Reuven Lehavy

Can Stock Recommendations Predict Earnings Management and Analysts' Earnings Forecast Errors?

In this article we present evidence that a firm’s stock price sensitivity to earnings news, as measured by outstanding stock recommendation, affects its incentives to manage earnings and, in turn, affects analysts’ ex post forecast errors. In particular, we find a tendency for firms rated a Sell (Buy) to engage more (less) frequently in extreme, income-decreasing earnings management, indicating that they have relatively stronger (weaker) incentives to create accounting reserves especially in the form of earnings baths than other firms. In contrast, firms rated a Buy (Sell) are more (less) likely to engage in earnings management that leaves reported earnings equal to or slightly higher than analysts’ forecasts. Our empirical results provide direct evidence of purported, but heretofore, weakly documented equity market incentives for firms to manage earnings. They are also consistent with a growing body of literature that finds analysts either cannot anticipate or are not motivated to anticipate completely in their forecasts firms’ efforts to manage earnings. ∗University of North Carolina;†University of Michigan. Special thanks to Robert Bushman and Raffi Indjejikian for many useful discussions and comments. We also appreciate the comments of Fran Ayers, Sudhakar Balachandran, Mary Barth, Sudipta Basu, Bill Beaver, Peggy Bishop, John Core, Tom Dykman, John Jacobs, Rick Lambert, Bill Lanen, Carolyn Levine, Chris Noe, Maria Nondorf, Pat O’Brien, Krisna Palepu, Christine Petrovits, Cathy Schrand, Abbie Smith (editor), Brett Trueman, Jim Wahlen, Beverly Walther, two reviewers, and seminar participants at Columbia University, Cornell University, Harvard University, the London Business School, Rice University, Stanford University, Tel Aviv University, the University of California–Berkeley, the University of Chicago, the University of North Carolina, the University of Oklahoma, the University of Pennsylvania, the University of Utah, the University of Waterloo, Mellon Capital Management, Barclays Global Investors, the First Annual Utah Winter Accounting Conference, and the 2001 Financial Management Association Paris meetings.

Investor Recognition and Stock Returns

It is well established that investment fundamentals, such as earnings and cash flows, can explain only a small proportion of the variation in stock returns. We find that investor recognition of a firm’s stock can explain relatively more of the variation in stock returns. Consistent with Merton’s (J Finance 42(3):483–510, 1987) theoretical analysis, we show that (i) contemporaneous stock returns are positively related to changes in investor recognition, (ii) future stock returns are negatively related to changes in investor recognition, (iii) the above relations are stronger for stocks with greater idiosyncratic risk and (iv) corporate investment and financing activities are both positively related to changes in investor recognition. Our research suggests that investors and managers who are concerned with firm valuation should consider investor recognition in addition to accounting information and related investment fundamentals.

Analyst Information Discovery and Interpretation Roles: A Topic Modeling Approach

Evidence in extant literature on the information interpretation and information discovery roles of sell side analysts is inconclusive. While studies in this literature employ different research designs and sample periods, they uniformly rely on equity market reaction to capture the analyst information role. Because equity market reaction may be incomplete or confounded by the simultaneous release of other information (e.g., earnings release and conference calls), this design choice may have hindered researchers’ ability to identify the precise information role analyst play in the capital market. In this study, we introduce novel measures of analyst information discovery and information interpretation that are based on the thematic content of a large sample of analyst reports. These measures allow us to explicitly identify and empirically quantify the amount of information analysts discover and interpret in their reports, without referencing to the equity market reaction. Consistent with information discovery, we document that analyst reports issued promptly after conference calls contain a significant amount of discussion on exclusive topics that were not referred to in the conference calls. Moreover, when analysts do discuss the topics covered in the conference call, they frequently use a different vocabulary from that used by managers, consistent with their information interpretation role. Cross-sectionally, we document evidence that analysts not only respond to investor demand for their services and play a greater information discovery role when firms’ proprietary cost is high, but also provide more interpretation when the processing cost of the information in conference calls is high. Finally, we show that investors value both the information interpretation as well as the information discovery role played by analysts.

