In Earning Season, Does Analyst Outlook Work?

It’s the earnings season again. Brokerages have started sending their December quarter “earnings preview” to clients. These reports will contain the latest estimate of their in-house analysts, complete with forecasts of quarterly earnings per share down to the last paisa and targets for stock price. Yet, in the current bull run, it’s well known that these targets have often had to be revised within a week of the report being published, the sheer speed of the rally catching even the most optimistic unawares. Of course, that hasn’t prevented analysts from going with the flow, bringing out still more glowing reports or finding “embedded value” in the stock. Rare is the analyst who has swam against the tide.

How impartial are analyst recommendations? In a National Bureau of Economic Research (NBER) paper written last year, titled, Do Security Analysts Speak in Two Tongues?, Ulrike Malmendier of the University of California at Berkeley and Devin Shanthikumar of Harvard Business School set out to study why security analysts issue overly positive recommendations.

To the sceptical layman, there seems to be a straightforward answer—analysts are paid to encourage clients to buy stocks, simply because the universe of potential buyers is always larger than the universe of potential sellers. Malmendier and Shanthikumar, not being so cynical, consider two alternative explanations: One, analysts pick favourite stocks and are genuinely overoptimistic; and two, analysts distort recommendations to maximize commissions and underwriting business, particularly if affiliated with an underwriter.

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