Paid-for stock research has generally elicited widespread skepticism, but a new scholarly paper by three accounting professors suggests that paid-for analysts are more like auditors and credit-rating firms than is generally believed.
The study, which appears in the current issue of The Accounting Review, a journal of the American Accounting Association, analyzes a sample of 247 paid-for reports and concludes that “the recommendations and forecasts supplied by paid-for research firms provide value-relevant information for the buy-and-hold investor and [that] they affirm the SEC Advisory Committee recommendations supportive of paid-for research as a means of filling the void left by declining sell-side analyst coverage."
The professors—Bruce K. Billings of Florida State University, William L. Buslepp of Texas Tech University and G. Ryan Huston of the University of South Florida—said they “fail to find significant differences in the quality of paid-for analyst research relative to matched sell-side analyst research in terms of bias, accuracy, or ability to distinguish favorable from unfavorable future performance....Our results suggest paid-for research offers potential benefits to investors in small- and mid-cap equity markets."
At the same time, the study distinguishes between paid-for research and investor-relations reports. "Investor-relations reports may have the look of genuine research documents, but they are essentially public-relations or marketing exercises,” said Billings. “By paid-for research, we refer specifically to outfits that can make a legitimate claim to independence, even though they are paid by the firms that are the subjects of their reports. In that way they are like credit-rating agencies, which are paid by companies to evaluate their debt, or auditors, who are paid by companies to certify their financial reports."
How can investors distinguish paid-for research from the investor-relations variety? "Paid-for outfits tend to have explicit rules -- for example, that the client may not prevent the publication of an unfavorable report or withdraw from coverage before the expiration of the agreed-on term," said Buslepp. "They may have rules against holding or trading in a client's stock (although there are unfortunate exceptions to this) and may require lump-sum cash payments up front. They are also more likely than investor-relations firms to emphasize their analysts' experience or credentials in finance."
In addition, as the paper notes about paid-for research firms, "Although contractual arrangements permit the client to review the analyst report for factual errors, analyst recommendations and forecasts are withheld from the report."
The professors analyzed 247 paid-for reports (the number being determined by the availability of adequate information on client companies), which were matched with the same number of reports produced by sell-side firms. Matching was based on an array of essential features of client firms, including size, age, earnings volatility, book-to-market ratio, high-tech status, R&D intensity, and percentage of shares held by institutions. Reports were assessed in terms of the bias and accuracy of earnings forecasts for periods of up to two years and by how analyst recommendations (ranging from strong sell to strong buy) squared with stock performance over periods extending from a day to a year following report release dates.
Comparing earnings forecasts with actual results, the professors report that "for both one- and two-year forecasts ...we fail to find that paid-for analysts....exhibit either optimism or pessimism bias. Results for tests of paid-for forecast accuracy are similar." While findings for sell-side analysts were much the same, the paid-for group actually had a slight edge on accuracy in their two-year forecasts, with the professors finding marginally significant evidence to that effect.
As for quality of analyst recommendations, "portfolio analysis reveals persistent positive mean [market-adjusted] returns over the year following the release of paid-for analysts' favorable (i.e., Strong Buy, Buy) recommendations... Tests of equality in returns for both Buy and Sell portfolios fail to identify significant differences between paid-for and sell-side analyst portfolios...While investors appear to initially respond more quickly to sell-side research, longer-window returns suggest that paid-for research does not reflect significantly lower quality in distinguishing future performance than matched sell-side research."
Buslepp, who did his doctoral dissertation on paid-for research, acknowledges that he didn't anticipate the quality of the analysis it provides. "I thought that it would turn out to be (to put it bluntly) garbage. That it didn't turn out that way was a pleasant surprise."
Entitled "Worth the Hype? The Relevance of Paid-For Analyst Research for the Buy-and-Hold Investor," the study appears in the May/June issue of The Accounting Review, published six times a year by the American Accounting Association.