When Do Sell‐side Analyst Reports Really Matter? Shareholder Protection, Institutional Investors and the Informativeness of Equity Research

• Author: Andreas Walter,Alexander Kerl,Daniel Arand
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12028.x
• Published date: 01 June 2015

When Do Sell‐side Analyst Reports

Really Matter? Shareholder Protection,

Institutional Investors and the

Informativeness of Equity Research

Daniel Arand, Alexander Kerl and Andreas Walter

Department of Financial Services, University of Giessen, Licher Str. 74, 35394, Giessen, Germany

E-mail: Alexander.Kerl@wirtschaft.uni-giessen.de

Abstract

We examine whether the informativeness of sell‐side analyst reports depends on the

strength of the regulatory environment of a country and the regulatory background

of the institutional investors of a company. Based on both measures that we use to

proxy the informativeness of analyst research (i.e., short‐term market reaction and

forecast errors with respect to corporate earnings), our results show that the

information value of research increases as the level of investor protection

increases. This result is robust to different specifications of investor protection. We

further demonstrate that analyst forecasts are more (less) valuable when the

majority of institutional investors are from strong (weak) investor protection

countries.

Keywords: shareholder protection, institutional investors, analyst reports, regulation

JEL classification: G14, G15, G18, G24, G32

1. Introduction

This paper addresses the question to what extent the informativeness of sell‐side analyst

research depends on the prevailing regulatory environment. On the one hand, the previous

literature considers the information environment, such as the regulatory and institutional

background of a company, and the informativeness of analyst research as substitutes (see,

e.g., Subramanyam, 1996). That is, analysts are more relevant to the stock market when

We thank an anonymous referee for valuable comments and suggestions. Furthermore, we

thank seminar participants at the 2012 Cologne financial market colloquium, the 2012

European Financial Management Association (EFMA) annual meeting in Barcelona, and

the 2013 Midwest Finance Association (MFA) annual meeting in Chicago, for helpful

comments. Correspondence: Alexander Kerl.

European Financial Management, Vol. 21, No. 3, 2015, 524–555

doi: 10.1111/j.1468-036X.2013.12028.x

© 2013 John Wiley & Sons Ltd

other sources of information are scant. Loh and Stulz (2011), for example, find that

analysts’recommendations are more likely to be influential on stock prices in the case of

small companies with only low analyst following. Similarly, Lang et al. (2004) report a

positive valuation effect of analyst coverage in the case of poor internal and weak country

level external governance.

On the other hand, other studies suggest that the general information environment of a

company and the informativeness of analyst research are complements. Francis et al.

(2002), for example, find a positive relation between abnormal returns and the information

contained in both earnings information and analyst reports. The authors do not find that

the informativeness of earnings announcements is reduced by the simultaneous

publication of analyst reports. In line with this result, Frankel et al. (2006) explicitly

state that the information value of analyst research and financial statements are

complements and that analyst report informativeness increases with institutional

ownership. This could be due to the fact that better shareholder protection leads to a

higher quality of financial reporting and corporate disclosure that ultimately translates into

better inputs for analyst research, and, hence, more valuable forecasts.

Based on this evidence, we consider the relationship between analyst research and the

regulatory environment an empirical issue that has not yet been resolved. We add to the

literature that has primarily used the legal environment and ownership structure of a

company to explain analysts’incentives to produce analyst research and to cover certain

stocks.

1

Related to this topic, the previous research has found plenty of evidence in regard

to the regulatory and institutional environment’s positive influence on the quality of

financial reporting (see, e.g., La Porta et al., 2000; Ball et al., 2000). Leuz et al. (2003)

reveal that earnings management decreases in investor protection. DeFond et al. (2007)

further show that annual earnings announcements are more informative in countries in

which insider trading laws are better enforced. Similarly, Haw et al. (2012) find that in

countries with strong investor protection, greater financial disclosure and higher‐quality

earnings are associated with more informative stock prices about future earnings. With

respect to the shareholder structure of a company, Yeo et al. (2002) and Velury and

Jenkins (2006) demonstrate that the quality of reported earnings increases with

institutional ownership. This finding is consistent with large external stockholders

assuming a monitoring role in corporations (see, e.g., Shleifer and Vishny, 1986; Chen

et al., 2007).

