Analysts' Forecast Bias and the Mispricing of High Credit Risk Stocks

Abstract

This paper investigates whether financial analysts' power to move prices arises from investors' tendency to blindly follow analyst earnings forecasts. We find that the degree of optimism or pessimism in these forecasts is predictable and leads to temporary distortions in the stock prices of firms with difficult-to-forecast earnings. For example, among stocks with poor credit quality, the quintile predicted to have the most conservative forecasts outperforms the quintile with the most optimistic forecasts by a risk-adjusted 13.2% per year. For better credit quality firms, analyst bias is unrelated to subsequent stock returns. Firms susceptible to imprecision in earnings forecasts, like those with to poor credit quality, large idiosyncratic volatility, or high forecast dispersion, are much more likely to have highly optimistic forecasts. The greater analyst optimism for these types of stocks explains their lower returns and negative alphas, and offers a behavioral explanation for the credit risk, idiosyncratic volatility, and analyst dispersion anomalies.