Academic researchers in corporate finance have in recent years taken a renewed interest in the impact of private firms on employment, growth, and other positive developments in national economies. In a recent article, we develop this new field of research by looking at how the financial system can foster (or hinder) a firm’s ability to make productive investments. Access to capital is a key factor in the success of firms with valuable investment opportunities, and financial analysts could improve access to external financing by producing and disseminating firm-specific information. As such, researchers have found that analysts help to reduce information asymmetries between corporate insiders (management) and outsiders (investors).
On the one hand, this increase in transparency should provide companies with easier access to capital and allow them to invest in long-term productive projects. On the other hand, transparency could focus investors’ attention on quarterly profits and pressure managers to forego valuable long-term investments in areas such as R&D to meet the short-term expectations (the so-called dark side of analyst coverage).
Although arguments on both sides are compelling, the effect of analyst coverage on the overall quality of corporate investment decisions remains an open empirical question: While an increase in external financing leads to higher capital expenditures, it does not automatically translate into good investment decisions. And while a reduction in R&D may damage the firms’ long-term growth, this is very difficult to measure, because the vast majority of firms do not file patents.
In our paper, we take a closer look at the effect of financial analysts on the quality of corporate investments by analyzing their impact on the efficiency of firms’ investment decisions. We use total factor productivity as proxy for that efficiency, allowing us to focus on the quality of investment decisions as measure by firms’ efficiency gains.
Drawing on an extensive sample of U.S. listed firms from 1991 to 2013, we show that greater analyst coverage leads to higher firm productivity, a finding that is robust after considering that causality may actually run in the opposite direction: Analysts themselves may prefer to cover highly productive companies.
We exploit the fact that the number of analysts covering a specific firm may drop when a brokerage house closes or two brokers merge. This reduction in coverage has nothing to do with the behavior of the specific firm, but we are able to show that it leads to lower firm productivity.
In the second part of our paper, we attempt to identify how financial analysts improve firm productivity.
A first hypothesis is that they reduce information asymmetries between management and investors. In support of this hypothesis, we find that the positive effect of analyst coverage on productivity is stronger in more opaque firms (smaller firms, firms with more intangible assets, etc.), where assessing risk and return prospects is more challenging for prospective investors.
A second, non-competing, hypothesis is that financial analysts can help to monitor managerial behavior and to certify executives’ commitment to creating shareholder value. Here we expect the external monitoring by analysts to be particularly important in firms where investor protection is relatively weak.
Consistent with our expectations, we find that the positive effect of analyst coverage on productivity occurs in firms where executives are shielded by stronger anti-takeover provisions or where powerful CEOs have gained firm control over the board of directors.
Overall, we provide novel micro-level evidence to shed new light on the role of financial analysts within the real economy. We show that, despite the frequent criticism that analysts encourage short-termism among corporate managers, analyst coverage helps to enhance firm productivity by reducing information asymmetries between corporate insiders and prospective investors and the risk of managerial misbehavior.
This post comes to us from Professor Marco Navone at University of Technology Sydney Business School, Professor Eliza Wu at the University of Sydney Business School, and Thomas To, a PhD student at the University of Sydney Business School. It is based on their recent paper, “Analyst Coverage and the Quality of Corporate Investment Decisions,” available here.