On the Structure of Analyst Research Portfolios and Forecast Accuracy

Abstract

ABSTRACT This study provides insights into the forces and constraints that shape analyst research coverage along country and sector dimensions and the impact of the structure of an analyst's portfolio on forecast accuracy. We find that analyst specialization by country and sector is sensitive to the extent to which firms "within" a country or sector and firms "across" country-sectors are exposed to common economic forces, the potential for revenue generation, and broker culture. Our tests indicate that existing research on the relation between analyst portfolio structure and forecast accuracy may suffer from an endogeneity bias. We use our analysis of analyst specialization to develop controls for this bias. Once we employ these controls, we find that country diversification is associated with superior forecast accuracy. However, the relation between sector diversification and forecast accuracy is context-specific. Specifically, sector diversification enhances forecast accuracy in an international context, while it detracts from forecast accuracy in a domestic U.S. context. Copyright (c), University of Chicago on behalf of the Accounting Research Center, 2009.

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On the Structure of Analyst Research Portfolios and Forecast Accuracy




Omesh Kini
Robinson College of Business
Georgia State University
e-mail: okini@gsu.edu


Shehzad Mian
Goizueta Business School
Emory University
e-mail: shehzad_mian@bus.emory.edu


Michael Rebello
A.B. Freeman School of Business
Tulane University
e-mail: mrebello@tulane.edu


Anand Venkateswaran
College of Business
Northeastern University
e-mail: anand@neu.edu



Latest Draft: November 2006






We would like to thank Sudipta Basu, George Benston, Lawrence D. Brown, Diane Denis, Karl
Lins, Mike Lemmon, Daphne Lui, Stan Markov, Grace Pownall, Raghu Rau, Jeremy Stein, and
Gregory Waymire. Discussions with Ashish Bhutani (Lazard), Mathew Chapin (UBS Warburg),
Devashish Chopra (formerly with Citi-SSB Asset Management), and Dan Meade (formerly with
Credit Suisse First Boston) have given us valuable insights from a practitioner’s perspective. We
thank IBES for providing us permission to use their database and Ajay Negi of IBES for
patiently answering all our questions regarding IBES International. We acknowledge valuable
research support from Terry Bennett and Ron Harris. The usual disclaimer applies.

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On the Structure of Analyst Research Portfolios and Forecast Accuracy





ABSTRACT

This paper provides insights into the determinants of the structure of analyst research portfolios,
and then investigates the impact of portfolio structure on forecast accuracy. Specifically, we
study the forces and constraints that shape analyst research coverage along country and sector
dimensions. We find that analyst specialization is sensitive to the extent to which firms within a
country or sector are exposed to common economic forces, the potential for revenue generation,
and broker culture. Further, in contrast to the existing research on the relationship between
analyst portfolio structure and forecast accuracy, we find that complex research portfolios
promote forecast accuracy once we control for the endogeneity in portfolio choice. Overall, our
results are consistent with brokerages organizing analyst research coverage in a pragmatic
manner. While maintaining a focus on the economic viability of the research production
process, the organization of brokerage research is consistent with producing high quality
research.


JEL Classification: G24; G15; L23
Keywords: International Analyst Coverage, Brokerage Organization, Forecast Accuracy, Capital
Markets

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On the Structure of Analyst Research Portfolios and Forecast Accuracy


Recent research has documented that U.S. analysts frequently cover stocks from
multiple sectors, and international analysts often follow stocks belonging to both different
countries and sectors (see, e.g., Clement and Tse (2005), Boni and Womack (2005), and Sonney
(2005)). Recognizing that this diversity in research portfolios can affect analysts’ research
output, researchers have attempted to assess its effect on analyst performance as captured by
forecast accuracy (see, e.g., Clement (1999), and Clement, Rees, and Swanson (2003)). Existing
studies, however, have treated the structure of analysts’ research portfolios as an exogenous
variable which may cause their results to be subject to a selection-bias given that analyst
research portfolios are the result of choices made by analysts and their employing brokerages
(see, e.g., Clement (1999), and Gilson, Healy, Noe, and Palepu (2001)).
In this paper, we examine the impact of portfolio structure on analyst forecast accuracy
while controlling for selection biases resulting from portfolio choices made by
analysts/brokerages. To accomplish this, we first examine the determinants of one aspect of
analyst organization—the choice between either single- versus multi-country coverage or
single- versus multi-sector coverage. We then use this analysis as a means of controlling for
self-selection in our examination of the relation between forecast accuracy and portfolio
diversity in the country and sector dimensions.
We employ a comprehensive sample of international (non-U.S.) analysts from 53
countries over the period 1996 through 2002. We focus on international analysts for the
following reasons. First, there is limited evidence on both the determinants of research portfolio
structure and forecast accuracy for international analysts. This omission in the literature
becomes all the more glaring once we consider the fact that international analysts account for

