Distribution of stock ratings and analyst recommendation revision

Abstract

With the implementation of NASD Rule 2711 in 2002, each brokerage firm is now required to publicly disseminate the distribution of stock ratings in each research report. Hence, this paper investigates the relationship between the percentage of buy recommendations and probability of deciding to downgrade or drop coverage of stocks. Our findings suggest that the percentage of buy recommendations can enhance the probability of deciding to downgrade stock ratings and drop coverage of stocks. Furthermore, we find that analysts tend to revise their recommendations downward to hold instead of an unfavorable level. In addition, we find the market tends to heed downgrade decisions of analysts with a higher percentage of buy ratings. This finding is consistent with Barber, Lehavy, McNichols, and Trueman (2006) by applying data at the broker level.This study further investigates the changing dynamic in buy ratio of analysts by partitioning pre and post regulatory reform period. We show that analysts are more likely to revise their ratings to hold and less likely to revise their ratings to sell; in particular after post regulatory reform. Moreover, we observe one key coefficient in the post-Rule period with superior performance in contrast to the pre-Rule period. Compared to the results in the pre-Rule period, the results show that analysts are more likely to revise their ratings to hold and less likely to revise ratings to sell, and more likely to drop coverage of stocks in the post-Rule period. Overall, our findings suggest that the implementation of Rule 2711 will contribute to reduce analysts’ optimistic stock ratings.