research suggests analyst research is especially valuable and informative in bad news scenarios.

References

Cao, J. & Kohlbeck, M. (2011). Analyst quality, optimistic bias, and reactions to major news. Journal of Accounting, Auditing & Finance, 26(3), 502–526.

Mokoaleli-Mokoteli, T., Taffler, R. J., & Agarwal, V. (2009, April/May). Behavioural bias and conflicts of interest in analyst stock recommendations. Journal of Business Finance & Accounting, 36(3) & (4), 384–418.