Abstract
We use proprietary data from a major investment bank to investigate factors associated with analysts’ annual compensation. We find compensation to be positively related to “All-Star” recognition, investment-banking contributions, the size of analysts’ portfolios, and whether an analyst is identified as a top stock picker by the Wall Street Journal. We find no evidence that compensation is related to earnings forecast accuracy. But consistent with prior studies, we find analyst turnover to be related to forecast accuracy, suggesting that analyst forecasting incentives are primarily termination based. Additional analyses indicate that “All-Star” recognition proxies for buy-side client votes on analyst research quality used to allocate commissions across banks and analysts. Taken as a whole, our evidence is consistent with analyst compensation being designed to reward actions that increase brokerage and investment-banking revenues. To assess the generality of our findings, we test the same relations using compensation data from a second high-status bank and obtain similar results.
Highlights
Sell-side research plays an important role in modern capital markets
Pooled regressions that estimate the market level of analyst pay based on observable characteristics indicate that, controlling for other hypothesized determinants: Institutional Investor (II) All-Star analysts earn 61% higher compensation than their unrated peers; top stock-pickers, as recognized by the Wall Street Journal (WSJ), earn about 23% more than their peers; analysts who cover stocks that generate underwriting fees for their banks earn 7% higher pay for each million dollars of fees earned; and the cross-sectional elasticity of compensation with respect to portfolio size is approximately 0.18
To evaluate pay-for-performance sensitivities, we follow the guidance in Murphy [1985] and estimate analyst-fixed-effect regressions that rely on intra-analyst variation in performance and compensation. These indicate that, controlling for other characteristics: gaining II status is associated with a 16% compensation premium; gaining/losing “star stock-picker” status in the WSJ is associated with an 11% change in pay; covering stocks that generate underwriting fees for the bank is accompanied by 6% higher pay for each million dollars of fees earned; and the intra-analyst elasticity of compensation with respect to portfolio scale is just under 0.07
Summary
Sell-side research plays an important role in modern capital markets. Within the United States, most top-tier investment banks spend in excess of one hundred million dollars annually on equity research. Institutions and retail investors use equity research to help make investment decisions (e.g., Madan, Sobhani, and Bhatia [2003]) and corporations rely on sell-side equity analysts to market their securities and boost liquidity (e.g., Krigman, Shaw, and Womack [2001]). Pooled regressions that estimate the market level of analyst pay based on observable characteristics indicate that, controlling for other hypothesized determinants: II All-Star analysts earn 61% higher compensation than their unrated peers; top stock-pickers, as recognized by the WSJ, earn about 23% more than their peers; analysts who cover stocks that generate underwriting fees for their banks earn 7% higher pay for each million dollars of fees earned; and the cross-sectional elasticity of compensation with respect to portfolio size is approximately 0.18. To evaluate pay-for-performance sensitivities (i.e., incentives), we follow the guidance in Murphy [1985] and estimate analyst-fixed-effect regressions that rely on intra-analyst variation in performance and compensation These indicate that, controlling for other characteristics: gaining (losing) II status is associated with a 16% compensation premium (penalty); gaining/losing “star stock-picker” status in the WSJ is associated with an 11% change in pay; covering stocks that generate underwriting fees for the bank is accompanied by 6% higher pay for each million dollars of fees earned; and the intra-analyst elasticity of compensation with respect to portfolio scale is just under 0.07. Our primary tests utilize observations from 1994, when the WSJ began rating analysts’ stock-picking performance, onward. This sample includes 401 analyst-year observations (an average of 33.4 analysts per year)
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