The value of sell-side equity analyst research is a source of ongoing debate.  The research suggests that analysts provide valuable information to investors through earnings forecasts and results analysis. But at the same time, there continues to be the perception in business – and among media –  that analysts are under too much pressure to be straight-talking with organisations, too keen to curry favour by delivering optimistic forecasts.

Analysts are seen as being incentivised to provide positive commentary on firms by the offer of access to management, and to win investment banking mandates for their employers; and reluctant both to respond negatively to poor results,  and to criticise management.

With these pressures in mind, we looked at whether there are circumstances where analysts are more likely to provide the kind of rigorous and critical research that investors rely on.  Insights from psychology suggest that people are more likely to seek in-depth explanations for events that are unexpected and/or disappointing, because such events challenge individuals’ expectations and previously assumed knowledge. We used this theory to test whether analysts act differently when firm’s quarterly earnings results are unexpectedly poor.

We predicted that unexpected bad news will cause analysts to engage in more rigorous and critical analysis of results compared with situations when performance expectations are met or exceeded.  To test this, we compared analyst commentary in response to quarterly earnings announcements where earnings missed expectations against commentary in quarters where earnings met or exceed expectations.

We examined the content of both analysts’ published research notes and questions posed to management at conference calls to determine whether analysts’ probed more deeply and were more critical after poor earnings news. Using two separate sources of analyst output allows us to examine a wider overview of analyst activity than either source would independently. We expect analysts to be more spontaneous and unguarded in conference calls compared with the prepared and more measured commentaries evident in research notes.

Analysts use expectations of future cash flows and assessments of risk or uncertainty to develop firm valuations. Negative earnings news may cast doubts on these, so we expect analysts to probe firm prospects more carefully and place less reliance  on using past results to predict future performance. Analysts may also challenge management more as part of a reappraisal of the risk associated with management and strategy.  Whether or not this incentive is offset by pressures to cultivate and maintain amicable relationships with management is an empirical question on which our research seeks to shed light.

Results confirmed that analysts show significantly greater levels of rigor and criticality after negative earnings news. In research notes, negative comments about firm prospects and management increase by 200 and 400 percent, respectively, compared to quarters where the same firm met or exceeded earnings expectations. Similarly, the fraction of conference call questions probing forward-looking threats and challenging management increases by 25 and 51 percent, respectively.  We also find that conference call questions display greater levels of uncertainty and that analysts use more robustly negative language in conference calls than in research notes.

Interestingly, we found evidence of negatively toned research notes and challenging questions at conference calls even in response to positive earnings news, albeit at much lower levels.  These findings do not support the stereotype of analysts producing anodyne research lacking in critical insight.

Collectively our results provide direct evidence that analysts’ work is not consistently bland, over-optimistic and uncritical. Instead we show that when incentives for rigor and criticality are high, analysts are prepared to ignore institutional pressures and challenge management directly about performance and to give investors an objectively negative view of the firm through their research notes.

Catherine Salzedo, Steven Young and Mahmoud El-Haj, Lancaster University Management School, www.lancaster.ac.uk/lums. The full research paper can be found here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2433019