OBriemm and Bhushan 1990

Accounting Research Center, Booth School of Business, University of Chicago
Analyst Following and Institutional Ownership

Author(s): Patricia C. O'Brien and Ravi Bhushan
Source: Journal of Accounting Research, Vol. 28, Studies on Judgment Issues in Accounting and
Auditing (1990), pp. 55-76
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journal of Accounting Research
Vol. 28 Supplement 1990
Printed in U.S.A.
Analyst Following and

Institutional Ownership
PATRICIA C. O'BRIEN* AND RAVI BHUSHANt
1. Introduction
In this paper, we examine analysts' decisions to follow firms, along
with institutional investors' decisions to hold these same firms in their
portfolios. Since the two decisions are interrelatedthrough institutions'
and brokers'customer/supplierrelationship, we develop a simultaneous
statistical model of the joint behavior. Taking account of the simulta-
neous decision context leads to different inferencesthan we wouldobtain
if we consideredthe determinantsof each decision separately.
A growing literature cites analyst coverage as a component of firms'
informationenvironments. For example, in Shores' [1990] study of the
"preemption"of annual earnings surpriseby interim disclosures,analyst
followingis a proxy for the level of interim information available about
a firm. Skinner [forthcoming]interprets an increase in analyst following
after a firm's common stock is listed for options trading as an indication
that more information is being gathered and disseminated about the
firm. Brennan and Hughes [1990] and Bhushan [1989b] equate analyst
following with the economy-wide amount of information gathering in
their models of stock splits and disclosure,respectively. Our motivation
for studyinganalyst followingis to identify characteristicsthat influence
* University of Michigan; t Massachusetts Institute of Technology. The authors are
grateful to Robert Egan and Melinda Su for research assistance, and to Lynch, Jones &
Ryan for providing the analyst data. We are indebted to Jeff Abarbanell, Stan Kon,
Maureen McNichols, Cindy Schipani, Dennis Sheehan, Doug Skinner, the referee, and
participants in the 1990 Journal of Accounting Research Conference for helpful comments
and discussions. We received valuable comments on an earlier paper from seminar partic-
ipants at Cornell University, Duke University, the University of Michigan, M.I.T., and
Washington University. Remaining errors and omissions are our responsibility.
55
Copyright (?, Institute of Professional Accounting 1991
56 JUDGMENT ISSUES IN ACCOUNTING AND AUDITING: 1990
firms' information environments. We focus on simultaneous decisions

made by analysts and institutional investors that create this environ-
ment.
Research analysts act as information intermediaries in order to affect
investors' holdings. Analyst reports are used to market brokerage services
to customers or potential customers, including institutions such as pen-
sion funds, trusts, and money managers. One effect of a successful
marketing effort is to increase institutional ownership in followed firms.
Merton's [1987] model of capital markets with incomplete information
contains a related idea: investors hold only securities they "know about."
Building on this, Brennan and Hughes [1990] model broker/analysts as
investors' information source, so investors buy only securities followed
by their brokers.
Likewise, institutional demand for information about particular firms
is likely to affect analyst decisions about which firms to follow. Institu-
tions require information, both as a basis for investment decisions and
to satisfy standards of fiduciary responsibility. If they are sued by
beneficiaries for poor investment performance, fiduciaries are held to a
"prudent person" standard, which is to exercise the care and judgment a
person of ordinary prudence and intelligence would exercise in dealing
with his or her own property, under the circumstances existing at the
time.1 Fiduciaries have cited use of analyst reports as evidence of care
and prudence.2 Institutions' willingness to pay for research gives analysts
a motive for following firms.
Because of the supply/demand link between analysts and institutions,
examining only one decision may miss feedback effects of the joint
decision environment. Statistical or analytical models of analysts' deci-
sions that treat institutions' behavior as exogenous are misspecified if
institutions are influenced by analyst behavior, and vice versa.
Other accounting contexts in which joint decision effects may influence
single-equation models include (1) the extent of testing by external
auditors and firms' internal control procedures, (2) accounting method
choice and management compensation, and (3) qualified audit opinions
1The Employee Retirement Income Security Act (ERISA), governing managers of
pension and other employee benefit funds, contains "prudent person" wording [29 U.S.C.A.
? 1104(a)(1)(B)]. Case law widely recognizes a similar standard for all fiduciaries, following
Harvard College v. Amory [26 Mass. (9 Pick.) 446 (1830)]. Since ERISA, many states have
enacted laws holding professional investment managers to a more stringent "prudent
expert" standard.
2 For example, in Beach v. Carter et al. [542 P.2d 994 (1975)], the Bank of California
successfully demonstrated its care as trustee by documenting its use of analyst research. It
is common for courts to accept trustees' search for and reliance on professional advice as
evidence of prudence. See, e.g., Chase v. 1pevear[419 N.E.2d 419 (1981)], Coulthard v. Speirs
[603 P.2d 1074 (1979)], and Estate of Scheuer [94 Misc.2d 538 (1978)]. Conversely, trustees
can be surcharged for lack of attention to the value of investments in their trust, e.g.,
Whitfield v. Cohen [S.D.N.Y., 682 F.Supp. 188 (1988)], Killey Trust [326 A.2d 372 (1974)],
and Wilmington Trust Co. v. Coulter [200 A.2d 441 (1964)].
ANALYST FOLLOWING AND INSTITUTIONAL OWNERSHIP 57
and firms' decisions to retain or switch auditors. For example, auditors
decide on a level of audit testing based on such factors as the likelihood
of error, the importance of potential misstatement, and the adequacy of
internal controls. Management's design of internal controls is also based
on the chance of error, the amount of possible misstatement, and an
interest in reducing audit fees and receiving a clean opinion. Thus,
management's decision about internal controls depends on the audit
environment, and the auditor's decision about audit testing depends on
the internal control environment. Across firms, neither can be taken as
strictly exogenous to the other.
Using single-decision models in multiple-decision contexts creates a
statistical misspecification known as simultaneous equations bias, which
makes coefficient estimates unreliable. Our results indicate this effect is
present, since we find different inferences from single-equation models
and a two-equation simultaneous system. In particular, the association
between firm size variables and analyst following may be artifacts of this
bias, rather than a causal relation.
To focus on analysts' and institutions' joint endogenous decisions, we
examine year-to-year changes in analyst following and institutional
ownership, rather than levels of these two variables. The reason for this
decision is illustrated by considering firm size, a widely noted character-
istic associated with the information environment. Bhushan [1989b] and
Shores [1990], among others, note that large firms generally are more
heavily followed by analysts.3 Our question is: if a firm grows, do more
analysts decide to follow (or more institutions to hold) the firm? Note
that the cross-sectional association documented in previous work does
not imply an affirmative answer to our time-series question.
Year-to-year changes in variables provide a stronger test of causal
relations than do levels of those variables, since the levels of many
economic and noneconomic variables are cross-sectionally correlated
without any direct causal link. While correlations in changes do not
imply causality either, a failure to find correlation in changes can help
to distinguish between meaningful and spurious associations, because
they provide a necessary condition for the existence of a correctly
specified causal relation.4
We investigate both firm and industry characteristics as determinants
of analyst following and institutional ownership. Our results show that
analyst following increases more in firms with smaller prior analyst
following and in firms whose return volatility has declined, and that
3 Studies that suggest more information is generated for larger firms include Grant
[1980], Atiase [1985], Collins, Kothari, and Rayburn [1987], Freeman [1987], and Bhushan
[1989a].
4Measurement problems and leads or lags in relations between variables may hinder
attempts to find correlations empirically. We refer here to "correctly specified" causal links
to abstract from these empirical considerations which are not discussed until later in the
paper.
58 P. C. O'BRIEN AND R. BHUSHAN
analyst following increases more in industries with regulated disclosure

