CFA Institute Journal Review 12 March 2020
Analysts to the Rescue? (Summary)
Journal of Corporate Finance
This is a summary of "Analysts to the Rescue?," by Andreas Charitou, Irene Karamanou, and Neophytos Lambertides, published in the Journal of Corporate Finance.
The authors’ goal is to verify financial analysts’ role in information delivery after the disclosure of an exogenous negative shock. They base their experiment on outcomes of the SEC’s decision to eliminate the reconciliation requirement for cross-listed companies and prove that this change resulted in more informative analyst reports post-regulation. Moreover, the cross-listed companies faced no drop in stock liquidity when analysts were able to compensate for the information loss.
What Is the Investment Issue?
The authors make two important contributions to the existing literature. First, they reinforce financial analysts’ role in capital markets. In particular, the authors show that analysts are able to provide new information to the market in times when such information is needed (e.g., during a data shortage). The second contribution refers to prior research that failed to depict adverse market effects after the SEC’s December 2007 decision that foreign companies listed in the United States that prepare their financial statements using only International Financial Reporting Standards (IFRS) would no longer have to reconcile their financial statements to US accounting rules. The explanation here could be that the increased level of informativeness of analysts’ reports effectively compensated for the subsequent loss of information.
On the grounds of the SEC’s aforementioned decision, foreign issuers’ financial statements would be accepted if they were prepared using IFRS as issued by the International Accounting Standards Board. The goal of this change was to strengthen the role of IFRS as a single set of high-quality accounting standards. The literature review the authors performed showed that such change would constitute a major information loss by capital markets. However, post-decision research produced no consistent results and showed no negative impact on liquidity or the probability of informed trading of firms’ stock. Two possible explanations exist for this lack of impact. The first is that the reconciliation between IFRS and US GAAP provided little value to the capital market. The second is that the resulting information loss was compensated for somehow. The authors assume that this compensation was achieved through the increased informativeness of analysts’ research (Hypothesis 1). Moreover, the authors investigate whether the impact of the elimination of the reconciliation requirement on market liquidity was less negative for firms with higher levels of analyst informativeness (Hypothesis 2).
How Did the Authors Conduct This Research?
The authors develop two regression models using panel data. To test Hypothesis 1, they regress analyst informativeness, proxied by capturing the market reaction on the release date of analysts’ forecasts of earnings, against the following variables: dummy variable for pre- and post-regulation year, dummy variable showing whether the firm was affected by the change in regulation, and a number of control variables (e.g., whether the firm was profitable in a given year, the ratio of capital expenditure to sales, the ratio of sales to total assets, share turnover, return volatility, the number of analysts following a given firm, firm size, industry, and country fixed effects).
To test Hypothesis 2, the authors split the research sample into two subsamples according to the median level of analysts’ informativeness. Then they regress the level of liquidity against a similar set of variables as in the model for Hypothesis 1. The liquidity in the model is proxied by four variations of liquidity measures (the Amihud illiquidity ratio, the bid–ask spread, the proportion of zero returns, and a composite of the three ratios). The second model comprises additional control variables, such as logarithm of the stock price and the book-to-market ratio.
The research sample is from the American Depositary Receipts (ADR) directory of the Bank of New York and consists of 245 firm-year observations. The firms are cross-listed on the NYSE, AMEX, and NASDAQ as Level II or Level III ADRs and were previously obliged to issue the reconciliation. The final sample represents 148 firms from 35 countries. From this sample, 94 observations representing 51 firms are affected by the new regulation. The authors collect analysts’ earnings forecasts from I/B/E/S for the 2006–08 period.
What Are the Findings and Implications for Investors and Investment Professionals?
The scope of the authors’ research encompasses two essential questions: first, that of the role of financial analysts and the value of their work and second, whether the diligence of such work and the resulting level of informativeness convey the level of liquidity of a given stock.
To state the validity of the paper, a critical assumption has been made that the work of the analysts was actually the factor that filled in the informational gap after the SEC’s decision. Taking that into consideration, the authors succeed in showing, using the methodology selected, that the average level of informativeness of analysts’ earnings forecasts increased in the post-regulation period. Moreover, the level of liquidity of stock turned out also to be positively related to the level of informativeness. This is consistent with the supposition that when analysts fail to compensate for information loss, a firm’s environment deteriorates and investors’ willingness to purchase a firm’s stock declines. The authors also verify alternative measures of analysts’ informativeness and test the robustness of their results against the impact exerted by the financial crisis.