Skin in the Game: The Inputs and Incentives that Shape Buy-Side Analysts’ Stock Recommendations

Lawrence D. Brown

Temple University – Department of Accounting

Andrew C. Call

Arizona State University (ASU) – School of Accountancy

Michael B. Clement

University of Texas at Austin – Department of Accounting

Nathan Y. Sharp

Texas A&M University – Department of Accounting

Abstract:

Buy-side analysts play an important role in capital markets through their influence on institutional investment decisions, but they are rarely the subject of academic research. We survey 344 buy-side analysts from 181 investment firms and conduct 16 detailed follow-up interviews to gain insights into the activities and incentives of buy-side analysts, including the inputs to their stock recommendations, the determinants of their compensation, the frequency and value of their communication with company management, their beliefs about financial reporting quality, and the role of sell-side analysts in buy-side research. One important finding is that buy-side analysts indicate recent 10-K or 10-Q reports are more useful than quarterly conference calls, management earnings guidance, and recent earnings performance for determining their stock recommendations. We also find that less than 3% of buy-side analysts believe sell-side stock recommendations are very useful, in spite of buy-side analysts’ strong incentives to produce their own profitable stock recommendations. Our findings highlight the fundamentally different incentives of buy-side versus sell-side analysts.

Incentives that shape buy-side analysts’ stock recommendations – Introduction

Buy-side analysts play an important role in equity markets because their research directly impacts the investing decisions of portfolio managers (Frey and Herbst, 2014; Rebello and Wei, 2014; Cheng, Liu, and Qian, 2006). Although buy-side analysts are closer than sell-side analysts to the ultimate investing decision, their stock recommendations are private and largely invisible to researchers, making them rarely the subject of academic research. The objectives of our study are to improve the literature’s understanding of the inputs and incentives that shape buy-side research and to provide a better understanding of the role of sell-side analysts in institutional-investment decisions.

We survey 344 buy-side equity analysts employed by 181 institutional investment firms and conduct 16 detailed follow-up interviews to examine the nature and frequency of buy-side analysts’ interactions with sell-side analysts, their interactions with company management, the inputs to their stock recommendations, the factors that determine their compensation, and their assessments of financial reporting quality. We find that over half of the buy-side analysts have private communication with sell-side analysts at least 24 times a year. Buy-side analysts also say they give very little consideration to either brokerage size or Institutional Investor (II) All-Star status when deciding which sell-side analysts’ information to use, despite prior research that analysts employed by large brokerages have more resources (Clement, 1999; Clement and Tse, 2003; Hong and Kubik, 2003) and that II All-Stars are superior analysts (Stickel, 1992; Asquith, Mikhail, and Au, 2005; Leone and Wu, 2007). Specifically, fewer than 3% say brokerage size and II status are very important considerations, and most say these attributes are not important. In contrast, sell-side analysts’ experience following a company and the frequency of their communication with senior management are the two most important determinants of buy-side analysts’ decisions to use information they provide.

Our findings highlight the fundamentally different incentives involved in buy-side versus sell-side research. For example, in contrast to the relatively short-term focus of sell-side analysts, more than 81% of buy-side analysts have an investment horizon longer than one year, and more than 27% have a horizon greater than three years.1 In addition, although the profitability of the stock recommendations buy-side analysts submit to their portfolio managers is the most important determinant of their compensation, sell-side analysts’ compensation is not as closely tied to the profitability of their stock recommendations (Brown et al., 2014). These divergent incentives to produce profitable stock recommendations may partially explain why fewer than 3% of buy-side analysts indicate sell-side stock recommendations are very useful when producing their own stock recommendations. Further, while relationships with senior management are an important factor in sell-side compensation (Brown et al., 2014), these relationships are fairly unimportant to buy-side compensation.

Buy-Side Analysts

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