New Study by UB Finance Professor Demonstrates Marketing Bias of Financial Analysts

BUFFALO, N.Y. -- A new study by a University at Buffalo finance professor has uncovered a pattern of behavior among financial analysts that suggests that their stock recommendations often conform to expectations of what will sell, rather than what stocks will provide better returns to investors.

Consequently, many financial analysts become de facto marketing agents for stock brokers, arming them with stock recommendations that will be attractive to individual investors, but less likely to provide high returns, says researcher Kee Chung, M&T Bank Professor of Finance in the University at Buffalo School of Management.

The results of the study, Chung says, support the belief that financial analysts and stock brokers often make recommendations based on their own incentives rather than the best interests of investors.

"Exactly what motivates analysts to follow the stocks of certain companies is not often clear," says Chung. "This study underscores a possible conflict of interest between analysts/brokers and investors. It suggests that analysts should be viewed as working alongside brokers as part of a brokerage firm's marketing team."

Chung theorizes that analysts have incentive to regularly follow better-known, high-quality firms -- as defined by a firm's Standard and Poor rating -- because brokers can more easily sell those stocks to investors who erroneously associate a firm's name recognition with its ability to generate high stock returns, even though lesser-known, un-rated companies typically provide higher returns.

In his study, Chung analyzed S&P's stock rating data from 1985-96 and compared them to the number of analysts who followed each company, according to data compiled by the Institutional Brokers Estimate System (I/B/E/S) containing analysts' forecasts of corporate earnings collected from approximately 400 leading brokerage firms.

He found that S&P-rated stocks were followed by more analysts than were un-rated stocks, and highly rated S&P stocks were followed by more analysts than poorly rated S&P

stocks. Moreover, he found a significant increase in analyst following when S&P upgraded a stock, and a significant decrease in analyst following when S&P downgraded a stock.

The findings, when added to existing research showing that brokers recommend buying versus selling of S&P stocks at a 4-to-1 ratio, are evidence of an S&P bias among analysts/brokers that could be a disservice to investors, Chung says.

He believes that brokers push S&P stocks more often not only because they are more sellable, but also because it's less likely that clients will sue if the stocks produce losses. "It's easier for analysts to demonstrate fiduciary responsibility after recommending S&P stocks," Chung says.

"S&P stocks give analysts a built-in excuse if they fail," he adds. "Analysts can point to a stock's high rating and say that the market was to blame, not the analyst, if a stock performs poorly. That argument doesn't hold up as well if an un-rated stock performs poorly."

Based on his findings, Chung cautions investors to be wary of the marketing bias of financial analysts/brokers and suggests that investors consider looking beyond the better-known companies when researching or considering stock investments.

"To the extent that stocks of higher-quality companies offer inferior returns to those of low-quality companies, it is important for investors to guard against the tendency of analysts/brokers to promote stocks of higher-quality companies," he concludes.

Chung's results were published recently in Financial Management, the journal of the Financial Management Association International.