New York, NY – An academic study slated to be published in an upcoming Journal of Financial Economics, which examines the effect of analyst coverage on public company innovation, finds that firms covered by a larger number of analysts generate less patents. In other words, increased analyst coverage is a bad thing, at least when it comes to being innovative.
The Study’s Findings
The paper, called The Dark Side of Analyst Coverage: The Case of Innovation, was published on February 5, 2013 by Jie (Jack) He of the Department of Finance at the University of Georgia and Xuan Tian of the Department of Finance at Indiana University. In their study, He and Tian use the number of patents generated by a public company as a proxy for its ability to innovate. The authors found that firms covered by a larger number of analysts generate fewer patents and patents with lower impact.
Clearly the first question to ask is whether there is a causal link between the number of analysts covering a company and the number of patents that company produces. He and Tian used a difference-in-differences approach and an instrumental variable approach in their analysis and determined that indeed there is a causal effect of analyst coverage on firm innovation. According to He and Tian’s study:
“In terms of economic significance, our analysis suggests that an exogenous average loss of one analyst following a firm causes it to generate 18.2% more patents over a three-year window than a similar firm without any decrease in analyst coverage.”
The authors conclude that this finding is consistent with the hypothesis that securities analysts exert too much pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative projects.
In addition, He and Tian discuss possible underlying mechanisms through which analysts impede innovation. A few of these mechanisms addressed in this study include “that an exogenous decrease in analyst coverage due to brokerage closures or mergers increases a firm’s equity ownership by dedicated institutional investors and decreases that by non-dedicated institutional investors.” In other words, increased analyst coverage means an increase in short-term speculative investors and fewer long-term buy-and-hold fundamentally committed investors. This shift in investor base increases a company’s focus on slashing R&D and focusing solely on meeting quarterly earnings targets.
He and Tian also discuss how a drop in analyst coverage makes a takeover less likely because these firms get less attention from potential acquirers. This, they argue, frees management to focus on long-term value creation rather than short-term issues like takeover protection or “accrual-based earnings management techniques”.
Even after controlling for such mechanisms, He and Tian’s study showed a residual negative effect of analyst coverage on firm innovation.
Analyst Coverage and Company Value
While this study shows a negative effect of analyst coverage on firm innovation, He and Tian warn that one must be cautious in drawing a normative conclusion from the results of their research. Since a firm’s optimal level of short term versus long term investment is usually firm specific, it is virtually impossible to determine whether firm managers, in the absence of analyst coverage, overinvest in long-term innovative projects. If financial analysts prevent firm managers from investing sub-optimally by squandering too many resources on long-term activities, then they could be performing a good deed for the shareholders. In that case, the results of He and Tian’s study could prove that analyst coverage is a good thing.
Consequently, He and Tian repeated the tests in Hall, Jaffe, and Trajtenberg’s 2005 study which found that an extra citation per patent boosts a firm’s market value by 3%. They discovered as a result of their own analysis that both the number of patents and the citations per patent have a significantly positive effect on a firm’s market value. This led them to conclude that increased analyst coverage could have a negative impact on the market value of a firm by discouraging innovative activities.
What This Study Does Not Suggest
While He and Tian’s study demonstrates one particular “dark side” of financial analysts, they ignore the impact of how analyst coverage could positively affect the value of a firm in numerous other ways. Hence, they admit that it is inappropriate to conclude, based solely on the evidence provided by their study, that analysts are detrimental to shareholder value or social welfare.
Further, although financial analysts are a key ingredient of the public capital markets, and their paper examines the influence of analyst coverage on individual firms’ incentives to innovate, their study does not address the impact of the overall financial and capital investment system on a company’s or even a nation’s innovativeness and competitive advantage. These questions are clearly beyond the scope of He and Tian’s study.