and with increasing numbers of firms. Institutional ownership increases
with firm size and with increased market risk.
In the next section we describe our methodology and rationales for the
variables we suggest as determinants of analyst following and institu-
tional ownership. Section 3 describes the data sources and some sample
characteristics. In section 4 we present the results, and section 5 contains
our conclusions.
2. Determinants of Analyst Following and Institutional

Ownership
In this section we discuss variables we expect to be associated with
changes in either analyst following or institutional ownership. Though it
is possible to construct scenarios to support other relations between and
among these variables, in this section we describe our ex ante expecta-
tions. We discuss some alternative scenarios in section 4, following the
results, which do not support all our ex ante predictions.
We use analyst data from the IBES Summary Tape produced by
Lynch, Jones & Ryan, covering the period January 1976-June 1988. All
stock return data and SIC codes are from the Center for Research in
Securities Prices (CRSP) 1987 Daily Stock and NASDAQ files. Institu-
tional ownership data are from Standard and Poor's (S&P) Security
Owners'Stock Guide,which includes "nearly 2,700" institutions "includ-
ing investment companies, banks, insurance companies, college endow-
ments, and 13-F money managers." S&P obtain the data from Vickers
Stock Research Corporation.
Ideally, the time period for measuring changes in analyst following and
institutional ownership ought to match analysts' and institutions' re-
sponse times to each other and to exogenous factors. Longer time
intervals raise the possibility that spurious associations may be confused
with causal ones, since changes measured over long enough spans ap-
proach levels. A year seems a generous overestimate of analysts' and
institutions' response times, but we use annual differences rather than a
shorter interval for measurement reasons. The number of analysts listed
in IBES and other data bases for a given firm tends to increase as the
fiscal year progresses. This structural feature of analyst data bases
appears unrelated to the level of analyst following, but would confound
measurement of changes in analyst following within a year.
Aggregate data from the SummaryTapeindicate that analyst following
levels off by about the tenth or eleventh month of the fiscal year and
remains stable through the earnings announcement date. We collect data
in the eleventh month of the fiscal year. For example, for a December
year-end company, we use the November IBES Summary List and the
November issue of the S&P Stock Guide. We obtain CRSP data from
roughly the same time: defining day 0 to be the year-end date, we obtain
stock-related variables as of trading day -45, approximately two calendar
months prior to the year-end. This timing gives us roughly contempora-
neous data from all three sources, allowing for a small time lag in the
collection and publication of information in the IBES Summary and
S&P Stock Guide.5
We used exploratory data analysis on the data from fiscal 1985-87 to
specify the variables and their functional forms. We examined several
functional forms for analyst following and institutional ownership, lead-
lag relations among variables, and several variables that do not appear
in the paper, such as the firm's number of exchange listings, its S&P
stock rating, and membership in the S&P 500. We selected variables and
functional forms based on preliminary regression results and residual
plots, and on our interest in exploring hypotheses advanced in previous
work.
Though it is common in empirical work, exploratory data analysis for
model specification can impair inference, because classical statistical
methods presume that the data are drawn after the model and hypotheses
are specified. Technically, reusing data reduces the degrees of freedom
for statistical tests, and as a practical matter it can result in an overfit
model, descriptive within the sample but not outside it. To protect against
this potential, we retain fiscal years 1981-84 as a holdout sample. Our
results, reported in section 4, are reasonably robust.
Our final selection of variables appears in table 1. The jointly endog-
enous variables are the annual change in the number of analysts fore-
casting the firm's current-year earnings per share, D/$iANLST, and the
annual change in the number of institutions holding the firm's common
stock, D/$iINSTN. These are proxies for the change in analyst following
and the change in institutional ownership, respectively.
2.1 DETERMINANTS OF ANALYST FOLLOWING

