Why do security analysts issue overly positive recommendations? One explanation is that analysts pick their favorite stocks and are truly too optimistic. An alternative explanation is that analysts distort recommendations to maximize trade commissions and underwriting business, particularly if affiliated with an underwriter. We use a novel approach to assess the relative importance of both explanations, exploiting the concurrent issuance of recommendations and earnings forecasts. We first show that small traders follow recommendations but not forecast updates; large traders discount recommendations and follow forecasts. As a result, analysts with conflicting interests may distort recommendations upwards to trigger small-investor purchases and to please management, but may not distort forecasts. They may in fact distort forecasts downwards shortly before the announcement to allow management to beat the forecast. If analysts are, instead, truly too optimistic they should express their positive view both in recommendations and in forecasts. We find that affiliated analysts issue more optimistic recommendations but more pessimistic forecasts than unaffiliated analysts. Moreover, the affiliated analysts who have the most positive recommendations outstanding also give the most negative forecasts, consistent with heterogeneity in incentive distortion but not in optimism.
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This paper was revised on October 10, 2007
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