A Catering Theory of Analyst Bias

Abstract

We posit a theory that runs counter to how conventional wisdom thinks about analyst bias, that it is the result of distorted incentives by "the system" -especially upstream factors like the analysts' employers. We suggest that analysts are also heavily influenced by what investors believe, the purported victims of analyst bias. We adapt Mullainathan-Shleifer's theory of media bias to build a theory of how analysts cater to what investors believe. The theory also predicts that competition among analysts does not reduce their bias. We provide empirical support for this theory, using an enormous dataset built from over 6.5 million analyst estimates and 42.8 million observations on investor holdings, which we argue is a proxy for what they believe. We use a simultaneousequations model for estimation, with instruments to rule out alternative interpretations of the direction of causality. For additional robustness, we investigate the time series of analyst bias and heterogeneity in investor beliefs from 1987 through 2003. Dickey-Fuller tests show that both have unit roots, but we establish that cointegration hold. Further, we employ a vectorautoregressive model to show Granger-causality between the two.The bias of analyst forecasts has received extensive empirical study, from as early as Mastrapasqua and Bolten (1973) and Brown and Rozeff (1978). A recent survey is in OʹBrien (2003). A large class of studies deals with how analysts' biases might affect stock prices and other aspects of the market. This paper joins an emerging class of studies that seeks to understand the source of the bias. For example, Hong and Kubik (2003) show that analysts who are positively biased get better jobs in the industry. Cowen, Groysberg and Healy (2003) provide evidence that analysts whose employers are more commissionbased, such as pure brokerages, are more bias. Underlying many of these explanations is an upstream source of analyst bias: that of distorted incentives by their employers and the companies covered.In this paper, we ask the seemingly obvious question: might not analysts' biases be a result of their catering to downstream influence -that is, their direct clients, the readers? This paper can also be viewed as a contribution to the already large body of literature on behavorial corporate finance, in which a theme is that firm behavior can be explained by their responses to clients and the market. This theme has been used to explain capital 2 structure (Baker and Wurgler (2002)), dividend payouts (Baker and Wurgler (2003)), and acquisitions (Shleifer and Vishny (2003)).Our "catering" theory, if true, has important practical implications. For example, it means that policy makers have to go beyond reforming incentives and organizational structures inside analysts' institutions, if we were to have any hope of reducing analyst bias. Finally, this research question opens up a range of others. The most important is how readers of analyst reports are in turn influenced by what analysts write.We start with Section I, in which...

Forecast Bias and Analyst Independence

“…Under certain analyst-utility assumptions, forecasts which minimize expected error are characterized by an optimistic bias (Lim, 2001). Bias might result from the use of judgmental heuristics (Affleck-Graves, Davis and Mendenhall, 1990), or from analysts catering to investor beliefs (Lai, 2004). Alternatively, estimates of bias might be imprecise because of data censorship (Hayes and Levine, 2003), or asymmetries in the distribution of forecast errors (Abarbanell and Lehavy, 2003).…”

The catering theory of dividends: the moderating role of firm characteristics, corporate governance factors and corporate ownership

“…For example, find that investor sentiment measures are highly correlated with, and have predictive power for, future market returns. Lai (2004) relies on the catering theory to explain the well-documented 'analyst bias'. He suggests that analysts are heavily influenced by investors, and he builds a theory showing how analysts cater to investor beliefs.…”

“…Recent studies (see, among others, Cliff, 2004, 2005;Lai, 2004;Fairchild and Zhang, 2005;Gemmil, 2005;Ferris, Sen and Yui, 2006;Kumar and Lee, 2006;Li and Lie, 2006;Zhang, 2006;Denis and Osobov, 2008;and Hoberg and Prabhala, 2009) show that this new theory can be decisive in the resolution of the dividend puzzle through investors' sentiments. Furthermore, a related strand of the recent behavioral literature focuses directly on developing measures of sentiment and relating these to expected stock return (see, for instance, Brown and Cliff, 2005;Wurgler, 2006, 2007;Portniaguina, 2006, or Qiu andWelch, 2006).…”

“…According to this new theory, when investors' demand for payouts increases, firms are more likely to increase payouts (via either dividends or repurchases 23 ). Recent studies (see, among others, Cliff, 2004, 2005;Lai, 2004;Denis and Osobov, 2005;Fairchild and Zhang, 2005;Gemmil, 2005;Hsieh and Wang, 2006;Cohen and Yagil, 2008;Han, 2008;Hoberg and Prabhala, 2009) show the growing interest that is lending to this new theory and they suggest that investors' sentiments can be decisive in the resolution of the dividend puzzle.…”

Are dividends and share repurchases substitutes? : evidence from the reaction of financial analysts

“…In addition, several prominent financial publications consider the institutional investors' input in the process of ranking financial analysts (Boni and Womack, 2002). Lai (2004) proposes a model adapted from Mullainathan and Shleifer (2005) concerning how financial analysts cater to their direct clients. He finds support for catering producing a bias in analysts' recommendation.…”