We presume analysts weigh the costs and benefits of following a
particular firm. Analysts in the IBES Summary data base are employed
by full-service brokerage houses, providing research reports and forecasts
to the brokerage sales force and to customers. Analyst research allows
full-service brokers to charge higher commission rates than do discount
brokers and helps generate trades by providing background support for
sales force recommendations. Thus, to the extent that commission rev-
enues are increased as a result of research analysts' activities, the
brokerage house benefits.
Analysts benefit only indirectly from commissions, since it is rare (and
controversial) for research analysts' compensation to be explicitly based
'The IBES data base is updated continuously as information arrives at Lynch, Jones &
Ryan, and the Summary is produced in the third week of each month. The monthly S&P
Security Owners' Stock Guide is "revised through the last business day of the prior month."
Therefore, data in the November issue are current as of the end of October.
TABLE 1
Definitionsof Variables
Variable Definition
Name
#ANLST*t The number of analysts with estimates of current-year EPS, as
reported in the IBES Summary File in the month prior to
the fiscal year-end.
#INSTN*t The number of institutions holding the stock, as reported in
the S&P Security Owners' Stock Guide in the month prior to
the fiscal year-end.
SIC The three-digit SIC code listed in CRSP for the firm.
SICGRO The net entry of firms to the industry over the five-year period
ending in the month prior to the fiscal year-end. Net entry is
the number of new firms listed in CRSP for the industry
minus the number of firms exiting the industry, divided by
the number of firms that were in the industry at the begin-
ning of the period.
REGIND Regulated industry: takes the value 1 if the industry is in SIC
421, 483, 493, 612, 621, 633, 805, or 809; and 0 otherwise.
Industry names are in table 3.
LNMVEQ* The natural logarithm of the market value of equity (in
$1,000s), 45 trading days prior to the fiscal year-end date.
Data are from the CRSP files.
MKTARET Market-adjusted return: the continuously compounded return
on the firm's common stock over trading days -294 to -45,
minus the value-weighted market return over the same
period (xIOO). Day 0 is the fiscal year-end date.
LNSHRS* The natural logarithm of the number of shares outstanding, as
listed in the CRSP files (cross-checked against data from the
S&P Guide).
BETA * The estimated systematic risk of the stock from a market
model regression using a value-weighted market index, esti-
mated over trading days -244 to -45. Day 0 is the fiscal
year-end date.
RESIDSE* The residual standard error (xOO) from the market model
regression described above in the definition of BETA.
* Variablenames markedwith an asteriskare used in first-differenced
form.
t The regressorsincludelagged,undifferenced#ANLSTand #INSTN.
6
on commissions. We assume an implicit link between commissions
revenue and analyst compensation, so analysts expect to derive more
benefit from following firms where more trades can be generated.
Analysts associated with full-service brokers may also be rewarded for
generating corporate finance fees, if the brokerage house is connected
with an investment bank. For example, an analyst who maintains good
relations with the management of firms he or she follows may attract
underwriting business from those firms to the broker's investment bank.
6 Stickel [1990] discusses the link between analysts' research activities and compensation.
Konrad and Greising [1989] and Torres [1989] discuss the controversy surrounding com-
mission-linked compensation for analysts.
We do not investigate this link empirically because we lack data on the

identities of the specific analysts and brokerage houses following our
firms.
We presume an analyst's benefit will be greatest in firms with little
competition from other analysts, and with high investor interest.7 Our
proxy for analyst competition is the prior-year level of analyst following,
L/$iANLST. Our indicators of investor interest include the contempora-
neous change in institutions holding the stock (jointly endogenous
D/$iINSTN), the number of institutions holding the stock last year
(L/$iINSTN), and changes in shares outstanding. Shares outstanding is
a crude proxy for the size of the potential investor base. However, Conroy
and Flood [1989] find that the number of individual owners, the number
of institutional owners, and the average daily number of trades increase
when the stock is split. While a stock split is only one of many possible
ways to increase the number of shares outstanding, their results support
our argument since they suggest a potential for more trading commissions
from an increase in shares outstanding. Our proxy is the annual change
in the natural logarithm of the number of common shares outstanding
45 trading days prior to the fiscal year-end, DLNSHRS.
Benefits from using analyst-supplied information may differ across
firms, if, for example, informed trading is better concealed in volatile
stocks. If analysts capture some of these benefits, then increases in
volatility should cause increases in following. Our proxy for volatility is
the standard error of excess stock returns, computed as the residual
standard error from a market-model regression using the value-weighted
index of NYSE, AMEX, and NASDAQ stocks over the trading-day
interval [-244, -45], where day 0 is the fiscal year-end date.8 We use
changes in volatility, DRESIDSE, as our regressor.
Weighed against the possible benefits of following a firm are costs of
gathering information, which also may vary across firms. We consider
two industry sources of differential costs of collecting information. First,
if there are economies of scale in learning about firms' operations (for
example, because information about technologies or products is common
across firms), then the cost per firm of this research will decline with the
number of firms in the industry. Therefore, we expect increases in the
number of firms in an industry to be associated with increased analyst
following of all firms in the industry. We use three-digit SIC codes to
define industries, because SIC codes are available for most firms, and the
three-digit level most closely approximates the industry classifications
in Nelson's Directoryof WallStreet Research.We define net entry to the
7 Our rationale for each exogenous variable is meant ceteris paribus with respect to the
other factors in our statistical model.

8 We require at least 50 return observations in this interval to perform the estimation.
Preliminary results did not differ when an equally weighted index from all markets was
used. Results differed when only the NYSE/AMEX index was used.
62 P. C. O BRIEN AND R. BHUSHAN
industry, SICGRO, as the net change in the number of firms in the

