How does a nation’s financial sector affect the real economy? While a highly developed financial market improves the efficiency of capital allocation and thus fosters the growth of
innovation, it also gives rise to various adverse externalities such as short-termism, opportunistic behavior, and rent-seeking, which impair firms’ incentives to invest and innovate. Understanding the role of stock market in motivating firm innovation is an important research question, both because innovation is a crucial driver of economic growth (Solow, 1957) and because publicly traded equity represents one of the most important sources of external capital to facilitate firm investment. A thorough investigation into this issue entails a comprehensive analysis of how various unique ingredients of the stock market affect firms’ incentives to engage in innovative activities.

The dark side of analyst coverage

In this paper, we focus on one key ingredient of the public equity market, namely, financial analysts. Specifically, we study whether financial analysts, an active market intermediary and gatekeeper, encourage or impede firm innovation. Although there has been a growing literature linking various market and firm characteristics to innovation, little is known about the roles played by financial analysts, who not only produce information for the firms they cover but also set external performance benchmarks such as earnings forecasts or stock recommendations. This topic is of particular interest to policy makers as analyst behavior in the U.S. is heavily regulated and altered by securities laws and regulations over time. The objective of this paper is to provide the first empirical study that examines how financial analysts causally affect firm innovation, using a rich set of identification strategies.

Motivating innovation is a challenge for most firms. Unlike routine tasks, such as mass production and marketing, innovation involves a long process that is full of uncertainty and with a high probability of failure (Holmstrom, 1989). Firms investing more heavily in innovative projects might be forced to make only partial disclosure and subject to a larger degree of
information asymmetry (Bhattacharya and Ritter, 1983), are more likely to be undervalued by equity holders, and have a greater exposure to hostile takeovers (Stein, 1988). To protect firms against such expropriation, managers tend to invest less in innovation (in many cases suboptimally) and put more effort in routine tasks that offer quicker and more certain returns, leading up to a typical managerial myopia problem.

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