Do Security Analysts Speak In Two Tongues?

Why do security analysts issue overly positive recommendations? We propose a novel empirical strategy to assess the relative importance of the leading explanations: strategic distortion, which reflects incentives to trigger small-investor purchases and please management, and non-strategic distortion, which reflects genuine over-optimism, due to self-selection or credulity. We exploit the concurrent issuance of recommendations and earnings forecasts by the same analyst to distinguish those motivations. While non-strategic distorters express their positive view both in recommendations and in forecasts, strategic distorters issue overly positive recommendations but slightly more negative (“beatable”) forecasts. We find that affiliated analysts who have the most positive recommendations outstanding make the most negative forecasts. The same does not hold for unaffiliated analysts. Affiliated analysts are also more likely to distort forecasts downwards just before earnings announcements, allowing management to beat the forecast. Our findings indicate widespread strategic distortion, though the heterogeneity across analysts is large. We show that strategic distortion is persistent within individual analysts, with potential forensic implications.