OCTOBER 2004

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Buy, Sell, or Hold

Creating Incentives for Financial Analysts

Research by Joseph D. Piotroski and Abbie J. Smith

Theories predict that the restriction of insider trading activity will increase incentives for analysts to follow firms. Consistent with these theories, recent research finds a positive association between the initial enforcement of insider trading laws and analyst coverage.

Information plays a key role in the growth and efficiency of economies and their capital markets. In spite of this widely acknowledged belief, there has been little research on how and why information systems vary around the world.

One such system is the flow of information from companies to financial analysts to investors. Previous research shows that greater analyst following is associated with an improved flow of information to outside investors. Insider trading is expected to obstruct this information channel, making it potentially more costly for the average investor to gather information about the performance and risk of individual firms. Such information also may be less beneficial to ordinary investors, since the trading benefits of knowledge about a firm will go first to insiders.

In the study "Insider Trading Restrictions and Analysts' Incentives to Follow Firms," University of Chicago Graduate School of Business professors Joseph D. Piotroski and Abbie J. Smith, along with Robert M. Bushman of the University of North Carolina Kenan-Flagler Business School, examine whether analyst coverage of publicly traded firms increases after the adoption of insider trading laws and/or the initial enforcement of these laws. Their study is motivated by theories predicting that allowing insiders to trade on their private information decreases trading profits available to outside investors, which decreases outsiders' demand for analyst forecasts and other forms of firm-specific information.

Nearly all past research on insider trading has focused on the United States. However, Piotroski notes, "It is difficult to get comparable data within the United States since federal insider trading laws have existed since the Great Depression. In the United States, there are limited opportunities to examine regime changes, such as when a market shifts from the tolerance of rampant insider trading to the credible enforcement of insider trading restrictions."

By comparing insider trading internationally, the authors are able to observe countries where insiders previously had the opportunity to trade legally, and what happens to analyst coverage when new insider trading laws are enacted and enforced.

Piotroski, Smith, and Bushman use data on analyst following for 100 countries from 1987 to 1998. They find that both the intensity of analyst coverage (the average number of analysts covering firms within a country) and breadth of coverage (the proportion of domestic listed firms followed by analysts) increase upon the initial enforcement of insider trading laws.

"Insider trading may contribute to a lack of corporate transparency, whereby insiders have superior information to make investment decisions," says Smith. "Our preliminary results are consistent with the prediction that restrictions on insider trading increase demand for information by outsiders, and therefore higher levels of analyst coverage."

While the authors find that the enforcement of insider trading laws is associated with an increase in analyst following, there is no clear relation between the enactment of such laws and analyst following.

"It's an issue of credibility," says Piotroski. "The enactment of the insider trading law is a nonevent in our study, suggesting that the analyst community views the writing of such laws with skepticism. In contrast, the initial enforcement of these laws is associated with an increase in analyst coverage, consistent with enforcement being viewed as a real change in the government's protection of outside investors' rights."

The Intermediaries

Financial analysts play a key role in any capital market, but how do they make their recommendations, and who uses their findings?

Financial analysts serve as intermediaries who gather, interpret, and analyze financial data to make recommendations about the quality of a firm's stock. They base their recommendations on information from the firm, the firm's competitors, suppliers, and customers, and broader macroeconomic trends. Analysts synthesize this information into assessments of the firm's products, profitability, and valuation with the ultimate goal of helping investors and capital market participants allocate their investments.

Rather than researching firms themselves, investors can rely on analysts to help them choose where to invest and determine the risk of their investment. Analysts may think that a stock is overvalued or undervalued at any point in time, and therefore issue a buy, sell, or hold recommendation based on their view of whether the stock is correctly priced. Analysts also produce reports of varying lengths that discuss a company's profit margins, short-term earnings, share forecasts, and long-term earnings forecasts.

Analysts' recommendations may be biased for any number of reasons, but perceptions of financial analysts have recently taken an especially negative turn. Part of the growing skepticism is due to cases where analysts have investment banking relationships with the same firms for which they forecast earnings and issue stock recommendations. There have been allegations that analysts may have been less than independent and objective in these cases, and were more concerned with currying favor with their investment banking clients than with the accuracy and truthfulness of their forecasts and recommendations.

Despite the prominent insider trading scandals of recent years, analysts play a fundamental role as specialists in the collection, interpretation, and analysis of financial information.

Enactment vs. Enforcement

For the 100 countries with stock markets in their study, Piotroski, Smith, and Bushman measured analyst coverage and how enactment and enforcement of insider trading laws shifted in each country over the twelve year period 1987 to 1998. Interestingly, the enactment and initial enforcement of insider trading legislation was a wide-spread phenomenon during the early 1990s across a broad set of both developed and emerging market countries.

The authors measured the number of analysts covering public firms in a given country. They then noted whether or not a country had enacted insider trading restrictions, and whether or not the country had enforced these laws, noting the year in each case.

Prior to 1990, only 32 countries had adopted insider trading legislation, and only 9 of these countries had enforced these laws. By the end of 1998, 87 countries in the sample had enacted insider trading laws, and 38 countries had enforced these laws.

Whether or not a country enforced its insider trading restrictions turned out to be the defining event in the study. Penalties may be vastly different across countries. For example, in the European Union, insider trading cases are enforced through the criminal courts and require proof beyond a reasonable doubt. In the United States, the SEC enforces insider trading restrictions through civil penalties.

Given the growing trend in analyst following across the globe, there may be several alternative explanations for the positive relation between analyst following and insider trading restrictions. The authors find that their results still hold even when controlling for year, as well as important country characteristics, including the date when a country liberalized its equity market. They also include two measures of a country's financial flows: the level of foreign direct investment and the openness of countries' product markets.

Liberalization of equity markets is a profound policy reform that opens a country's market to the free flow of capital. Liberalization can result in an inflow of foreign capital, which can improve risk sharing and pressure firms to improve governance.

After insider trading laws are enforced, the increase in analyst following is much more dramatic for emerging market countries than developed countries. The authors' measures of analyst following are also much lower in years prior to financial market liberalization.

Emerging Markets

For emerging market countries, Piotroski, Smith, and Bushman find that enforcement of insider trading restrictions may be associated with a more fundamental shift in a country's property rights regime than in developed countries. Enforcing these new laws in emerging markets may signal political commitment and encourage market participants, including analysts, to transition to a new property rights regime.

"In emerging markets, prosecuting someone for insider trading is a powerful signal in an environment without much prior rule of law," says Smith. "The implication of prosecuting for the first time is more dramatic than in a developed country."

The authors furthermore explore the economics of analyst following by isolating characteristics that are associated with the level of analyst response following enforcement of insider trading restrictions. They look at three characteristics of each country: legal origin, political structure, and concentration of economic activities.

With respect to legal origin, the authors find that the introduction of insider trading restrictions is associated with a greater increase in analyst coverage in civil and socialist origin countries than in common-law origin countries, presumably due to the lower levels of preexisting investor protections in those economies. A country's political structure is not related to analyst response. Finally, they find that the reaction of analysts to the enforcement of insider trading laws is much stronger in countries that have diverse economies, suggesting that analyst activity may have greater value when guiding capital across different sectors in an economy.


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Joseph D. Piotroski is associate professor of accounting at the University of Chicago Graduate School of Business. Abbie J. Smith is Boris and Irene Stern Professor of Accounting at the University of Chicago Graduate School of Business.

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