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 WHICH TYPES OF ANALYST FIRMS MAKEMORE OPTIMISTIC FORECASTS?
Amanda CowenBoris GroysbergPaul HealyHarvard Business SchoolMay 15, 2003This research was funded by the Division of Research at Harvard Business School. Weare grateful to research assistance from Sarah Eriksen, and for helpful comments provided by Steve Balog, Fred Frankel, and Pat O’Brien, as well as participants at theaccounting seminar at the University of Waterloo.
 
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1. Introduction
The reputation of sell-side financial analysts, particularly those at the leadinginvestment banks, has been seriously impaired during the last two years. First, they werecriticized for their optimistic reports on dot-com stocks following the dot-com collapse.They were then censured for failing to detect the accounting and over-valuation problemsat Enron. Finally, there is evidence that some of the leading telecom analysts publiclytouted firms about which they were privately skeptical.The popular explanation for all of these failures is that analysts working for investment banks have either been compromised by the hefty bonuses that they can earnfrom writing positive reports on investment banking clients, or have been pressured towrite favorable reports by investment bankers at their firms. Optimistic research presumably helps attract new investment banking clients, and provides the sales pitchused to place new issues with investors. Optimistic analyst earnings forecasts, particularly long-term forecasts, also appear to boost stock prices at the issue date.DeChow, Hutton and Sloan (2000) find that analysts’ long-term forecast optimism partially explains the initial price increase observed on the issue day, as well as thesubsequent long-term decline in prices that occurs as analysts’ expectations fail to bemet.
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The optimism in issue firms’ earnings forecasts does not appear to harm initial investors who are able toflip the stock soon after the issue. Ritter and Welch (2002) show that in the period 1980 to 2001, theaverage first-day return on IPOs was 18.8%. During the height of the dot com IPO market, this daily returnwas 65%. Aggarwal (2002) finds that initial investors in “hot” IPOs, are able to flip their stock soon after the IPO. These investors are primarily institutions and favored clients who have ongoing relationships withthe leading banks and almost surely recognize the optimism in analyst reports. However, investors who purchase stock 
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a new issue (and who miss out on the initial day discount), or initial investors whoelect to hold the stock for the long-term on average earn negative returns. The average three-year buy-and-hold return for firms making IPOs in the period 1980 to 2001, adjusted for the market, was –23.4% (seeRitter and Welch (2002)).
 
 2In response to regulatory concern about optimistic analyst research at leadinginvestment banks, on April 28, 2003, ten of the largest U.S. investment banks agreed toimplement a series of analyst reforms, and to pay penalties for prior indiscretions.Reforms included new operating procedures by banks to separate research frominvestment banking, refocusing security analyst compensation on stock-picking ability,disclosure in analyst reports of any conflicts of interest faced by their firms, disclosure of analyst forecasting and stock-picking performance, and elimination of ‘spinning”(providing shares in “hot” IPOs to executives of favored clients). The ten banks agreed to pay $900 million in fines and disgorgement of profits. In addition, they were required to pay an additional $85 million for investor education, and $450 million (over the next fiveyears) to acquire and distribute three independent research reports along with their ownreports for every company covered.The optimism observed in equity research during the tech boom of late 1990s, aswell as the regulatory responses raise a number of important research questions. First,how important were investment banking conflicts in explaining analysts’ researchoptimism? Regulators’ focus on investment bank analysts suggests that they believe that banking conflicts were the primary source of research optimism.
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Analysts at investment banks were certainly rewarded handsomely for helping to sell new equity offers, andwere allegedly pressured by their firm’s investment bankers to make optimistic earningsand price forecasts. However, while there is convincing evidence of unethical behavior 
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Up until 1975, brokerage firms charged fixed commissions for trading, and used some of these funds tofinance research by in-house sell-side analysts, which they distributed free to large institutional clients. InMay 1975, fixed commissions were deregulated and began to bring in much less revenue, leading brokerage houses to a search for other sources of funding for research ((Strauss, 1977)).
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