industry over the past five years, divided by the number of firms that
were in the industry five years ago. We use all firms listed in the CRSP
NYSE/AMEX and NASDAQ files to construct this variable, not just the
firms that met our data requirements. Since the counts are limited to
listed firms, SICGRO will be inaccurate for industries with privately held
firms that are followed by analysts.
The second industry proxy for differential costs of collecting infor-
mation is regulation. Since regulatory oversight and disclosures provide
operating information that supplements the financial disclosure required
of all firms, we expect analysts to prefer regulated industries. The
regulated industries in our sample, the selection of which is detailed in
section 3, are Trucking, Broadcasting, Utility Services, Savings Institu-
tions, Securities Brokers, Insurance, Nursing and Personal Care, and
Health. All of these industries are required to provide information that
exceeds GAAP disclosure to regulatory agencies, and many are subject to
regulatory audit as well.
If firm size, specifically the market value of equity, is important to
analysts, then both changes in shares outstanding (DLNSHRS) and
price changes should be associated with changes in analyst following.
However, price performance may be important in its own right, if, for
example, analysts prefer to cover stocks that have performed well. Our
proxy for price performance is the market-adjusted return, MKTARET,
the difference between the continuously compounded return on the stock
and the return on the value-weighted index over a 250-trading-day period
ending 45 trading days prior to year-end.9
In summary, we expect positive associations between changes in ana-
lyst following (DY$<ANLST) and changes in institutional ownership
(DY$<INSTN), lagged institutional ownership (LY$<INSTN),changes in
shares outstanding (DLNSHRS), changes in volatility (DRESIDSE),
net entry of firms to the industry (SICGRO), regulation (REGIND), and
stock performance (MKTARET). We expect a negative association be-
tween changes in analyst following and lagged analyst following
(L/$<ANLST).
2.2 DETERMINANTS OF INSTITUTIONAL OWNERSHIP
Institutional investors, as fiduciaries, face legal and statutory restric-
tions on their decisions and are held to "prudent person" standards. We
expect changes in institutional ownership to be associated with firm size,
'A precise decomposition of changes in firm size can be obtained from the sum of
DLNSHRS and the log of relative prices (in [Pt/P,_1]). MKTARET differs from this simple
price relative by the dividend payout, stock split adjustments, and the market adjustment.
However, MKTARET measures firm-specific performance, in line with the rationale for its
association with analysts' decisions. We have replicated our results using changes in the
natural log of the market value of equity, instead of DLNSHRS and MKTARET, without
altering our conclusions.
analyst following, and the prior level of institutional ownership, all of
which have been used to establish the prudence of investments in legal
cases.10
If firm size is important to institutions because of prudence standards,
both price performance (MKTARET) and changes in shares outstanding
(DLNSHRS) should be associated with changes in institutional owner-
ship. However, the two components may differ if other factors come into
play. To the extent that size reflects an institutional preference for
"winners," there will be a positive association between stock performance
and changes in institutional ownership, but no link with changes in
shares outstanding is implied. If liquidity increases with the number of
shares outstanding, institutions will find it less costly to trade large
blocks in companies with more shares,1"implying institutional ownership
will increase along with shares outstanding, with no implication about
stock performance.
Institutions typically pay their managers based on the dollar value of
assets under management. More explicitly performance-based compen-
sation arrangements were prohibited until November 1985 by section
205(1) of the 1940 Investment Advisers Act. The prohibition, intended
to prevent investment managers from making overly speculative invest-
ments, was relaxed by the SEC's Release No. IA-996, which allows fees
based on performance. In late 1986, the Department of Labor opened the
door for pension funds to use incentive fee structures by ruling that
certain performance-based fee arrangements would not violate ERISA's
self-dealing prohibition.12 However, in August 1988, Institutional Investor
reported that incentive fees were still uncommon at corporate pension
funds, perhaps because of the complexity of establishing appropriate
performance benchmarks.13 Therefore, for the 1981-87 period covered by
this study, it is probably reasonable to assume institutional money
managers' fees were of the traditional percent-of-assets type.
Fees based on a percentage of assets under management provide a
weak link between performance and pay, but no extraordinary reward
for superior performance. On the other hand, the possibility of lawsuits
for lack of prudence is clearly greater for large losses than for gains.
Further, although ERISA requires trustees of employee benefit plans to
diversify plan holdings, modern portfolio theory is not universally ac-
cepted by the courts in evaluating fiduciaries, and many statutes and
case law precedents stipulate that each investment, evaluated separately,
10See, e.g., Chase v. Pevear [419 N.E.2d 419 (1981)] and Estate of Scheuer [94 Misc.2d
538 (1978)].
" See Ring [1987], Blanc [1986], and Priest [1985] for discussions of liquidity costs faced
by institutions because of their large holdings.
12 Investment Advisors Act [15 U.S.C.A. ? 80b-5(1)] and ERISA [29 U.S.C.A. ? 1106(b)
and 1108(c)].
13
Elliott [1988]. Cf. Paustian [1987], Fisher [1986], and Lipton [1986].
must be prudent.14 Percent-of-assets compensation arrangements com-

bined with potentially large "downside" legal liability may induce insti-
tutional money managers to be more averse to negative outcomes than
are other investors. We predict institutions will avoid firms with higher
systematic risk because adverse economic times will affect these firms
more.15This indicates a negative relation between changes in systematic
risk (DBETA) and changes in institutional ownership, ceteris paribus.
We estimate systematic risk using the market model described in section
2.1.
In summary, we expect changes in institutional ownership
(DY$<INSTN)to be positively associated with changes in analyst following
(jointly endogenous DI$ANLST), stock performance (MKTARET),
changes in shares outstanding (DLNSHRS), lagged analyst following
(LI$ANLST),and lagged institutional ownership (LYI$INSTN).We ex-
pect a negative relation between changes in institutional ownership and
changes in systematic risk (DBETA).
2.3 SIMULTANEOUS EQUATIONS
If we believed analysts' decisions to cover firms were independent of
institutions' decisions to hold stocks, we might estimate the following
two equations separately using OLS:
DYIANLSTt= ao + a, DYI$INSTNit
+ a2 SICGROit+ a3 REGINDit
+ a4 MKTARETit+ a5 DLNSHRSit + a6 DBETAit

(1)
+ a7 DRESIDSEit + a8 LY$ANLSTit
+ a9 LYI$INSTNit
+ e1it
and:
DY$<INSTNit= bo + bi DY$ANLSTit+ b2 SICGROit+ b3REGINDit
+ b4 MKTARETit + b5 DLNSHRSit + b6 DBETAit (2)
+ b7DRESIDSEit + b8LY$ANLSTit
+ bgLYI$INSTNit
+ e2it
However, to the extent that the two dependent variables are jointly
determined by similar factors and equations (1) and (2) capture these
relations imperfectly, the unexplained portions of analyst following and
institutional ownership, e1itand e2it, will be correlated. Since DYI$INSTN
appears on the right-hand side of equation (1) (similarly for DYI$ANLST
14
ERISA [29 U.S.C.A. ? 1104(a)(1)(C)]. Cases where the court required each investment
to pass a prudence test include Chase v. Pevear [419 N.E.2d 1358 (1981)] and Estate of
Beach [542 P.2d 994 (1975)]. See Young and Lombard [1985] for a discussion of fiduciary
responsibility.
15
Badrinath, Gay, and Kale [1989] make a similar argument.
in equation (2)), the correlation between the error terms implies corre-
lation between the regressor DXIUNSTNand the error term elit, violating
OLS assumptions. This correlation causes the single-equation coeffi-
cients to be biased and inconsistent.
We use two-stage least squares (2SLS) to eliminate the simultaneity.
That is, in the first stage, we regress each of the jointly endogenous
variables against all variables other than DYI$INSTNand DI$ANLST.
The fitted values from these regressions, which by construction are
independent of their respective error terms, are used as instrumental
variables in the second stage.
To avoid creating a singular covariance matrix in the second stage, we
identify the two-equation system by specifying regressors that influence
only one of the two endogenous variables. Based on our argument that
institutions form a clientele with distinct preferences about systematic
risk, DBETA should influence analyst following only through its effect
on institutions. It is therefore a natural candidate for exclusion from the
analyst equation. Our premise for SICGROis that analysts find it costly
to become informed about industry products and processes, so SICGRO
should affect institutional ownership only via analyst following. Exclud-
ing one variable from each equation makes the following system just-
identified:
D1*$ANLSTit
= + C2 SICGROit+ C3REGINDit
Co + C1DYI$INSTNit
(3)
+ C4MKTARETit + c5 DLNSHRSit + C7DRESIDSEit
+
+ c8 LY$ANLSTit c9 LYI$INSTNit
+ e3it
and:
D/I$INSTNit
= do + d1 D/IANLSTt + d3 REGINDit
+ d4 MKTARETit+ d5 DLNSHRSit + d6 DBETAit (4)
+ d7 DRESIDSEit + d8 LY$ANLSTit
+ d9 LY$<INSTNit
+ e4it
In the second stage of 2SLS we estimate (3) and (4), substituting the
instruments constructed in the first stage for DYI$INSTN in equation (3)
and DY$<ANLSTin equation (4). Since both equations are just-identified,
2SLS gives identical results to other simultaneous equations procedures
such as maximum likelihood or three-stage least squares. For comparison,
we also estimate equations (3) and (4) using ordinary least squares (OLS).
3. Sample Selection and Data Description

