In the era of globalization, firms are increasingly followed by analysts from their own countries and also by analysts from other countries; in the mean time, analysts follow firms in their own countries as well as firms in other countries. With these cross-country pairings of analysts and firms, one would wonder which country’s rules and regulations analysts use to produce their research output—notably target prices, forecasts on earnings per share, and buy/sell recommendations. As an example, if an analyst in Japan covers a Canadian firm, is the analyst subject to Japanese or Canadian rules and regulations? There’s no global legislation governing such a choice. Hence, if there are no restrictions, analysts are likely to choose the one that works in the best interest of themselves and their employers—likely the country with the laxest standards.
On the other hand, the CFA Institute, a global analyst organization for investment professionals who have obtained the Chartered Financial Analyst designation promotes the following standards:
Some members or candidates may live, work, or provide investment services to clients living in a country that has no law or regulation governing a particular action or that has laws or regulations that differ from the requirements of the Code and Standards. When applicable law and the Code and Standards require different conduct, members and candidates must follow the more strict of the applicable law or the Code and Standards.
Associate Professor Alan Huang from the School of Accounting and Finance and his co-authors Mark Bradshaw (Boston College) and Hongping Tan (McGill University), use over one million target prices issued by about 17,000 analysts from 45 countries to examine this issue. Analysts’ target prices are routinely inflated, and the inflation is commonly attributed to analysts’ conflicts of interest driven by investment banking and trading incentives. If there are no restrictions, analysts will inflate the target prices as much as possible, whereas if the CFA standards are adhered to, target price inflation will be moderated by the stricter of the regulations of the covered firm’s headquarter country or the analyst residing country.
They find that neither is the case. Instead, they find that analyst forecast optimism is attenuated by the institutional environments at analysts’ residing countries. They focus on two aspects of institutional environments, viz. investor protection and legal enforcement, and document that analysts in countries with stronger investor protection and legal enforcement inflate target prices less, and that these target prices are more informative about future stock returns. When analysts move to a country with weaker investor protection and legal enforcement, their target price optimism increases (and vice versa).
Their explanation of their findings is that a country with stronger investor protection and legal enforcement would impose higher costs on residing analysts’ opportunistic optimism (or at least may create an environment that tempers such opportunistic behavior). Stronger investor protection affects analysts because they play such an important role in equity markets; similarly, legal enforcement provides the necessary incentives for analysts to not harm investors.
For everyday investors, one lesson learned from the research is that when reading an analyst’s report, pay special attention to where the analyst is from, not which brokerage the analyst is affiliated with or where the firm that is covered is headquartered. A top-name global brokerage house can have analysts in London, Seoul and Shanghai covering a U.S. firm. Are they all the same? The research by Professor Huang and his co-authors, forthcoming in the Journal of Accounting Research suggests we should give the one in London the most credit.
The study, The Effects of Analyst-Country Institutions on Biased Research: Evidence from Target Prices was co-authored by Mark T. Bradshaw, Alan Guoming Huang and Hongping Tan is forthcoming in the Journal of Accounting Research.