Do Security Analysts Reduce Noise?

Abstract

This study investigates the role of security analysts in reducing noise in stock price fluctuations. Using a sample of analyst coverage initiations between 1984 and 2006, the study finds that (1) noise is significantly reduced in the year following the initiation and (2) the extent of the noise reduction is a function of the intensity of analyst coverage during the initiation year. The results suggest that analyst coverage makes stock prices less noisy. Analysts’ noise-reducing ability can have positive consequences for the performance of corporate and portfolio managers who rely on forecasting to make long-term financial decisions.

Much of the stock price fluctuations we observe on a daily basis are, to a large degree, unrelated to company fundamentals. This excess volatility comes at a great cost to market participants because it introduces additional uncertainty about future cash flows.

In this article, we try to explain why stock prices fluctuate more often and more widely than company fundamentals would suggest. In particular, we examine whether the presence of security analysts makes prices more informative (i.e., less noisy). We focus on analysts because of their influence on a large number of investors and their advantage over uninformed investors in terms of experience and training. We hypothesize that analyst coverage helps investors gauge the informational content of company-specific news and reduce the proportion of noise-motivated trades. Our study finds evidence consistent with this hypothesis. We find that residual volatility declines significantly in the year following analyst initiation. We also find that the reduction in noise is directly related to the intensity of analyst coverage. That is, the larger the increase in recommendations or revisions on a stock during initiation, the larger the noise reduction. We also find that analysts’ ability to reduce noise in price fluctuations was diminished during the 1998–2000 TMT (technology, media, and telecommunications) bubble and that this reduction was more pronounced for tech stocks. This reduction might have occurred for two reasons. First, the increase in cash flow volatility and the proportion of intangibles in total assets might have temporarily undermined the effectiveness of fundamental analysis. Second, investor optimism and overconfidence during this period was high; in such an environment, investors are more likely to rely on sentiment than on the advice of informed parties, such as analysts.

Our results confirm traditional views of the role of analyst research as an instrument for investors to better understand the informational content of company-specific news. On a large scale, the noise-reducing ability of analysts can have important consequences for price and capital allocation efficiency. More efficient prices are more informative and allow for more accurate forecasting, which benefits corporate decision makers and investors. For corporations, seeking analyst coverage for their stocks can improve forecasting ability and reduce business risk. For an individual investor or portfolio manager, incorporating stocks covered by analysts into portfolios can reduce the uncertainty of future portfolio returns and help avoid future economic losses.