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

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 2

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) 3

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) 4

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) 5

Research Objectives 1. 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 6

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

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) a. They normally do not have a contrarian style b. Their concurrent forecast revisions on these stocks are significantly smaller, compared to those on other stocks or those from other analysts 8

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 9

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

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:

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

Returns around Flow-Forced Buys and Sells 13

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 14

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 15

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? 16

Table 3: Recommendation Changes and Past Stock Returns 17

Table 3: Recommendation Changes and Past Stock Returns 18

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 19

Table 4: Concurrent Earnings Forecast Revision 20

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) 21

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 22

Table 5: Improvements of Liquidity 23 Other controls included …

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

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

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 26

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

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

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

Table 9: Robustness Check to Address Potential Endogeneity 30

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 31

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? 32

Table 10: Performance of Earnings Forecasts 33

Table 11: Performance of Rec. Changes 34

Table 11: Performance of Rec. Changes 35

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 signal of an analyst’s overall research skill 36