Analysts, astrologers and lemmings – three of a kind?

“Financial forecasting appears to be a science that makes astrology respectable”, Burton Malkiel, professor of economics at Princeton, once said.

As you know, analysts, employed by investment banks, follow a number of firms (usually in a particular industry), evaluate them and offer us recommendations – in terms of “buy”, “sell” or “hold” – whether we should invest in their shares.

However, on average, these analysts give the advice “sell” in less than 5 percent of the cases. Yet, clearly, more than 5 percent of listed companies’ share prices go down. So what’s going on?

Well, there are various explanations but one is that, for various reasons (pertaining to incentives in investment banks), analysts are inclined to cover firms that they expect will go up in terms of share price. Therefore, perhaps an even more important decision than whether to recommend “buy, sell or hold” is the decision which firms to cover.

And this is where it gets tricky (and almost a self-fulfilling prophecy). Research has shown that the stock price of firms goes up when they gain analyst coverage. That is, purely the fact that a research department (employing the analyst) decides to start covering the firm will increase its share price, probably simply because the firm becomes more well-known, is exposed to additional investors, which enables it to raise capital more easily, etc.

But how do research departments decide to start covering a firm? Well, research by professors Huggy Rao, Henrich Greve and Jerry Davis shows that this is very much influenced by imitation. They analysed 1442 firms listed on the NASDAQ stock market and the analysts covering them and, through elaborate statistical analysis, showed strong evidence that when one analyst starts covering a firm, his colleagues at other investment banks are inclined to start doing the same (irrespective of this firm’s performance), thus creating a “cascade” of analyst coverage.

However, Huggy and his colleagues showed something else. Their models’ findings also revealed that, in such cascades, the imitating analysts were prone – more than usual – to overestimate the firm’s future performance. And this made it very much a mixed blessing for the firm. Because analysts are inclined to cease coverage of companies which are underperforming in comparison with their predictions – which was very likely in this case, given the analysts’ over-optimism – firms that initially benefited from increased analyst coverage were the same ones that subsequently were likely to suffer from analysts abandoning them.

The analysts, much like lemmings, optimistically jumped in, only to find out that the place they landed in wasn’t as rosy as they had expected. This prompts them to jump out again, saving their skin, but leaving the firm trampled and bruised.