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The Bias of Wall Street Analysts

HBS professor Mark Bradshaw reports
“The prediction was that all [Wall Street sell-side research] analysts would be more optimistic for firms that were issuing debt and equity securities than for firms that were either not engaging in such activity or were reducing their financing needs. An integral part of the forecasting function that analysts perform is assessing the need for external financing to fund operations. Thus, analysts are already intimately aware of what financing needs a company is likely to have. Accordingly, in periods leading up to a need to go to market for financing, we predict that all analysts would tend to increase the level of optimism embedded in their published research. This is exactly what we found.”

“Even more interesting is that the optimism embedded in analysts’ forecasts differs depending on whether the firm is issuing debt or equity securities. For firms that issue securities, their concern is the initial pricing of those securities. The pricing of equity is largely determined by the long-term performance of the firm, whereas the pricing of debt is limited on the upside, with investors standing to recapture principal and receive interest payments. Accordingly, we see that analysts’ optimism varies with the type of security being issued. For debt, the optimism is restricted to near-term earnings forecasts (i.e., the next two years); for equity, the optimism is concentrated in longer-term forecasts (i.e., growth forecasts, target price forecasts) and stock recommendations.”

In other words, not only is sell-side research impacted by the investment banking needs of the companies covered, but it’s impacted in a very sophisticated and targeted way.  Interestingly, Bradshaw found that this was true regardless of whether or not the analyst’s employer was current providing investment banking services to the client.  “The predictions in prior research were always that the affiliated analysts would be more optimistic than the unaffiliated analysts. This always seemed odd to me because unaffiliated analysts want to be affiliated so they can realize the benefits of associated investment banking fees and other ancillary services such as mergers and acquisition work, private placements, asset financings, and so on.”

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