Download the benefits of sell-side research

THE BENEFITS OF SELL-SIDE
RESEARCH
An Extensive Review of the Literature
JSE Limited Reg No: 2005/022939/06 Member of the World Federation of Exchanges
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Contents
Benefits ................................................................................................................................................ 3
Introduction ......................................................................................................................................... 3
Stock prices move in line with analyst coverage ................................................................................. 4
Analyst coverage leads to increases in liquidity .................................................................................. 5
Analyst coverage causes higher institutional and retail trading.......................................................... 6
Analyst coverage reduces the cost of capital for companies .............................................................. 7
The benefits of analyst coverage during ‘bad times’ ........................................................................... 8
The firm-size effect of analyst coverage .............................................................................................. 8
The drawbacks of losses in analyst coverage ...................................................................................... 9
The need for more analyst coverage in emerging markets ................................................................. 9
Conclusion .......................................................................................................................................... 10
References.......................................................................................................................................... 10
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BENEFITS
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Sell-side equity research plays an important role in capital markets
For over ~40 years, increased analyst coverage has been associated with increased stock
trading activity (liquidity) toward the securities under interest
Stock prices are observed to follow the recommendations derived from analyst coverage
Increased analyst coverage typically causes investors to believe that more superior
information will be priced into a stock’s prospects and value
Analyst coverage catches the attention of retail investors and thereby boosts liquidity
Reductions in the cost of capital are possible through increased analyst coverage
Analyst coverage adds the most value during volatile economic periods or ‘bad times’
In emerging markets, weakly distributed information presents a lack of firm-specific
information from being incorporated into stock prices
Smaller companies are in line to benefit the most from analyst coverage off their limited
visibility
Losses in analyst coverage increase the likelihood of a company delisting.
If analyst coverage is stopped, there is a high chance that the coverage will not be picked
up at a later period
The SEC Advisory Committee on Smaller Public Companies officially endorsed the paid-for
research model in 2011
Overall, there are severe drawbacks for losses in analyst coverage as well as large benefits
for increased levels of coverage
INTRODUCTION
Sell-side equity research continues to play an important role in capital markets. A collection of
investment banks within the United States alone spends in excess of one hundred million dollars
annually on equity research. Extensive research indicates that institutions rely on sell-side equity
analysis to market their securities, boost liquidity and aid in investment decisions1-5.
Equity research frequently includes several core components, namely: earnings forecasts, a stock
recommendation (such as buy, sell, or hold) and a price target. This is alongside extensive
quantitative and qualitative analysis supporting such claims.
Equity research analysts process a large quantity of information to conduct and compare security
valuations. They usually possess superior information and a superior information processing ability
and through introducing new information to the market and changes in analyst recommendations,
investors are incentivised to trade on such information, which increases liquidity 6.
From a general perspective, research shows that analyst coverage improves firm valuation7,
enhances stock liquidity3, and reduces the cost of equity8.
As there is no natural benchmark that exists against which to accurately assess the value of analyst
research, we conducted a thorough literature review on the topic, obtaining information that
dates back over several global business cycles. Overall, we identified many benefits arising from
analyst coverage.
STOCK PRICES MOVE IN LINE WITH ANALYST COVERAGE
In 1978, reseachers9 studied the market’s reaction to analyst recommendations appearing in the
Wall Street Journal and later in 1980, followed the market’s reaction to forecasts published by
Merrill Lynch analysts10. The research revealed larger swings in stock price returns under the
heightened analyst activity.
Later in 1987, further research confirmed that such price movements were not occurring by
chance and that a change of direction in analyst recommendations caused stock prices to move
significantly11. In 1997, researchers were able to directly measure any extreme returns at the
opening of the bourse following analyst recommendations12 (up to ~4% for NYSE stocks and up to
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~7% for NASDAQ stocks). In 1998, the impact of initiation analyst research was measured and
found that significant (~3%) extreme returns followed initial buy recommendations13.
After examining 2128 analyst recommendations and the corresponding companies under analysis,
similar extreme stock price movements were witnessed in 2003 after the initiation of coverage by
sell-side analysts3. The research also highlighted that the commitment of resources by research
houses toward the analysis of a stock, indirectly attached value to the stock’s prospects.
Later research demonstrated that bullish recommendations by analysts typically lead to stock
price outperformance in comparison to bearish analyst sentiment which lead to stock price
underperformance14.
It was then further exhibited that investors bought on the recommendations of analysts’ earnings
and growth forecasts, with the strongest occurrence in the U.S. and Japanese equity markets, with
weaker occurrences in almost every other developed economy except Italy15.