Table 2 contains a description of the initial sample selection. Of 5,811
firms listed in the IBES file, 4,920 are in the combined CRSP NYSE/
TABLE 2
Sample Selection
Panel A; Intersection of Analyst and Stock Market Data Sets
IBES NYSE/AMEX NASDAQ
Firms in data set ............. ............. 5,811 5,019 7,659
Firms matched by CUSIP1......... .......... 4,920 2,545 2,854
Matched firms with no industry change1 ....... 4,254 2,267 2,466
Panel B: Selection of Industries

Numberof: Firms Industries
Intersection, from panel A ....... ........... 4,254 318
Industries with >5 firms ........ ............ 3,887 155
Every 4th industry selected .................. 1,104 38
Panel C: Data Availability

Numberof: Firms Industries Firm-Years
Data from all sources .......... ............. 846 38 3,977
First-differenced data ......... ............. 716 38 3,000
Fiscal 1985-87 ............................. 570 38 1,347
Fiscal 1981-84 ............................. 664 38 1,653
1 The numberof firms matchedon IBES does not equal the sum of those matchedon the NYSE/
AMEX and those matchedon NASDAQ,becausesome firms changedfrom OTC to one of the major
exchanges(or the reverse)between 1976 and 1986, and so appearon both. We used CRSP'sIPERM
identificationnumberto verifythat these were identicalfirms.
AMEX and NASDAQ files. Since we use industry characteristics in our

analysis, we omit 666 firms with no SIC code listed or with changes in
SIC codes between 1976 and 1986.16 The remaining 4,254 firms represent
318 three-digit SIC industries. We restrict our analysis to 155 industries
(3,887 firms) with at least 5 firms, to ensure sufficient data to define the
industry characteristics. To reduce the burden of hand collecting data,
we select every fourth SIC code in numerical order, leaving 38 industries
with 1,104 firms. Since SIC codes are numerically related (e.g., three-
digit codes are subsets of two-digit codes), selecting every fourth industry
gives us a broad-based set of industries.
Of the 1,104 firms, 846 have complete data from all sources in any
year, and 716 firms with 3,000 firm-years have complete data in consec-
utive years for first-differencing. Our two subsets, from fiscal years 1985
through 1987 and from fiscal years 1981 through 1984, have 1,347 and
1,653 firm-years, respectively.17
16
We began the study intending to collect data for the period 1976-86. We added 1987
when the CRSP data for this year became available. We later found that the S&P Security
Owners' Stock Guide began including pension funds in its definition of institutions during
1981, so we chose to work with the shorter span of years with consistent data.
17 The reported final sample numbers are after deletion of two outliers that influenced
the regression results. In 1984, Energy Management Co. (CUSIP 29270110) had a measured
change in volatility of 13.84, more than twice the range in volatility of all other observations.
In 1985, Medical Care Int. (CUSIP 58450510) was the only sample firm in the Health and
Allied Services Industry (SIC 809) which had a five-year industry growth rate of 1300%,
more than quadruple the next-highest observation. Each of these observations influenced
one regression coefficient substantially (for volatility and industry growth, respectively)
but had little effect on other coefficients.
Tables 3 and 4 give information on the sample's industry and time
composition. In table 3, the 38 industries are reported by name, along
with the number of sample firms in each. SIC 671, Holding Offices,
contains 31% of the sample firms. About one-third of the firms in SIC
671 are bank holding companies, but it includes many insurance holding
companies, several of the regional telephone companies, and other hold-
ing companies whose operating subsidiaries are in diverse industries (e.g.,
TABLE 3
Sample Industries
Numberof
SIC IndustryName Sample
Firms
131 Crude Petroleum and Natural Gas 61
201 Meat Products 6
205 Bakery Products 3
221 Broadwoven Fabric Mills, Cotton 8
232 Men's and Boys' Furnishings 14
243 Millwork, Plywood & Structural Members 7
264 Misc. Converted Paper Products 11
275 Commercial Printing 15
283 Drugs 46
287 Agricultural Chemicals 4
301 Tires and Inner Tubes 9
324 Cement, Hydraulic 5
332 Iron and Steel Foundries 8
343 Plumbing and Heating, Except Electric 7
349 Misc. Fabricated Metal Products 18
354 Metalworking Machinery 13
358 Refrigeration and Service Machinery 11
364 Electrical Lighting and Wiring Equipment 14
369 Misc. Electrical Equipment and Supplies 12
379 Misc. Transportation Equipment 5
384 Medical Instruments and Supplies 40
394 Toys and Sporting Goods 9
421 Trucking and Couriers Services, Except Air 17
483 Radio and Television Broadcasting 13
493 Combination Utility Services 32
503 Lumber and Construction Materials 3
512 Drugs, Proprietaries and Sundries 10
533 Variety Stores 6
566 Shoe Stores 5
591 Drug Stores and Proprietary Stores 14
612 Savings Institutions 21
621 Security Brokers and Dealers 11
633 Fire, Marine and Casualty Insurance 15
671 Holding Offices 224
721 Laundry, Cleaning and Garment Service 4
751 Automotive Rentals, No Drivers 4
805 Nursing and Personal Care Facilities 8
809 Health and Allied Services, NEC 3
716
TABLE 4
Sample Distribution Information
Panel A: Number of Observations by Fiscal Year-End and Fiscal Year
Fiscal Numberof Fiscal Numberof
Year-End Observations Year' Observations
1 79 81 338
2 41 82 411
3 64 83 431
4 44 84 473
5 41 85 499
6 115 86 455
7 35 87 393
8 71 3,000
9 124
10 71
11 59
12 2,256
3,000
Panel B: Summary Statistics on Variables' Sample Distributions2

