The economic value of the sell-side analyst in UK equity markets

This thesis is primarily concerned with the economic value of the sellside analyst in the UK equity markets. Fundamental to the sell-side analyst's economic value is the concept of market efficiency. If markets are fully efficient in the absence of the analyst then his/her investment recommendations and earnings forecast revisions would not generate abnormal returns as the information content of such earnings forecast revisions and recommendations would already have been absorbed by the market through other sources. Though analysts' investment recommendations may generate abnormal returns, it does not necessarily follow that the sell- side analyst plays a major role in keeping the equity markets efficient. Analysts' earnings forecast revisions and investment recommendations may, in fact, explain such a small proportion of company prices changes and trading volume activity that their investment recommendations and earnings forecast revisions may be dominated by other forms of firm-specific news in explaining company share price changes and trading volume activity. In such circumstances the economic value of the sell-side analyst may indeed be limited. Central to the analyst's role in keeping the markets informationally efficient is the nature of the information impounded into his/her investment recommendations. Is the analyst a superior processor of publicly available information and! or is the analyst privy to private information not generally available to the market as a whole? In addition is the nature of some "information" such that, in the absence of the sellside analyst, the information may otherwise go unreported in the marketplace perhaps arising from its intangibility (Roll, 1988)? In this thesis we undertake three empirical investigations into the economic role of the sell-side analyst in the equity markets. Firstly, we test the "absolute" value of sell-side analysts' investment recommendations by analysing the abnormal return performance associated with the new buy and new sell recommendations made by six leading UK based stockbroking houses over the 18 month period January, 1994 to June, 1995. Secondly, we explore the "relative" value of analysts' recommendations and earnings forecast revisions by determining the size (proxying for information content) of company "large" market-adjusted price changes and trading volume movements that are triggered by analysts' recommendations and earnings forecast revisions vis-a-vis other firm specific information categories. We perform this test on 215 London Stock Exchange FTSE 100 and FTSE Mid 250 companies covering the two-year period January, 1994 to December, 1995. Thirdly, we directly test the nature of the analyst's informational advantage, and in particular hislher ability to act as a conduit for the flow of "nonpublic" information to the market. We perform this test for a sample of 1 00 companies drawn predominantly from the upper regions of the FTSE Mid 250 Index. In addition, in performing this test, we examine the nature of the information not apparently in the public domain and whether it differs in nature from its "publicly -available" counterpart (Roll, 1988). Our results show that analysts' investment recommendations have value in an "absolute" sense. We fInd that share prices are significantly influenced by analysts' recommendation changes, not only at the time of the recommendation change but also in subsequent months. We also find that the magnitude of the abnormal return performance generated is influenced cross-sectionally by factors associated with firms' information environments and the analysts' incentives literature. In addition, we report that analysts' earnings forecast revisions and recommendations not taking place concurrently with other firm specific information releases account for 18 % of large "explained" price changes and 160/0 of large "explained" trading volume movements thus suggesting that sell-side analysts have a major role to play in keeping the equity markets efficient. Finally, we find that the sell-side analyst is able to explain in excess of 90% of those price movements not traceable to "publicly-available" information which is consistent with a high degree of market knowledge. We find that a significant proportion of these price changes (17%) are attributable to factors unrelated to information per se thus providing support for Roll's (1988) hypothesis that a significant proportion of company price changes are triggered by "soft" events relating to fads, fashions, sentiment etc. In summary, therefore, the sell- side analyst plays a major role in the UK equity markets. His/her investment recommendations and earnings forecast revisions communicate valuable information to the market. In addition, an important aspect of the analyst's role in the market is to communicate information to the market that may not be available from other more conventional sources, thus suggesting that tests of the investment value of analysts' company recommendations and earnings forecast revisions may, at least in part, be tests of strong-form efficiency. A substantial proportion of this information may be classified as "soft" information which in the absence of the sell-side analyst may otherwise go unreported.