By 2004, researchers provided evidence and confirmed that changes in the direction of analyst
recommendations were strong predictors of future stock performance4.
In 2007 it was found that companies with cutbacks in analyst coverage experienced significant
stock price declines16. It was also demonstrated how investors overreacted to a decrease in the
number of analysts covering a stock and that a drop in analyst coverage could lead to increased
negative price returns within as little as one year17. In 2010, researchers commented on a similar
effect where the stock price of firms that had been temporarily neglected by analysts rose
significantly as the analysts resumed coverage of these firms18.
Ultimately, analyst recommendations play a major role in the continuous fluctuations of stock
prices.
ANALYST COVERAGE LEADS TO INCREASES IN LIQUIDITY
In 1995, Brennan and Subrahmanyan developed their liquidity theory which suggested that an
increase in analyst coverage caused increased liquidity19. In 1998, researchers reiterated this by
showing that liquidity was positively related to the number of analysts following a company 20.
Their findings additionally demonstrated that analyst coverage caught the attention of retail
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investors and thereby boosted liquidity. More so, discontinuations of coverage caused a liquidity
slowdown.
In 2004, heightened stock liquidity was observed on the Toronto Stock Exchange for 10 days after
revised analyst forecasts and recommendations were released21. In 2005, a similar occurrence was
found when analyst research recommendations and earnings forecasts were released for the
Australian stock market, as well as finding that optimistic recommendations had a greater impact
on increased stock liquidity22. Such effects were also identified within the US equity market in
201523.
Ultimately, when analyst updates are released into the market, new information is essentially
ready to be analysed, priced-in and traded on, thereby leading to increases in liquidity.
ANALYST COVERAGE CAUSES HIGHER INSTITUTIONAL AND RETAIL TRADING
In 2001, researchers found that changes in analyst recommendations often encouraged fund
managers to trade24 and in 2005, it was again highlighted that fund managers seemed to place
large importance on the information content of analyst recommendations25. More recently in
2013 it was revealed that mutual funds actually ‘herded’ on changes in analyst
recommendations26.
Modern Portfolio Theory would suggest that in a perfectly efficient market, analysts would not be
able to add any value since any information they have would already be reflected in market
prices27. However, above-mentioned research15 confirmed that even countries that have the most
developed stock markets in the world were semi-strong form efficient when analysed (not all
information is priced into stock prices) and there was still high potential for analysts to provide
additional information to the market and ultimately, encourage fund managers to trade on such
information.
From a retail perspective, the average investor who commonly holds smaller stakes in securities,
usually retains limited resources to produce a thorough analysis of company value and prospects.
As a result, this creates demand for analysts who can produce high quality information for such
uninformed investors.
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ANALYST COVERAGE REDUCES THE COST OF CAPITAL FOR COMPANIES
In 1985 it was shown that analyst coverage could reduce information asymmetry (where one party
has more or better information than another party) 28. Information asymmetry often resulted in
less attraction to investing in financial markets as uninformed investors became hesitant to trade
against potentially more-informed investors.
Owing to this, when issuing new equity, companies would mostly issue their shares at a discount
to counteract any risk concerns of uninformed investors. Such discounting lead to smaller
proceeds going to the issuing company and ultimately a higher cost of raising equity capital. The
information asymmetry worked against the company when the firm was undervalued and was
unable to issue equity, however, when it was overvalued, it was presented with a window of
opportunity given its inability to issue equity more regularly.
Later in 2006 it was showed that firms that received less coverage (usually smaller firms) issued
equity less frequently, but when they were presented with a window of opportunity, they issued a
larger amount of equity, which could often be harmful in the long-run to the firm’s capital
structure29. When information asymmetry was reduced the cost of raising equity capital was
reduced, as investors required lesser returns off the perception of lower risk conditions. The same
occurrence was later reiterated in 2008, when analyses of 4,766 seasonal equity offerings (SEOs)
between 1984 and 2000 were conducted.
Amount of analysts
Group 1 (no coverage)
Group 2
Group 3
0
1 to 4
8 and above
Effect of coverage on cost of
capital
0%
-1.19%
-1.24%
Table 1. The effects of analyst coverage and cost of capital30
The research proved that when compared with companies without analyst coverage, companies
with even fluctuating levels of analyst coverage demonstrated a lesser cost of capital (see the
results in Table 1) 30.
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THE BENEFITS OF ANALYST COVERAGE DURING ‘BAD TIMES’
In 2014 it was demonstrated that the value of analyst work differed substantially in ‘bad times’
(characterised as either macro or microeconomic issues) as during such conditions, analysts
became more active and their outlooks became more significant 31.
