Deal Making and Stock Picking: Better Be Optimistic than Good?
Posted: 13 Aug 2006 Last revised: 2 May 2009
Date Written: August 11, 2006
Abstract
The common wisdom about sell-side analysts is that their recommendations tend to be overly optimistic under the pressure from their investment banking colleagues. This paper answers the question whether it is the optimistic analyst or the good analyst (an analyst with superior stock-picking ability) who increases the chance of winning equity mandates for investment banks. We find that analysts' recommendation performance can explain their investment banks' chance of winning future mandates. There is a positive relation between the performance of an analyst's recent buy and strong buy recommendations and his bank's chance of winning future underwriting mandates. On the other hand, the relation between an analyst's optimism and his bank's chance of winning future mandates is weakly negative. The results are robust after controlling for analyst and investment bank characteristics as well as past investment banking relationship. We conjecture that stock-picking earns analysts credibility among investors and this reputation plays an integral role in investment banks' underwriting process. And we document anecdotal evidence to support our conjecture. The key finding of this paper identifies a countervailing force to the well-documented incentives for analysts to be optimistically biased. The current organization structure of investment banks, i.e., the affiliation between equity research and investment banking, has been blamed for analysts' optimism due to the conflict of interest problem. The feedback effect identified in this paper suggests that the affiliation also provide analysts with incentive to be good rather than optimistic.
Keywords: analyst, investment bank
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