Study explains analyst bias

Equity analysts have a tendency to inflate target prices, resulting mainly from conflicts of interest, according to research conducted by experts from Boston College, the University of Waterloo, and SUNY-Buffalo.

Previous research showed a glaring difference between actual market returns, and the returns implied by the price targets given by analysts. The average implied return was 32.9% for the period from 1997 to 1999, and 24% from 2000 to 2009, the study notes. But “data provided by CRSP shows that the nominal NYSE/Nasdaq/Amex market return over the period of 1997 to 2009 is 8.1%.”

The study uncovers what’s causing the skewed numbers, and explains the factors that minimize the tendency to inflate target prices. It’s based on data covering 11,436 analysts in 41 countries.

“Brokers that have previous investment banking ties with the covered firms, or reside locally…may provide less biased target price forecasts due to their information advantage arising from underwriting relationship and geographic proximity,” the authors explain.

At the same time, these analysts are at greater risk of a conflict of interest. “An analyst may seek to maintain a good relationship with the target firm’s management to generate underwriting business and to enhance her career opportunities.”

The report also cites what it calls “indirect investment banking pressure.” In this case the analyst identifies companies “that have greater needs of investment banking business and [tries] to please these firms with overly optimistic target prices.”

Countries with strong investor protections, and a more transparent financial services industry show “less optimistic” target prices, the report says.

Read the report here.

Also read:

Sell-side analysts more accurate than buy-side: Study

Indian authorities turn up heat on Canadian analysts

S&P analysts bullish for 2013

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.