This was particularly proven earlier in 2012, when it was demonstrated that analyst coverage
became more valuable and in greater demand when company financials provided weaker signals
about future cash flows (an example of ‘bad times’) 32.
Overall, during difficult market conditions, it became almost impossible for uninformed traders to
assess the prospects of stock, and even informed traders began to rely on the views of other
informed traders. This occurred particularly on a relative valuation basis, as during bad times, it
was often easy to arrive at a conflicting view or companies often lacked the resources to
adequately value a company and had to rely on other analysts’ abilities to gather and price in
information.
In 2015, researchers gathered the transcripts of 46,000 analyst conference calls that occurred
between 2002 and 2013, and demonstrated that investors placed significant value on analyst
views because analysts were/are viewed as informed investors who offered/offer a superior
understanding of companies and their prospects33.
At this, an increased amount of analyst coverage typically causes investors to believe that more
superior information will be priced into a stock’s prospects and value.
THE FIRM-SIZE EFFECT OF ANALYST COVERAGE
In 1989, it was argued that larger companies tended to be more appealing to analysts while
smaller firms experienced the opposite, causing smaller firm stock prices to move slower and/or
irrationally34. This was mainly owed to the significant costs involved in following and analysing
companies as well as the payoff usually coming in higher for following larger companies. This
caused smaller companies whose prospects were more difficult to forecast to attract little-to-no
analyst coverage and subsequently trade more thinly.
Ironically, smaller companies were in line to benefit the most from analyst coverage off their
limited visibility, higher agency costs, larger uncertainty and higher information asymmetry. This
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had become such an issue, that the SEC released a statement in 2006 that suggested that up to
83% of US firms with market caps less than $125 million had no coverage35. In the same year, the
SEC Advisory Committee on Smaller Public Companies officially endorsed the paid-for research
model and recommended the SEC to actively encourage it as a means for companies to obtain
analyst coverage and remedy the problem.
The issue was unfortunately still prevalent in 2009, when it was protested that over the past 20
years, the number of firms listed on public exchanges had dropped by over 20% and was at least
partly due to analysts failing to cover small- and mid-capitalisation stocks36. The issue caught the
eye of the press as they too begun to speculate over the matter that small and mediumcapitalisation firms were increasingly losing analyst coverage. (See for example, the Economist,
2009, High-speed slide, November 14, 2009, 85–86.).
THE DRAWBACKS OF LOSSES IN ANALYST COVERAGE
In 2012, researchers analysed a sample of 12,600 companies that went without any analyst
coverage for at least one year, between 1983 and 2004. Their research showed that companies
that lost all analyst coverage for one year had a significantly higher probability of delisting than
their covered peers37. Such companies showed a significantly higher delisting occurrence, with
companies that experience one year without analyst coverage to be 11% more likely to delist than
their peers. In addition, firms with complete losses of coverage were significantly more likely to
delist than firms experiencing large but not complete losses of coverage.
They also found that analysts usually dropped coverage of a firm due to that firm’s poor
performance and were usually reluctant to resume coverage. This caused a ripple effect that
negatively affects liquidity, turnover, and an institutional shareholder sell-off. As analysts turned
off the spotlight and the company began to fall off the investment radar, the company’s survival
odds in the financial markets dropped rapidly.
THE NEED FOR MORE ANALYST COVERAGE IN EMERGING MARKETS
In 2000, research indicated that stock prices in emerging markets contained less company-specific
information as opposed to developed markets38. Their research proved that in emerging markets,
information was not readily available and discouraged informed trading and therefore, prevented
firm-specific information from being incorporated into stock prices.
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In 2000 the immense difficulty in forecasting company prospects in emerging markets was also
highlighted, owing to the lack of publicly available company-specific news due to less stringent
requirements for information disclosure in certain parts of these markets 39. The following year,
evidence indicated that analyst coverage increased the rate with which prices embedded public
information and ultimately, has the potential to remedy the issue40.
In 2004, researchers again reiterated this after having suggested that increased analyst coveragedrastically lead to observed increases in firm value41. Thus, the benefits to be gained from
collecting company-specific information might be high enough to provide more incentive for
analysts to collect such information.
CONCLUSION
After careful review, we believe we have identified many benefits arising from analyst coverage.
Particularly, such research provides value through introducing new and superior information to
the market, ultimately moving stock prices and increasing liquidity.
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This report was commissioned by the JSE and compiled by Merchantec Capital
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