Sell-Side Analysts’ Responses to Mutual Fund Trading Pressure

1. Sell-Side Analysts’ Responses to Mutual Fund Trading Pressure • By • Johan Sulaeman (SMU) • Kelsey D. Wei (University of Texas at Dallas) Hong Kong, 2013

2. Mutual Fund Flow-Driven Trading Pressure Coval and Stafford 2007; Frazzini and Lamont, 2008; Lou, 2012 • Mutual funds experiencing extreme capital flows must quickly adjust their positions • Concentrated trading by these funds exerts significant price pressure on the underlying stocks they trade in common • Liquidity provision tends to be slow due to correlated capital shocks and investment constraints faced by potential arbitrageurs

3. Short-Run and Long-Run Financial and Real Effects • Such flow-driven trading pressure exhibits short-term persistence and subsequent reversals that may span up to 18 to 24 months • Prolonged stock mispricing leads to significant real economic impacts • Increased takeover likelihood and reduced investments due to depressed stock price (Edmans et al., 2012; Hau and Lai, 2012; Lou and Wang, 2012) • More equity issues and stock-based acquisitions (Khan et al. ,2012)

4. Why Focusing on Sell-Side Analysts? • Sell-side analysts may be better at recognizing the divergence of market price from intrinsic value • Analyst research has investment value beyond common investment signals (Womack, 1996 and Jegadeesh et al., 2004) • Analyst coverage improves price efficiency (Brennan et al, 1993; Hong et al., 2000; and Ayers and Freeman, 2003)

5. The Unique Role of Analysts in Correcting This Type of Mispricing • The effect of recommendation changes: • No direct trading involved • But may signal to the market about mispricing • Indirectly prompt participation by potential liquidity providers when they follow analyst recommendations. • This role of analysts in stabilizing the financial market could manifest when traditional arbitrageurs face limits of arbitrage • During the 2008 crisis, hedge funds chose to withdraw from the market due to their significantly reduced funding liquidity (Aragon and Strahan, 2012; Ben-David et al., 2012)

6. Research Objectives • To investigate whether equity analysts can help correct mispricing using this “natural experiment” setting • A mispricing event that is largely exogenous to firm fundamentals • Flow-driven fund trading is driven by trading necessity at the fund level, … • … rather than fundamental related information on the underlying stocks

7. Research Objectives 2. To examine the impact of analyst revisions on the price correction process • Improved liquidity? • Accelerated price correction? 3. To examine what drivestheir responses to flow-driven trading pressure • Fund flow-related information? • Overall research skill?

8. Preview of Main Findings I • A group of analysts persistently make recommendation changes in the direction of price correction: upgrade (downgrade) stocks that are subject to mutual fund flow-driven underpricing (overpricing) • They normally do not have a contrarian style • Their concurrent forecast revisions on these stocks are significantly smaller, compared to those on other stocks or those from other analysts

9. Preview of Main Findings II • Price-correcting recommendation revisions help improve stock liquidity and speed up the price correction process following flow-driven mispricing events • greater liquidity recovery and speedier price correction immediately following analyst revisions • Smaller long-run return reversals • These effects are more pronounced for stocks with: • lower institutional ownership • greater earnings forecast dispersion

10. Preview of Main Findings III • Mispricing-Sensitive Analysts have superior performance in general • More accurate earnings forecasts • More influential recommendations regardless of whether the stock is subject to flow-driven mispricing or not

11. Data • Mutual fund data • Trades: Thomson Reuters quarterly holdings • Fund flows and returns: CRSP Mutual Fund Database • Analyst data • Recommendations: I/B/E/S detail recommendation history • Forecasts: I/B/E/S detail one-year ahead earnings forecast history • Control variables • CRSP, Compustat, 13f institutional ownership • Sample Period: 1993-2006

12. Measuring Flow-Driven Trading Pressure • Extreme-flow funds: funds with flowsabove the 90th/below the 10th percentile each quarter • Aggregate flow-driven sales/purchases by funds as • Stock-level flow-driven sales/purchases: • Forced Sell: Forced <percentile (10th) • Forced Buy: Forced>percentile (90th)

