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Business School professor analyzes the analysts

STANFORD-- Is it fair to assume that investment banks have a conflict of interest when their own analysts recommend a stock the bank is underwriting?

In a series of research reports, Stanford Business School associate professor of accounting Maureen McNichols and doctoral student Hsiou-wei Lin are investigating how underwriting relationships influence analysts' recommendations and trying to determine what factors motivate analysts and affect the kinds of information they disclose.

In "Underwriting Relationships and Analysts' Research Reports," the researchers studied the seasoned equity offerings of large publicly traded firms between 1979 and 1992. They found that investment bank analysts issue more favorable earnings forecasts for their firms' underwriting clients than do analysts unaffiliated with the underwriter.

"Underwriters' analysts may be behaving strategically to respond to the investment banking interests of the firm," McNichols said, "or the bank may have been given the business because the nature of the information they had about the firm is more favorable than that of other investment banks."

What is surprising, however, is that "While we find underwriter analyst reports are more favorable, we find no evidence that their forecasts are less accurate than those issued by non- underwriters."

Nor did they find evidence to suggest that underwriter analysts are pressured by their employers to alter negative reports. But they did see a greater frequency of favorable recommendations for firms generating the largest fees, suggesting a certain self-interest on the part of the analysts.

Investors may eventually sense a bias, Lin and McNichols found. Investors place less weight on the forecasts of underwriter analysts in the post-offering period.

In a second paper, yet to be published, McNichols and Lin examine analysts' relationships to firms that have recently gone public.

"We have been able to document that, in the year following an initial public offering, 50 percent of the analysts covering the company are actually affiliated with the underwriter who took the company public," said McNichols. Forecasts of initial public offerings are more favorable when they are issued by an affiliated company -- in fact, the difference in affiliated analysts' bias is greater with initial public offerings than with seasoned equity offerings, McNichols said.

"It's very interesting that, given the more biased reports, there are so few unaffiliated analysts out there to counteract the affiliated analysts."

Affiliated analysts also are more likely to cover overpriced stocks than are unaffiliated analysts. "One anomaly is that when a firm goes public, there's a stock price jump of about 16 percent in the first day. In the following year, the offering underperforms the market by an average of about 15 percent," McNichols said. "We've found in our sample that the offerings that have only affiliated coverage or no coverage at all underperform the market by about 20 percent in the first year. Initial public offerings for which there is the greatest independent coverage tend to do better, underperforming on average by about 7 percent."

Does this mean independent analysts deliberately choose to cover stock offerings that they expect to perform well? A third paper will consider that question.

"All of these findings are of particular interest to accountants," McNichols said. "Financial analysts play a central role in the processing and interpretation of financial statement information."



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