Overnight Returns and Firm-Specific Investor Sentiment

We examine the suitability of using overnight returns to measure firm-specific investor sentiment by analyzing whether they possess characteristics expected of a sentiment measure. We document short-term overnight-return persistence, consistent with existing evidence of short-term persistence in the share demand of sentiment-influenced investors. We find that short-term persistence is stronger for harder-to-value firms, consistent with existing evidence that sentiment plays a larger role for such firms. We show that stocks with high (low) overnight returns underperform (outperform) over the longer term, consistent with prior evidence of temporary sentiment-driven mispricing. Overall, our evidence supports using overnight returns to measure firm-specific sentiment.

Management Expectations and Asymmetric Cost Behavior

We examine the effect of managerial expectations on asymmetric cost behavior in the context of resource adjustment costs and unused resource constraints. Our results show that the incremental impact of managerial expectations on cost asymmetry is the strongest when adjustment costs and unused resources are high. Conversely, when both are low, expectations have no impact on the degree of cost asymmetry. Furthermore, when the degree of unused resources is high, managerial pessimism is associated with anti-sticky cost behavior but managerial optimism reverses this relation and results in cost stickiness. Finally, we find the strongest cost stickiness under the following: a low degree of unused resources, a high magnitude of adjustment costs, and optimistic managerial expectations; by contrast, the strongest cost anti-stickiness occurs when all three drivers operate in the opposite direction. Our study suggests that additional economic determinants should be considered when assessing the impact of managerial expectations on cost behavior.

A Contextual Analysis of the Impact of Managerial Expectations on Asymmetric Cost Behavior

We examine the effect of managerial expectations on asymmetric cost behavior in the context of resource adjustment costs and unused resource constraints. Our results show that the incremental impact of managerial expectations on cost asymmetry is the strongest when adjustment costs and unused resources are high. Conversely, when both are low, expectations have no impact on the degree of cost asymmetry. Furthermore, when the degree of unused resources is high, managerial pessimism is associated with anti-sticky cost behavior but managerial optimism reverses this relation and results in cost stickiness. Finally, we find the strongest cost stickiness under the following: a low degree of unused resources, a high magnitude of adjustment costs, and optimistic managerial expectations; by contrast, the strongest cost anti-stickiness occurs when all three drivers operate in the opposite direction. Our study suggests that additional economic determinants should be considered when assessing the impact of managerial expectations on cost behavior.

The Tone of Management Forward Looking Statements and Asymmetric Cost Behavior

We examine the effect of managerial expectations on asymmetric cost behavior in the context of resource adjustment costs and unused resource constraints. Our results show that the incremental impact of managerial expectations on cost asymmetry is the strongest when adjustment costs and unused resources are high. Conversely, when both are low, expectations have no impact on the degree of cost asymmetry. Furthermore, when the degree of unused resources is high, managerial pessimism is associated with anti-sticky cost behavior but managerial optimism reverses this relation and results in cost stickiness. Finally, we find the strongest cost stickiness under the following: a low degree of unused resources, a high magnitude of adjustment costs, and optimistic managerial expectations; by contrast, the strongest cost anti-stickiness occurs when all three drivers operate in the opposite direction. Our study suggests that additional economic determinants should be considered when assessing the impact of managerial expectations on cost behavior.

The Tension between Management Expectations, Slack Resources, and Adjustment Costs and Asymmetric Cost Behavior

We examine the effect of managerial expectations on asymmetric cost behavior in the context of resource adjustment costs and unused resource constraints. Our results show that the incremental impact of managerial expectations on cost asymmetry is the strongest when adjustment costs and unused resources are high. Conversely, when both are low, expectations have no impact on the degree of cost asymmetry. Furthermore, when the degree of unused resources is high, managerial pessimism is associated with anti-sticky cost behavior but managerial optimism reverses this relation and results in cost stickiness. Finally, we find the strongest cost stickiness under the following: a low degree of unused resources, a high magnitude of adjustment costs, and optimistic managerial expectations; by contrast, the strongest cost anti-stickiness occurs when all three drivers operate in the opposite direction. Our study suggests that additional economic determinants should be considered when assessing the impact of managerial expectations on cost behavior.