Does Forecast Bias Affect Financial Analysts’ Market Influence?

Abstract

Prior studies find that analysts tend to bias their forecasts upward in poor information environments and downward in rich information environments, consistent with attempts to curry favor with management. We find that investors anticipate this behavior by reducing their response to upward forecasts in poor information environments and downward forecasts in rich information environments. Using Hugon and Muslu’s measure of analyst conservatism as an ex ante indicator of individual analysts’ forecast bias tendencies, we show that the stronger return response they find to conservative analysts’ forecast revisions is restricted to poor information environments, where optimistic analyst bias is prevalent. Our results suggest that analysts pay a price in market influence when their forecasts reinforce analysts’ typical forecast bias for the firm’s information environment. Conversely, analysts whose forecasts conflict with the typical bias for the firm are rewarded with larger than average return responses.

The Effect of Analyst Conservatism on Earnings Management.

“…In other words, the monitoring effect increases due to conservative analysts responding more negatively to bad news, and the pressure effect decreases due to a relatively easier benchmark to achieve. Because the stronger market reaction to conservative analysts exists only in poor information environments (Keskek and Tse 2018), we predict these effects of analyst conservatism will occur in poor information environments. Accordingly, we state our hypotheses as follows:…”

“…Keskek and Tse (2018) find that the stronger market reaction to forecast revisions from conservative analysts originally documented in Hugon and Muslu (2010) is only significant in poor information environments (where analyst forecast dispersion is greater). In other words, Keskek and Tse (2018) find that investors anticipate and combat biased analysts by reducing their response to upward (downward) forecast revisions in poor (rich) information environments. Thus, it appears that when information is lacking, investors do not put much faith into positive forecast revisions from analysts; and when information is plentiful, investors are not shocked by downward revisions.…”

“…An individual analyst's conservatism is calculated as the ratio of their response to bad news versus good news, (β0 +β1)/β0. Following Keskek and Tse (2018), if β0 is less than 0.1, we scale (β0 +β1) by 0.1 rather than β0 to avoid large conservatism values due to a small denominator. 6 In line with Hugon and Muslu (2010), we require (1) that each analyst make at least eight forecast revisions in a calendar year, including at least two upward revisions and two downward revisions,…”

“…Investors value information contained in earnings forecast revisions of conservative analysts in poor information environments (Keskek and Tse, 2018). That finding involves both analyst characteristics and the information environment, but does not consider firm or management behavior.…”

“…In poor information environments, where forecast dispersion and uncertainty about firm information are high, analyst forecasts are more optimistic on average (Tse and Yan, 2008). The stronger market reaction to conservative analyst forecast revisions is only evident in the poor information environment, where the average analyst issues more optimistic forecasts (Keskek and Tse, 2018). Thus, the value of a conservative analyst-who responds more to negative news than positive news-is greatest when the information environment is poor and the conservative analyst acts contrary to the average optimistic analyst in that environment.…”