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Cranfield University CRANFIELD UNIVERSITY THABANG MOKOALELI-MOKOTELI ARE ANALYSTS BIASED? AN ANALYSIS OF ANALYSTS’ STOCK RECOMMENDATIONS FOR STOCKS THAT PERFORM CONTRARY TO EXPECTATIONS SCHOOL OF MANAGEMENT PhD THESIS CRANFIELD UNIVERSITY School of Management Accounting and Finance Group PhD Thesis Academic year 2004/05 THABANG MOKOALELI-MOKOTELI ARE ANALYSTS BIASED? AN ANALYSIS OF ANALYSTS’ STOCK RECOMMENDATIONS FOR STOCKS THAT PERFORM CONTRARY TO EXPECTATIONS SUPERVISOR: PROFESSOR RICHARD TAFFLER SEPTEMBER 2005 © Cranfield University, 2005. All rights reserved. No part of this publication may be reproduced without the written permission of the copyright holder. This thesis is submitted in partial fulfilment of the requirements for the degree of Doctor of Philosophy Are analysts biased? An analysis of analysts’ stock recommendations for stocks that perform contrary to expectations Abstract The finance literature suggests that analysts’ stock recommendations have negligible impact on market prices. Some studies suggest this lack of market impact may be partly driven by the affiliations between investment banks and the firms their brokerage arms cover (conflicts of interest). However, most of these studies fail to take into account other factors including institutional and trading issues and psychological biases which may well be just as important in influencing analysts when they gather, process and interpret information about stocks. The aim of the current study is to establish the factors which are associated with analysts issuing stock recommendations that lack market impact. I find that nonconforming analysts’ stock recommendations are associated with overconfidence bias (as measured by optimism in the language they use) and representativeness bias (as measured by previous stock price performance, market capitalisation, book-to-market and change in target price). Thus, stocks that receive a buy rating and subsequently underperform the respective benchmark are associated with a high level of optimism in the tone of the language used by analysts in their investment reports that they prepare to justify their recommendations, have positive previous price momentum, have large market capitalisation, have low book-to-market ratio and have their target prices changed in the same direction as the stock recommendation. Not surprisingly, there is also a relationship between the investment bank issuing the recommendation and the firm. In addition, stocks that are awarded sell rating and subsequently outperform the benchmark have characteristics opposite to those of nonconforming buys. Finding that potential conflicts of interest significantly predict analysts’ nonconforming stock recommendations supports recent policy-makers’ and investors’ allegations that analysts’ recommendations are driven by the incentives they derive from investment banking deals. These allegations have led to implementation of rules governing analysts’ and brokerage houses’ behaviours. However, finding that cognitive biases play a major role in the type of recommendation issued suggests that these rules may work only in as far as regulating conflicts of interest, but will have a limited role in regulating psychological bias, as my results suggest that analyst bias is inherent in their work. Surveys of what fund managers expect of analysts indicate low rankings of analysts’ investment advice as manifested in their recommendations (e.g., All-America Research Team Survey 2002). My results further indicate that fund manager concern is likely to continue because not all behavioural factors in analyst stock recommendations can be controlled. i ACKNOWLEDGEMENTS First of all, I wish to thank God, the almighty for giving me ability and strength to cope with the difficult and long PhD process. I would like to give my sincere thanks to my supervisor, Professor Richard Taffler for his guidance and support through this process. His insight and personal commitment opened up a wide range of exciting new paths for me to explore. I would like to thank my review committee, Professor Cliff Bowman and Professor Sudi Sudarsanam for their constructive comments and suggestions on earlier versions of this thesis. Many thanks to Dr Vineet Agarwal for his valuable comments. To all my friends in Cranfield who shared this journey with me. Thanks very much for your support and for the friendship we have woven. A journey is always easier when you travel together. To all my family and friends in Lesotho and South Africa for your encouragement and for supporting me in so many different ways. In particular, I want to thank my cousin Lineo for helping me with my son who needs a lot of attention health-wise. To my parents, Ntate Makalla and ‘M’e Mathabang Mokoaleli for giving me a chance to acquire knowledge and education and for making me believe in my capabilities from a very early age. I am grateful to my husband Morena for his love, patience, encouragement and support during the PhD period. Without his support, I would not have been able to reach the end of this process. To my son Bokang whose bubbly character brought a different and interesting dimension to this journey. I highly appreciate the role played by Commonwealth Secretariat and Cranfield University for funding this project. ii Table of contents ABSTRACT ..................................................................................................................... i ACKNOWLEDGEMENTS ........................................................................................... ii LIST OF TABLES....................................................................................................... viii LIST OF FIGURES....................................................................................................... xi CHAPTER 1.................................................................................................................... 1 1.1 INTRODUCTION .................................................................................................. 1 1.2 BACKGROUND OF THE RESEARCH ...................................................................... 1 1.3 RESEARCH PROBLEM AND RESEARCH QUESTIONS .............................................. 2 1.4 RESEARCH OBJECTIVES...................................................................................... 5 1.5 RATIONALE FOR FOCUSING ON STOCK RECOMMENDATION NEXUS..................... 5 1.6 RESEARCH APPROACH ....................................................................................... 8 1.7 OVERALL CONCLUSIONS.................................................................................. 10 1.8 STRUCTURE OF THE THESIS.............................................................................. 11 CHAPTER 2 LITERATURE REVIEW ................................................................ 16 2.1 INTRODUCTION ................................................................................................ 16 2.2 THE ROLE OF ANALYSTS IN THE STOCK MARKET.............................................. 16 2.2.1 Function of analysts ............................................................................... 16 2.2.2 Information used by analysts.................................................................. 18 2.2.3 Analysts’ following and herding behaviour............................................ 20 2.2.4 Analysts and stock recommendations..................................................... 22 2.2.5 Analysts’ conflicts of interest.................................................................. 27 2.2.6 Regulation of financial analysts ............................................................. 31 2.3 ANALYSTS’ BEHAVIOUR AND MARKET ANOMALIES ......................................... 34 2.3.1 Financial analysts and market anomalies.............................................. 34 2.3.2 Analysts and cognitive biases................................................................. 37 2.4 CONCEPTUAL FRAMEWORK ............................................................................. 39 2.5 SUMMARY, RESEARCH GAPS AND RESEARCH QUESTIONS................................. 42 CHAPTER 3 HYPOTHESES DEVELOPMENT AND VARIABLES............... 45 iii 3.1 INTRODUCTION ................................................................................................ 45 3.2 HYPOTHESIS DEVELOPMENT AND VARIABLES.................................................. 45 3.2.1 Do overconfidence and representativeness biases influence analysts’ decisions about the stock recommendations they issue?........................ 45 3.2.2 Does the previous price performance influence the type of rating financial analysts award to the stocks they follow? ............................... 47 3.2.3 Does firm size influence the type of rating financial analysts award to the stocks they follow?.................................................................................. 48 3.2.4 Does book-to-market influence the type of rating that financial analysts award to the stocks they follow? ............................................................ 49 3.2.5 Does target price influence the type of rating financial analysts award to the stocks they follow?............................................................................ 50 3.2.6 Does the existing relationship between the investment bank and the company being researched influence the type of recommendation that analysts issue on a stock?....................................................................... 51 3.3 CONTROL VARIABLE.......................................................................................
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