13. Returns around Flow-Forced Buys and Sells

14. Is Flow-Driving Trading Pressure Exogenous? • Coval and Stafford (2007) and other studies show that stocks subject to widespread trading by unconstrained funds experience significant price impact with no reversals • When funds are experiencing extreme flows, their tendency to buy/sell good performing versus poor performing stocks is unrelated to the direction of flows • Similar trading pressure is observed when focusing on newly initiated positions as a result of inflow-driven purchases • Similar trading pressure is observed when focusing on fund holdings whose performance is in the opposite direction of fund flows

15. Identify “Mispricing-Sensitive” Analysts • An analyst is considered as mispricing-sensitive in quarter t if • issuing at least one recommendation upgrade (downgrade) in quarter t • for stocks that are subject to mutual fund flow-driven underpricing (overpricing) in either of the preceding two quarters (t-2, t-1) • Each quarter, about 26%-29% of stocks subject to flow-driven trading receive price-correcting recommendations • About 15% of analysts are found to be mispricing-sensitive

16. Are their Recommendation Changes Driven by Mispricing? • The average sell-side analyst tends to follow stock momentum • (Bradshaw, 2004; Jegadeesh et al., 2004) • Are mispricing-sensitive analysts simply those employing a contrarian recommendation strategy?

17. Table 3: Recommendation Changes and Past Stock Returns

18. Table 3:Recommendation Changes and Past Stock Returns

19. Are their Recommendation Changes Driven by Mispricing? • Are mispricing-sensitive analysts’ recommendation changes driven by changes in firm fundamentals? • Kecskes, Michaely and Womack, 2010; Brown and Huang, 2011 • If “mispricing-sensitive” analysts change their recommendations on Fire Sale/Purchase stocks due to mispricing, they should not change their cash flow estimates for these firms

20. Table 4: Concurrent Earnings Forecast Revision

21. The Unique Role of Analysts in Improving Price Efficiency • The speed of price recovery depends on the degree of liquidity provision by other market participants • Analysts face fewer constraints • mutual funds or pension funds: may face correlated liquidity shocks and be constrained by narrow investment mandates (Zhang, 2010) • Hedge funds: may engage in front-running and be constrained by limits of arbitrage (Shive and Yun, 2011; Ben-David, et al., 2010) • Corporate insiders: may have diversification concern and be constrained by black-out periods (Ali, Wei and Zhou, 2011)

22. Unique Role of Analysts in Improving Price Efficiency • Through recommendation changes • Signal to the market about mispricing • Indirectly induce participation by potential liquidity providers • Improve stock liquidity and accelerate price correction • Short-run effect: greater immediate price-correction for stocks with price-correcting recommendation changes • Long-run effect: smaller subsequent return reversals relative to unrevised stocks in the later period

23. Table 5: Improvements of Liquidity Other controls included…

24. Table 6: Short-Term Price Correction Effect of Recommendation Changes

25. Table 7: Effect on Long-Run Return Reversals Less reversals

26. When Would Analysts Matter the Most? • When the potential pool of likely liquidity providers is smaller • Stocks with lower institutional ownership: • Large institutional investors have the resource to provide liquidity • When there is greater uncertainty regarding the mispricing • Stocks with greater earnings forecast dispersion: • Uncertainty regarding the true value of the stock could constrain potential liquidity supply

27. Table 8: Institutional Ownership and Forecast Dispersion Short-term price correction effect

28. Table 8: Institutional Ownership and Forecast Dispersion Long-term price correction effect

29. Table 9: Robustness Check to Address Potential Endogeneity Panel A. The Short-Term Price Correction Effect of Recommendation Revisions

30. Table 9: Robustness Check to Address Potential Endogeneity

31. Potential Sources of Analyst Actions • Private information regarding fund trades • From affiliated mutual funds involved in fire sales/purchases • From affiliated brokerage houses handling mutual fund trades • Superior performance should be limited to Forced-Sell/Buy stocks

32. Potential Sources of Analyst Actions • Better understand the fundamental value of the firm involved • Mispricing-sensitive analysts should have superior research performance on the average stock they cover, regardless of whether it is subject to trading pressure or not • More accurate earnings forecasts? • More profitable recommendation changes?

33. Table 10: Performance of Earnings Forecasts

34. Table 11: Performance of Rec. Changes

35. Table 11: Performance of Rec. Changes

36. Conclusion • Analysts represent a unique force that helps to stabilize the financial market • Their role in improving price efficiency manifests in severe mispricing events such as mutual fund flow-induced trading pressure • The ability to identify mispricing could be a useful signalof an analyst’s overall research skill