analysts are not in a fiduciary relation with the investing public). The as-
sumption these parties make, naturally, is that analysts’ advice is unbiased
and valuable to investors and the markets as a whole. The hope is that se-
curity analysts will be the market’s financial “watchdogs,” keeping man-
agements honest and focused through their criticism as well as their praise.
If analysts are producers of valuable information, then they will strengthen
the integrity and efficiency of the securities market.
As part of their marking efforts, investment banks and analysts claim
that their views are unbiased. For example, Morgan Stanley’s response to the
accusation that the corporate finance division “put pressure on the firm’s
research analysts to influence their view of the stock” (The Wall Street
Journal, July 14, 1992) is exactly along these lines. Morgan Stanley argued
that customers of its equity research report recommendations are too so-
phisticated to accept research influenced by investment banking pressure,
and thus there is no reason for the corporate finance division to exert any
pressure on research analysts.
What does the empirical evidence tell us about these issues? On average,
the value of analysts as information gatherers ismodestly justified, since their
pronouncements move stock prices to new price equilibria that are not mean
reverting. It is reasonable to say, therefore, that analysts do make the market
more efficiently priced. But as we also point out, their pronouncements and
advice are not unbiased. Their projections are overly optimistic and they
issue many more buy than sell recommendations, at least partially as part of
their marketing efforts. The corporate finance arm of the bank, corporate is-
suers and, to a lesser extent, institutional investors prefer to hear positive
analysis rather than negative. As Ken Lay, former chairman of now bankrupt
Enron so blatantly put it in criticizing Merrill’s Enron analyst who had main-
tained the unattractive “hold” recommendation on his firm (as reported in
The Wall Street Journal), “We are for our friends.” Later, when that analyst
was replaced with another who upgraded his Enron recommendation, Mer-
rill landed substantial investment banking business from the company.^12
If investors are aware of this marketing bias and discount it appropri-
ately, then, to some extent, no harm is done: Analysts gather information,
issue recommendations (albeit biased) and investors, recognizing the bias,
discount their recommendations, especially when banking relationships
exist. But the empirical evidence suggests that investors do not recognize
the full extent of the bias: despite the fact that the long-term performance
after positive recommendations by conflicted analysts is negative, the im-
mediate market reaction is positive. At least some investors cannot separate
bias from valuable information content.
410 MICHAELY AND WOMACK
(^12) The Wall Street Journal, “Merrill Defends Ties to Enron Before Congress—Yet a Veteran
Analyst’s Perspective On the Firms’ Dealings Shows Pressures From Major Clients,” July 31,
2002, p. C1.