VariableName Mean Standard Median Minimum Maximum
Deviation
D#ANLST 0.71 2.07 0.00 -9.00 13.00

D#INSTN 9.29 21.09 4.00 -85.00 202.00
SICGRO 0.14 0.33 0.13 -0.57 2.75
MKTARET -0.03 0.34 0.00 -2.12 1.29
DLNSHRS 0.13 0.27 0.01 -2.05 2.52
DBETA -0.01 0.39 0.00 -1.68 1.97
DRESIDSE 0.03 0.57 0.00 -2.33 4.21
L#ANLST 8.17 7.66 5.00 1.00 39.00
L#INSTN 81.84 117.61 38.00 1.00 771.00
1 Ourfiscal year conventionis illustratedby the followingexample:fiscal yearsendingbetweenJune
1985and May 1986are regardedas fiscal 1985.
2
The summarystatistics are computedover all 3,000 firm-yearsin the sample.
Grumman Corp., Toys R Us, Jaguar PLC). While it is not a clearly

defined industry whose member firms share operating characteristics, its
firms are legitimate observations in other, firm-specific respects. Our
primary results include SIC 671, and in section 4 we discuss further
investigation of this industry classification.
Panel A of table 4 shows the distribution of observations by calendar
year and fiscal year-end. As expected, December year-ends dominate the
sample, but approximately one-quarter of the observations are for other
year-ends. Observations are roughly evenly distributed across years.
Panel B of table 4 reports summary statistics on the sample distributions
of the variables over all 3,000 firm-year observations.
In table 5 we report pairwise correlations between variables for the full
sample and each subsample. Correlations are fairly stable between sub-
periods. Although we indicate statistical significance at the 5% level, we
do not wish to draw inferences from these correlations, first because we
are interested in the multiple correlations, and second because statistical
significance is based on assuming that all observations are independent
draws. This assumption is clearly violated in some cases. For example,
the number of institutions holding a firm's stock is correlated from year
to year.
The correlations in table 5 are important for comparing inferences
from our first-differenced model with the levels-form correlations re-
ported in other studies, particularly since our variable definitions differ
from those in other studies. Even in first-differenced form, our dependent
variables DY$<ANLSTand DY$<INSTNare apparently strongly correlated
with each of the size-related variables, MKTARET and DLNSHRS, as
well as with other regressors. Some of these associations disappear or are
reversed in the simultaneous equations estimation in section 4, but the
table 5 correlations should reduce concerns that our later results are
simply due to misspecification of, for example, the functional form or
the timing of the association. Moreover, our exploratory data analysis of
the 1985-87 subsample did not in general reveal stronger associations
with other specifications of functional form or between the levels of these
variables and lagged levels.
4. Results
As discussed in section 2, we model analyst following and institutional
ownership as simultaneous equations and make initial estimates using
the 1985-87 subperiod. In table 6, we present results for single-equation
regressions as well as simultaneous estimation of the two-equation system
on this subsample.
Within each subsample, we pool time-series and cross-section obser-
vations. Since the data are annual changes, the possibility that we are
pooling correlated observations is not as great as when variables are
measured in levels, but this still may be a concern. For example, if
changes in analyst following or institutional ownership are serially cor-
related, consecutive years' observations for a single firm are not inde-
pendent draws. We tested for this possibility by sorting the data by year
within firm and computing the first-order residual autocorrelation and
Durbin-Watson statistic. The estimated residual autocorrelations in both
2SLS equations are about -0.04, insignificant at the 5% level.18
Two single-equation OLS regressions are reported for each endogenous
variable in table 6, the first including all possible regressors, and the
second in the same form as the just-identified 2SLS model of equations
(3) and (4). The results reported in the 2SLS column for each endogenous
18 Under the null hypothesis of no autocorrelation, the standard error on this estimate
is approximately 1/ln or 0.027. The Durbin-Watson statistics are 2.083 for the analyst
equation and 1.925 for the institutions equation. Tabled values for the statistic of which
we are aware (King [1983] and Savin and White [1977]) extend only to N = 300, while our
sample size is 1,347. For N = 300, k' = 8, the region [da, 4 - dJ] in which the statistic fails
to reject the null of no autocorrelation at the 5% level is [1.859, 2.141].
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TABLE 6
OLS and 2SLS Regressions of Analyst Following and Institutional Investor Ownership on
Firm and Industry Characteristics, 1985-87
Coefficient Estimates (t-statistics in parentheses)

D#ANLST D#INSTN
OLS OLS 2SLS OLS OLS 2SLS
INTERCEPT 0.56 0.56 0.54 -0.28 -0.29 -0.14
(5.60) (5.59) (4.95) (-0.31) (-0.33) (-0.05)
D#INSTN 0.03 0.03 0.05
(9.49) (9.56) (1.15)
D#ANLST 2.21 2.21 1.98
(9.49) (9.51) (0.46)
SICGRO 0.33 0.32 0.31 -0.08
(1.91) (1.89) (1.80) (-0.05)
REGIND 0.35 0.35 0.36 -1.09 -1.11 -1.01
(2.25) (2.24) (2.24) (-0.79) (-0.81) (-0.46)
MKTARET 0.90 0.91 0.60 12.48 12.48 12.79
(4.61) (4.70) (0.86) (7.34) (7.34) (2.09)
DLNSHRS 0.08 0.09 -0.27 17.01 17.01 17.15
(0.36) (0.41) (-0.33) (8.88) (8.89) (5.17)
DBETA 0.07 3.17 3.18 3.21
(0.47) (2.47) (2.48) (2.22)
DRESIDSE -0.18 -0.17 -0.18 0.73 0.73 0.69
(-1.68) (-1.61) (-1.65) (0.79) (0.79) (0.58)
L#ANLST -0.06 -0.06 -0.07 0.76 0.76 0.75
(-4.34) (-4.35) (-2.23) (6.75) (6.78) (3.72)
L#INSTN' 0.20 0.19 0.09 4.59 4.59 4.67
(2.26) (2.25) (0.39) (6.09) (6.10) (2.70)
Regression Summary Statistics

