Is Doing Good, Good for Business: The Effect of Corporate Rating Analysts’ Corporate Bias on Investor Reactions to Changes in Social Responsibility

Abstract

In this study, we explore how investors reconcile information on firms’ social responsibility with analysts’ assessments of future firm risk in share pricing. We ask whether investors pay attention to small strides toward and/or small slips away from socially responsible behavior, arguing that analysts’ corporate bias toward gains and against losses influences investor reactions to corporate social responsibility. We hypothesize that analysts notice and reward improvements in social responsibility, yet excuse lapses. We find support for this hypothesis, using a unique dataset of the sample of eighteen firms that appeared within the 2013 KSE 100 index for 5 years (2014–2018). We also collected firm-level social responsibility disclosures data through content analysis of selected companies' annual reports. We also gather share-specific data of risk of default and pricing from rating agencies. Results suggested better CSR disclosures seem to positively affect returns. Surprisingly, higher-risk companies also enjoy higher returns. Moreover, according to expectations, market risk like beta and default risk measures like debt to equity ratio seems to decrease stock returns, whereas ROA seems to have a positive effect. Interestingly smaller size companies enjoy higher returns. We also found robust evidence that when firms increase the amount of good that they do (i.e., their social performance improves), analysts reward them with improved risk ratings. Yet, we also note an asymmetrical effect: analysts do not punish, and investors do not respond to, decreases in social responsibility. In short, analysts seem to be subject to a strongly positive corporate bias when interpreting corporate social responsibility performance. This bias prompt analyst to improve risk ratings when social responsibility improves but resist worsening risk ratings when social responsibility declines. Other findings suggested that default risk decreases more with a higher level of risk, higher debt to equity ratio also seems to cause an increase in growth of default risk, ROA also seems to cause a decrease in default risk. Results also suggested the inclusion of independent directors seems to decrease the default risk. A decrease in default risk also seems to have a positive effect on returns. Our findings elaborate earlier behavioral research on how corporate bias influences analysts’ assessments of risk. As a result, firms may come to understand that they merely must start social responsibility projects to gain the cost of capital benefits—they need not follow through with them. Second, investors may find that relatively minor decreases in social responsibility accumulate over time to constitute quite substantial risks— but they will not be forewarned about these risks because analysts ignore them, and as a result, they will have failed to raise their yield expectations commensurate with these escalating risks. Hence, our work motivates more critical scrutiny of the role analysts plays in revising the future risk of today’s social action versus inaction.