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approximately 60% of all analysts in the IBES database. Second, by using international analysts
we add a dimension that would be missing in an analysis of only U.S. analysts since analysts in
our sample can diversify by following firms either across countries or sectors.
To examine the choice of single- versus multi-country (single- versus multi-sector)
coverage, we estimate binomial logistic regressions to explain specialization of analyst
portfolios by country (sector). We find that increased commonalities among stocks in a country,
as proxied by common variation in returns, increase the likelihood that analysts will specialize
by country. Similarly, increased commonalities among stocks in a sector promote sector
specialization. We also find that higher country equity market capitalization increases the
likelihood of country specialization, while a larger total equity market capitalization of a sector
in a particular country (country-sector market capitalization) increases the likelihood that
analysts will cover firms in a single sector. Finally, we find that international analysts
employed by a U.S. brokerage are more likely to specialize by sector and less likely to specialize
by country.
We then consider the impact of portfolio choice on forecast accuracy. To establish a
benchmark, we first follow the extant literature and treat portfolio structure as an exogenous
variable in our tests. We find that neither country diversification nor sector diversification has
an effect on forecast accuracy. These results are similar to those documented by Clement, Rees,
and Swanson (2003) in their investigation of Canadian, German, Japanese, and U.K. analysts.
Next, we investigate the relation between forecast accuracy and portfolio organization by
employing a two-stage Heckman methodology that controls for research portfolio choice.1 The
results from this analysis support our central thesis that self-selection can have a significant

1 See, for example, Heckman (1978; 1979), Heckman and Robb (1986), and Greene (2000) for a general
approach to estimate a causal parameter in the face of selection bias. Also see, Li and Prabhala (2005) for a
survey on the use of self-selection models in finance research.

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impact on analyst forecast accuracy. Further, once we employ the Heckman procedure to
control for endogeneity in analyst portfolio choices, we find that diversified portfolios boost
analysts’ forecast accuracy. This is the case whether we consider portfolio diversification across
either countries or sectors. These findings stand in contrast to the results in earlier studies
which document that, when analyst organization is treated as an exogenous variable, portfolio
diversification either has no impact or detracts from forecast accuracy (see, e.g., such as those of
Clement (1999), Clement, Rees, and Swanson (2003), and Clement and Tse (2005)).
Our explanation for these results is as follows: A focused portfolio should enable an
analyst to enjoy economies of scale in information acquisition and production. The time and
effort savings resulting from these scale economies could be transferred to gaining a more
thorough understanding of the companies she follows and, thus, enable the analyst to construct
more accurate forecasts. By switching to a diversified portfolio, an analyst will lose some scale
economies but gain exposure to complementary information that is needed to research
companies in other countries or sectors. By accessing and analyzing this complementary
information, the analyst may obtain a more complete picture of the economic forces at play, and
thereby generate more accurate forecasts. The benefit from accessing complementary
information is likely to dominate the resulting loss in scale economies when the possibility of
harnessing scale economies by maintaining a focused portfolio is relatively low. Thus, analysts
will tend to follow diversified portfolios when the cost of diversification, i.e., the loss of scale
economies, is relatively low. This is precisely what our results seem to suggest as (i) the
diversified portfolios in our sample boost forecast accuracy and (ii) analysts tend to follow
diversified portfolios precisely when the common variation in returns, our proxy for the
presence of scale economies, is relatively low for stocks belonging to the same country (sector).