Observations . . 1,347 1,347 1,347 1,347 1,347 1,347
Adjusted R2....... 0.1327 0.1332 0.0831 0.4140 0.4144 0.3939
RegressionF ...... 23.88 26.86 15.15 106.65 120.07 108.71
p-value forF ...... 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
' The laggednumberof institutions holding the firm is dividedby 100 for this estimation,so the
coefficientcan be reportedin two decimalplaces.
variable are from joint estimation of the two-equation system. The 2SLS
estimation explains about 8% of the variation in changes in analyst
following and about 39% of the variation in changes in institutional
ownership.
From the 2SLS results, changes in analyst following appear positively
associated with net entry to the industry and regulation, and negatively
associated with preexisting analyst following, as expected from our dis-
cussion in section 3. Our expectation that analysts would prefer volatility
is refuted by the significantly negative coefficient on that variable.
Changes in institutional ownership are positively associated with stock
performance, increases in shares outstanding, lagged analyst following,
and lagged institutional ownership, as expected. Institutions do not
appear to shun systematic risk as we suggested, since DBETA has a

significant positive coefficient.
Evidence of simultaneity is seen by comparing the OLS and 2SLS
results. In both equations, the coefficient on the jointly endogenous
variable is significantly positive in the OLS regressions but not in the
2SLS estimation. The 2SLS estimation substitutes instrumental vari-
ables for the joint endogenous variables. The instrument for D/$ANLST,
for example, omits the portion of that variable that is orthogonal to the
other regressors and potentially correlated with the error in the institu-
tions equation. The statistical insignificance of the coefficients on the
joint endogenous variables in the 2SLS estimation reflects that the
exogenous and predetermined regressors provide "good" instruments in
the sense of reasonable fit to the underlying variable. As a result, these
instrumental variables are somewhat collinear with the other regressors.
Stock performance provides no explanatory power in the 2SLS analyst
equation beyond what is contained in the instrument for D/$INSTN but
retains significant, though reduced, explanatory power in the institutions
equation. Increases in shares outstanding are unimportant in the analyst
equation but remain significant in the institutions equation, regardless
of the estimation procedure. Very similar results are obtained if the
change in firm size, measured as the change in the natural log of the
market value of equity, is substituted for the two variables DLNSHRS
and MKTARET. In the analyst equation, the OLS coefficient on this
size variable is 0.77 (t = 5.04), while the 2SLS coefficient is 0.50 (t =
0.97). In the institutions equation, the OLS coefficient is 13.87 (t =
10.23), and the 2SLS coefficient is 14.42 (t = 2.29). We conclude from
these results that institutions add growing firms to their portfolios.
However, once we account for the feedback effects between analysts' and
institutions' behavior we find no evidence that analysts move to cover
growing firms. This result does not negate the fact that analyst following
and firm size are related but does not support a direct behavioral or
causal link between the two.
Other than lagged institutional holding, which we discuss further
below, coefficients on other variables in both equations are either unaf-
fected by the 2SLS estimation or are reduced somewhat in statistical
significance, but without altering inferences.
We test the robustness of our results by performing the same estima-
tion on the earlier subperiod, with observations from fiscal 1981-84.
These results are reported in table 7. As expected in holdout sample
tests, R2 is lower for these regressions than for their counterparts in
table 6, approximately 5% in the 2SLS analyst equation and 10% in the
institutions equation. The tenor of most of the results reported above is
preserved, however.
The 2SLS results in the 1981-84 period show that changes in analyst
following are positively related to net entry to the industry and regulation,
TABLE 7
OLS and 2SLS Regressions of Analyst Following and Institutional Investor Ownership on
Firm and Industry Characteristics, 1981-84
Coefficient Estimates (t-statistics in parentheses)
D#ANLST D#INSTN
OLS OLS 2SLS OLS OLS 2SLS
INTERCEPT 0.39 0.38 0.29 0.87 0.75 2.13
(5.29) (5.19) (2.48) (1.31) (1.17) (1.03)
D#INSTN 0.02 0.02 0.09
(8.71) (8.80) (1.60)
D#ANLST 1.85 1.84 -1.08
(8.71) (8.68) (-0.26)
SICGRO 0.32 0.32 0.34 -0.93
(2.31) (2.25) (2.13) (-0.75)
REGIND 0.34 0.35 0.36 -0.91 -0.81 0.06
(2.80) (2.87) (2.58) (-0.85) (-0.76) (0.04)
MKTARET 0.32 0.35 -0.19 7.37 7.59 8.89
(2.31) (2.55) (-0.39) (6.08) (6.44) (3.99)
DLNSHRS 0.31 0.34 -0.54 12.73 12.67 14.63
(1.83) (1.99) (-0.69) (8.56) (8.53) (4.60)
DBETA 0.17 2.28 2.32 2.96
(1.32) (2.05) (2.08) (1.99)
DRESIDSE -0.22 -0.19 -0.19 -0.11 -0.11 -0.79
(-2.58) (-2.32) (-1.96) (-0.15) (-0.15) (-0.63)
L#ANLST -0.03 -0.03 -0.05 0.33 0.33 0.26
(-2.91) (-2.87) (-2.46) (3.51) (3.51) (1.84)
L#INSTN1 0.41 0.41 0.39 -0.51 -0.51 0.70
(6.21) (6.25) (5.11) (-0.87) (-0.88) (0.38)
Regression Summary Statistics

