Devin M. Shanthikumar

The Stock Selection and Performance of Buy-Side Analysts

Prior research on equity analysts focuses almost exclusively on those employed by sell-side investment banks and brokerage houses. Yet investment firms undertake their own buy-side research and their analysts face different stock selection and recommendation incentives than their sell-side peers. We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts from mid-1997 to 2004. We find that the buy-side firm’s analysts issue less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicate that annualized buy-side Strong Buy/Buy recommendations underperform those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings are driven by differences in the stocks recommended and their market capitalization. After controlling for these selection effects, we find no difference in the performance of the buy- and sell-side analysts’ Strong Buy/Buy recommendations.

The Geographic Dispersion of Google Search and the Market Reaction to Earnings Announcements

We examine the impact of distance on investor search behavior, and the effect of geographic dispersion of investor search on the stock market response around earnings announcements. We find significant “local bias” in Internet search behavior. While more visible firms have more geographically dispersed search, there is significant additional variation in search dispersion. Motivated by theories of network effects and psychological distance, we predict and find that firms with a higher geographic dispersion of search experience higher abnormal trading volume, lower abnormal bid-ask spreads, and larger earnings response coefficients at the time of earnings announcements, as well as weaker post-earnings-announcement drift. These results hold both cross-sectionally and when examining changes in dispersion or propensity-score matched pairs. In addition, path analysis suggests that both network effects and investor psychology are significant drivers of the return results. Overall, our results suggest that geographic proximity affects search, and that firms with more geographically dispersed search experience better market responses to earnings announcements.

CEO Incentives and New Product Development: Insights from Trademarks

New product development is critical for firms to achieve and maintain growth and performance. We build a novel dataset of 123,545 USPTO trademark registrations by S&P 1500 firms from 1993 to 2011 to study whether and how CEO compensation risk incentives motivate new product development. Using the OECD’s broad definition of innovation that includes new product development, our tests offer evidence on how risk incentives affect innovation of new products. We find that the number of trademarks increases with the fraction of compensation in the form of stock options, the convexity of incentives, and unvested stock options, both in low-patent (non-high-tech) and high-patent (high-tech) industries. Using a revised accounting rule, SFAS 123(R), as an exogenous shock, we find that reductions in stock option compensation cause reductions in trademark creation. Overall, the evidence indicates that CEO risk-taking incentives are important drivers of product development.

Private Firm Investment and Public Peer Misvaluation

We examine whether misvaluation of publicly traded industry peers is associated with capital expenditures by privately-held firms. An economic competition hypothesis predicts a negative relation because misvaluation-induced new investment by public firms crowds out investment by private firms when they share common input or output markets. An alternative shared-sentiment hypothesis predicts a positive relation because private firm stakeholders share in the sentiment associated with misvaluation in public markets. Misvaluation is proxied using both the price-to-fundamental ratio and an exogenous instrument obtained from mutual fund flows. The evidence is consistent with the shared-sentiment hypothesis, and robust to alternative treatments for growth opportunities. We find expected cross-sectional variation in the strength of the positive relation between public-peer misvaluation and private firm investment. Our results indicate that private firms finance misvaluation-induced investment primarily internally or externally with debt, not equity. Finally, misvaluation-induced investment increases future return on investment for private firms in contrast with public firms. Overall, these findings suggest that overvaluation in public markets increases private firm investments and has beneficial effects on private firm investments by relaxing financing constraints.