Strategic Interactions Between Sell-side Analysts and the Firms they Cover

Abstract

How do firms balance their use of management access and investment banking when enticing analysts to bias their reports? Which analysts should investors trust? What are the main determinants of analysts' forecast biases and precisions? This paper develops an infinite-horizon, repeated game to explore these questions. We obtain closed-form solutions which offer new insights and explain recent empirical findings. First, we find that forecast precision is decreasing in the ability of the analyst's corporate finance department and in the flow of investment banking business generated by the firm. Hence, we posit that an analyst makes less precise estimates when she is affiliated with the lead underwriter or when she is covering glamour stocks. Second, we show why an investor with a long horizon should avoid the advice of analysts from reputable brokerages with successful corporate finance departments. This is true even when these analysts have high initial signal precisions. Third, we explain (i) why in the recent years, the biases of analysts in their annual earnings forecasts are increasing in the size of the firms they cover, (ii) why IPO underwriters are chosen based on the strength of their equity research departments, and (iii) why there is greater optimism for glamour stocks than for value stocks. Finally, we predict that the biases will be smaller under the SEC's Regulation Fair Disclosure.