Following this evidence, our study contributes to the existing literature by analysing

whether the regulatory environment influences the informativeness of analyst research

because analysts directly depend on the quality of information available to them as inputs.

Hence, we evaluate whether the informativeness of analysts’research is affected by (i) the

overall level of investor protection within a country and (ii) the regulatory background of

the institutional investors of a company. To measure the informativeness of forecasts, we

use two different approaches. First, we follow Frankel et al. (2006) by focusing on the

short‐term market reaction in response to the publication of an analyst report. Under the

1

Bushman et al. (2005), for example, find that the strength of the legal environment is

positively associated with the number of analysts issuing research on a company. Similarly,

Bhushan (1989) argues that analyst following increases in institutional ownership. This

finding could be related to the fact that institutional investors are the main consumers of

analyst research.

© 2013 John Wiley & Sons Ltd

When Do Sell‐side Analyst Reports Really Matter? 525

assumption of efficient capital markets in which any new information instantaneously

influences stock prices, the market reactions following the revision of analysts’forecasts

serve as a valid proxy for the information value that market participants attribute to new

information. Second, we also compute report‐specific earnings forecast errors. By

comparing, for example, the actual reported earnings with the previously issued earnings

forecast, it is possible to identify which forecasts were more accurate and therefore

contained more information value.

Before describing our results, we would like to comment on the measures that we use to

identify the level of investor protection. Because different shareholder protection and

regulatory enforcement measures have been suggested within the previous literature (e.g.,

La Porta et al., 1998; Djankov et al., 2008; Jackson and Roe, 2009), we deploy a set of

conceptually different approaches in this context. These measures cover formal indicators

of the strength of the applicable shareholder rights law as well as enforcement proxies that

estimate the degree to which individuals and institutions can rely on norms and

regulations being put into effect and the intensity with which wrongdoing is being

prosecuted.

With respect to the first measure of forecast informativeness, namely, the short‐term

market reaction, our results reveal that the value of analyst reports depends significantly

on the country‐specific level of investor protection. For analysts’target price and earnings

forecast revisions

2

,wefind a material increasein information value as the level of investor

protection increases. However, our results also show that recommendation upgrades are

hardly considered valuable within strong investor protection countries, whereas this is the

case in weak investor protection environments. One possible explanation for this finding

is that strong investor protection markets such as the USA are characterised by more

sophisticated market participants who properly discount the value of potentially biased

recommendations. All our results are robust to the different specifications of investor

protection that we apply.

We further refine our analyses and find that the information value of analysts’forecasts

also depends on the investor‐specific regulatory background. In particular, our results

suggest that the informativeness of analysts’forecasts increases (decreases) in line with

the percentage of institutional investors from strong (weak) investor protection countries.

For example, in the subset of companies located in strong investor protection

environments such as the USA, those companies with a high percentage of foreign

institutional ownership (and, hence, an increased likelihood of institutional shareholders

being located in less regulated countries) presumably are characterised by worse

governance and a lower quality of financial reporting. This scenario consequently leads to

analyst forecasts that are of reduced information value. Analogously, we find that

companies located in weak investor protection environments benefit from a high

percentage of foreign institutional ownership (and, hence, an increased likelihood of

institutional shareholders being located in more regulated countries). This result could be

attributed to better governance, which positively affects a company’s information

environment and ultimately results in analyst research of higher information value. Our

results therefore support the previous findings of Aggarwal et al. (2011) who have shown

2

For the purpose of this paper, ‘revisions’in terms of analysts’stock recommendations, target

prices and earnings forecasts include both changes and reiterations of the prior forecast levels.

© 2013 John Wiley & Sons Ltd

526 Daniel Arand, Alexander Kerl and Andreas Walter