Analyst Credibility: The Investor's Perspective [*].(Brief Article)

Analysts serve a vital role in the financial markets. It is the analyst's independent perspective that monitors and interprets the agency relationship between management and shareholders, thus reducing agency costs (Jensen and Meckling, 1976). However, the investment decision makers relying on analysts' reports extend beyond management or existing shareholders to include prospective shareholders, investment bankers, and the analyst profession. The analyst profession thrives because of its reputation for independent, credible assessments of firm value. The work of each analyst collectively defines the profession's value to financial markets (Regan, 1993). Conversely, investment bankers are keenly concerned about the value analysts place on companies with upcoming stock issues as they seek to manage the new public offering. Hence, it is a diverse constituency that relies upon the work of analysts as a key source of information and analysis.

Because the analyst's work is so influential to such a broad group of decision makers, some attempt to manage their relationship with the analyst to influence the analyst's assessment. For instance, it is well documented that management actively seeks to provide analysts with a perspective that advances their desired public image (Dutta and Trueman, 1997; Galant, 1990; Schultz, 1990). Most frequently analysts are pressured to offer favorable recommendations or at least temper negative opinions. No fewer than 61% of analysts responding to a survey reported personal experience with management threatening reduced future access to the company, severing business ties to the investment firm, lawsuits, and even having the analyst terminated (Galant, 1990). Although this behavior is pervasive, it is considerably more intense during recessions and when companies are suffering poor financial performance (Schultz, 1990). Recent academic research models the analyst-management relationship as one where management avidly shares information with analysts when the analyst is optimistically pre-disposed to the company, but withholds information when the analyst exhibits pessimistic views of the firm's prospects (Dutta and Trueman, 1997). Within the analyst's own firm, evidence exists that the separation between the research and investment banking departments, commonly known as the Chinese Wall, may be permeable (Hayward and Boeker, 1998; Lin and McNichols, 1997; Hirst et al., 1995). When an investment banking client is the subject of the analyst's research, internal pressures encourage the analyst to offer a favorable recommendation/forecast of the client's prospects.

Financial markets view the analyst's contribution as a form of risk reduction (Jensen and Meckling, 1976). By providing an unbiased assessment of the firm's future potential and evaluating managerial skill, analysts reduce the risks inherent to outside stockholders who cannot observe the actions of management. This lowers the return demanded by the market. Analysts also serve to enhance market efficiency by acting as a conduit through which value-relative information can be disseminated effectively from management to investors. Hence, both management and shareholders have a vested interest in the quality of the analyst's work and the perceptions of the profession in the public's eye. The consequences of acquiescing to the pressure from one constituent can ultimately be detrimental to all constituents if it appears to others that the demands of one have been accommodated in such a way that the analyst's independence is compromised. It is the independent analysis that the analyst "sells" to the market and if t he analyst does not maintain credibility with constituent groups the value of the analyst is impaired. If investors perceive analysts behaving systematically to conform to pressures from management and others they may begin to question the credibility of all analysts. As presented earlier, once the professions' credibility is marred, its role in enhancing market efficiency and reducing agency costs is diminished (Regan, 1993). In essence, pressures on analysts to issue favorable reports create a short-term benefit to certain constituents in exchange for a long-term cost for all stakeholders.

The goal of this research is to begin to explore whether investors expect analysts to produce optimistic forecasts and how investors behave given their expectations. Few studies have experimentally examined the effect of individual investors' beliefs on their investment decision-making behavior. Most studies of behavior are centered at the aggregate market level. However, without analyzing behavior at the individual level, it is difficult to construct a full picture of the impact that analyst forecasts have upon the market. The experiment undertaken here focuses on the issue of optimism and seeks to determine whether investors react negatively to analyst optimism given that much has been written about pressures on analysts to present companies they follow in a favorable light. Individual investors have a small voice relative to other stakeholder constituencies but they are also a group that relies upon the work of analysts to provide inputs into their own analysis (Epstein and Pava, 1993). Hence, this resear ch is an important first step towards discovering how investors incorporate the information provided by analysts.

Specifically, reports of external pressures may have created the perception among individual investors that analyst optimism is a consequence of such pressures rather than an independently formed opinion. Such perceptions, regardless of analysts' skills or intentions, may adversely affect analysts' credibility.

THEORETICAL FOUNDATION FOR CREDIBILITY ASSESSMENTS

Essentially this study examined the perceptions of individual investors towards analysts after having observed their behavior. When people attempt to understand observed behaviors, they focus on personal or situational factors as explanations for the actions. The goal of this study is to identify the underlying cause of the observed behavior to facilitate the appropriate reaction in the given setting. This act of attributing cause to actions is a robust phenomenon, commonly occurring whenever people find it necessary to infer the motivations of others (Kelley, 1973; Jones and Davis, 1965; Heider, 1944). Attribution Theory is the cornerstone that predicts how people will construct their inferences of others.

When making a causal attribution there are a number of factors that when present or absent facilitate the observer's ability to determine the motivations underlying the actor's actions. The first is consensus (Kelley, 1973). When others in similar situations have behaved in the same way, the presence of that situation is likely to result in the same behavior for the individual actor. Thus, when the behavior is observed, the attributed cause is more likely to be the situational events rather than personal factors. In the context of analyst forecasting, it is widely reported that analysts have responded to external pressures to issue optimistic forecasts (Hayward and Boeker, 1998; Lin and McNichols, 1997; Galant, 1990). Hence, an investor observing an optimistic analyst forecast will be likely to attribute the underlying basis for that optimism as the persistent pressures on the analyst, rather than the analyst's private beliefs based on independent research.

When assigning motive to observed actions it is necessary to look at the actor's ability to freely choose his/her behavior. If the actor's behavior is constrained by forces beyond individual control then the causes underlying the actions will be attributed to the external forces, rather than the personal choice of the actor (Jones and Davis, 1965). For instance, if the analyst is experiencing pressure to issue optimistic forecasts, his/her freedom to act independently is constrained. Optimistic forecasts are then interpreted as a consequence of such pressures rather than the individual judgment of the analyst, which impairs the credibility of the analyst's forecast. It is irrelevant whether the analyst has ceded to the pressures; it is the perceptions of external influence that drive the causal attribution (Jones and Davis, 1965).

The observer implicitly assigns a probability distribution to each potential cause as the possible reason for the observed behavior. If the desirability of outcome is high, the cause will receive a higher probability than those of lesser desirability (Jones and Davis, 1965). Analysts depend on interaction with management as a key source for the information they use to make their predictions of the company s prospects. One of the sanctions management uses when analysts issue forecasts that are not favored by management is to curtail the analyst's access to employees of the company (Galant, 1990). Hence, the combination of the analyst's need for management access and the threats to that access if the analyst offends the company indicate that it is reasonable to expect an investor observing an optimistic forecast to assign a high probability to managerial pressures as the cause of the optimism.

Finally, it is important to examine the actions of the actor with respect to the expected role behavior as evidenced from their prior choices (Jones and Davis, 1965). The reasons for analyst optimism have been widely reported as external pressures. These prior choices are important to the investor when the underlying cause for observed optimism is being assessed. If the investor expects the analyst to be optimistic (i.e., perform in-role behavior) the reasons are assumed to be (1) to gain implicit approval from authority, (2) to demonstrate they know what is required of them, and (3) to avoid embarrassment (Jones and Davis, 1965). Out-of-role behavior--pessimistic forecasts--are more telling. They are more likely to occur because of the analyst's motivation to act independently regardless of the sanctions. Hence, it is necessary to compare in- and out-of-role behavior to determine the extent to which it is expected role behavior that influences investors' credibility assessments.

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