Observations . . 1,653 1,653 1,653 1,653 1,653 1,653
AdjustedR2....... 0.1010 0.1005 0.0523 0.1442 0.1444 0.1035
RegressionF ...... 21.61 24.08 11.34 31.93 35.86 23.72
p-value for F ...... 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
' The laggednumberof institutions holding the firm is dividedby 100 for this estimation,so the
coefficientcan be reportedin two decimalplaces.
and negatively related to volatility and lagged analyst following. As

before, the association between stock performance and analyst following
apparent in the OLS results disappears in the 2SLS regression. Institu-
tional ownership, as before, is positively associated with stock perform-
ance, changes in shares outstanding, changes in systematic risk, and
lagged analyst following.
The major difference between the 1985-87 and 1984-84 periods is in
the results on lagged institutional ownership. We expected positive
coefficients in both equations but find conflicting results. Analyst follow-
ing is strongly positively related to lagged institutional ownership in
1981-84 but not in the later subperiod. Changes in institutional holding
are unrelated to lagged institutional holding in 1981-84 but are strongly
positively related in 1985-87. Since the purpose of a holdout sample is

to guard against ungeneralizable inferences brought about by overfitting
the model to a specific sample, we must conclude from this inconsistency
that the inferences regarding L/$INSTN are sample specific.
To investigate whether the unexpected results for DRESIDSE in the
analyst equation and DBETA in the institutions equation are caused by
poor market-model parameter estimates for OTC firms, we replicate the
tests using only NYSE and AMEX firms. The 2SLS coefficient on
DRESIDSE in the analyst equation becomes -0.20 (t = -1.19), and the
coefficient on DBETA in the institutions equation becomes 2.97 (t =
1.56). Neither is statistically significant at the 10% level, but both are
still opposite in sign to our expectation.
The positive relation between systematic risk and institutional holding
could result from agency problems between institutional fund managers
and the individuals whose money they manage. For example, if managers
are compensated for achieving high returns and their portfolios are not
monitored for risk, they have incentives to invest in high-risk securities
to increase their portfolios' expected returns. This is the opposite of our
a priori expectation that fund managers' fiduciary responsibility makes
them more risk-averse than most investors, but consistent with our
results.
The weakly significant negative relation between changes in analyst
following and volatility changes refutes our argument that analysts
choose volatile firms to capture larger benefits from informed trading. It
may be that trading profits, if any, generated by analyst information do
not depend on volatility. Alternatively, analysts may be unable to capture
any of the benefits, for example, if brokerage commissions on informed
trading are not directed to the brokerage houses that produced the
research.
Since SIC 671, Holding Offices, contains more than 30% of sample
firms, we investigate its influence on the results further. Our attempts
to do so include (1) excluding all 224 sample firms classified as SIC 671
by CRSP, (2) obtaining alternative SIC codes from Compustat for 126 of
the SIC 671 firms, reclassifying them, and keeping the remaining 98
firms in SIC 671, and (3) obtaining alternative SIC codes as in (2) but
deleting the 98 firms not on Compustat.19Of the 126 firms on Compustat,
26 are reclassified into sample industries and so remain in the sample.
Results are very similar for all three investigations, so we summarize
only (1) here. When SIC 671 from the 1985-87 subsample is excluded
and the analyst equation reported in the first column of table 6 is
replicated, the coefficient on regulation increases to 0.59 (t = 3.05), and
that on net entry of firms to the industry decreases to 0.09 (t = 0.47).
19We used the Compustat Primary-Supplementary-Tertiary, Full Coverage, and Research

files to search for firms.
Other coefficient values are similar in magnitude and statistical signifi-
cance to those in the first column of table 6.
5. Conclusions
We find evidence of a behavioral link between analysts' decisions to
follow firms and differential costs and benefits of gathering information.
We find that analysts prefer industries with increasing numbers of firms
and regulated industries and tend to avoid volatility and competition
from preexisting analyst following. We find no evidence of a causal link
between changes in analyst following and changes in firm size, once the
simultaneity with institutions' decisions is eliminated. Our evidence
supports a behavioral association between institutions' decisions to hold
firms' common stock and changes in firm size (both price changes and
changes in shares outstanding) and prior analyst following. Somewhat
paradoxically, we find that institutions seem to prefer firms whose risk
has increased. Overall, our results are reasonably robust when the model
is tested in an earlier time period.
We examine analyst following from a perspective different from that
of most prior information environment studies. By examining changes
in analyst following along with changes in institutional ownership, we
produce more demanding tests of the causal relations between firm and
industry characteristics and analysts' and institutions' decisions. The
lack of evidence that increasing firm size increases analyst following,
once feedback effects between institutions and analysts are considered,
calls into question some conventional assumptions about how size affects
information production. If analyst following is a reasonable proxy for
information production, our results fail to support a direct causal link
between it and size, instead suggesting an indirect link via institutions'
simultaneous decision.
Multiple-decision settings are probably the rule, not the exception, in
the real world, yet accounting researchers often consider decisions as
single endogenous events. Cross-sectional variation in firm characteris-
tics such as capital structure or the existence of executive bonus plans
are probably jointly endogenously determined, not exogenous to such
accounting decisions as audit qualifications or accounting method
choices. In our study, taking account of simultaneity between analysts'
and institutions' decisions alters the empirical results and therefore alters
implications for modeling information production. Similar results may
pertain in other accounting decision contexts.
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Accounting Research Center, Booth School of Business, University of Chicago

Analyst Following and Institutional Ownership

Analyst Following and

firms' information environments. We focus on simultaneous decisions

analyst following increases more in industries with regulated disclosure

2. Determinants of Analyst Following and Institutional

2.1 DETERMINANTS OF ANALYST FOLLOWING

We do not investigate this link empirically because we lack data on the

other factors in our statistical model.

industry, SICGRO, as the net change in the number of firms in the

must be prudent.14 Percent-of-assets compensation arrangements com-

+ a4 MKTARETit+ a5 DLNSHRSit + a6 DBETAit

3. Sample Selection and Data Description

Panel B: Selection of Industries

Panel C: Data Availability

AMEX and NASDAQ files. Since we use industry characteristics in our

Panel B: Summary Statistics on Variables' Sample Distributions2

D#ANLST 0.71 2.07 0.00 -9.00 13.00

Grumman Corp., Toys R Us, Jaguar PLC). While it is not a clearly

C| oCg ^$ ?o~ C~lloH C2

Coefficient Estimates (t-statistics in parentheses)

Regression Summary Statistics

appear to shun systematic risk as we suggested, since DBETA has a

Regression Summary Statistics

and negatively related to volatility and lagged analyst following. As

positively related in 1985-87. Since the purpose of a holdout sample is

19We used the Compustat Primary-Supplementary-Tertiary, Full Coverage, and Research

BADRINATH, S. G., G. D. GAY, AND J. R. KALE. "Patterns of Institutional Investment and

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