The dark side of analyst coverage: The case of innovation

Jie (Jack) He Terry College of Business University of Georgia jiehe@uga.edu (706) 542-9076

Xuan Tian Kelley School of Business Indiana University tianx@indiana.edu (812) 855-3420

This version: February, 2013

* We are grateful for helpful comments from an anonymous referee, Shai Bernstein, Utpal Bhattacharya, Matt
Billett, Daniel Bradley, Yingying Dong, Alex Edmans, Stuart Gillan, Jean Helwege, Harrison Hong, David Hsu, Paul Irvine, Pab Jotikasthira, Sreeni Kamma, Robert Kieschnick, Josh Lerner, Jim Linck, Harold Mulherin, Jeff Netter, Bradley Paye, Avri Ravid, Bill Schwert (the editor), Pian Shu, Tao Shu, Krishnamurthy Subramanian, Yan Xu, Scott Yonker, Xiaoyun Yu, and conference participants at the 2012 Kauffman-RCFS Entrepreneurial Finance and Innovation conference, the 2012 Northwestern University Conference on Entrepreneurship and Innovation, the 2012 China International Conference in Finance, the 2012 Financial Management Association Meetings, and seminar participants at Indiana University, the University of Georgia, and the University of South Carolina. We thank Mike Flores, Yifei Mao, and Zhong Zhang for their competent research assistance. We remain responsible for any remaining errors or omissions.

Electronic copy available at: http://ssrn.com/abstract=1959125

The dark side of analyst coverage: The case of innovation

ABSTRACT We examine the effects of financial analysts on the real economy in the case of innovation. Our baseline results show that firms covered by a larger number of analysts generate fewer patents and patents with lower impact. To establish causality, we use a difference-indifferences approach that relies on the variation generated by multiple exogenous shocks to analyst coverage, as well as an instrumental variable approach. Our identification strategies suggest a negative causal effect of analyst coverage on firm innovation. The evidence is consistent with the hypothesis that analysts exert too much pressure on managers to meet shortterm goals, impeding firms investment in long-term innovative projects. We further discuss possible underlying mechanisms through which analysts impede innovation and show that there is a residual effect of analysts on innovation even after controlling for these mechanisms. Our paper offers novel evidence on a previously under-explored adverse consequence of analyst coverage its hindrance to firm innovation.

Keywords: innovation, analyst coverage, patents, citations, managerial myopia JEL classification: G24, O31, G34

Electronic copy available at: http://ssrn.com/abstract=1959125

1. Introduction How does a nations financial sector affect the real economy? While a highly developed financial market improves the efficiency of capital allocation and thus fosters the growth of innovation, it also gives rise to various adverse externalities such as short-termism, opportunistic behavior, and rent-seeking, which impair firms incentives to invest and innovate. Understanding the role of stock market in motivating firm innovation is an important research question, both because innovation is a crucial driver of economic growth (Solow, 1957) and because publicly traded equity represents one of the most important sources of external capital to facilitate firm investment. A thorough investigation into this issue entails a comprehensive analysis of how various unique ingredients of the stock market affect firms incentives to engage in innovative activities. In this paper, we focus on one key ingredient of the public equity market, namely, financial analysts. Specifically, we study whether financial analysts, an active market intermediary and gatekeeper, encourage or impede firm innovation. Although there has been a growing literature linking various market and firm characteristics to innovation, little is known about the roles played by financial analysts, who not only produce information for the firms they cover but also set external performance benchmarks such as earnings forecasts or stock recommendations. This topic is of particular interest to policy makers as analyst behavior in the U.S. is heavily regulated and altered by securities laws and regulations over time.1 The objective of this paper is to provide the first empirical study that examines how financial analysts causally affect firm innovation, using a rich set of identification strategies. Motivating innovation is a challenge for most firms. Unlike routine tasks, such as mass production and marketing, innovation involves a long process that is full of uncertainty and with a high probability of failure (Holmstrom, 1989). Firms investing more heavily in innovative projects might be forced to make only partial disclosure and subject to a larger degree of information asymmetry (Bhattacharya and Ritter, 1983), are more likely to be undervalued by equity holders, and have a greater exposure to hostile takeovers (Stein, 1988). To protect firms against such expropriation, managers tend to invest less in innovation (in many cases suboptimally) and put more effort in routine tasks that offer quicker and more certain returns, leading up to a typical managerial myopia problem. A potential solution to the distortion of
Recent regulatory changes include the 2000 Regulation Fair Disclosure (Reg FD), the 2002 National Association of Securities Dealers (NASD) Rule 2711, and the 2003 Global Research Analyst Settlement, among others.
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Electronic copy available at: http://ssrn.com/abstract=1959125

investments in innovation due to information asymmetry is financial analysts. Financial analysts collect information from various sources, evaluate the current performance of firms that they follow, make forecasts about their future prospects, and make buy/hold/sell recommendations to current and potential investors. Existing literature suggests that analysts help to reduce information asymmetry along a variety of dimensions (see a detailed discussion of this literature in Section 2). If analysts accurately convey the information of a firms innovative activities to other financial market participants (especially its investors) and help them understand the real value of these long-term investments, then the management of the firm would not refrain from engaging in value-enhancing innovation activities. Therefore, our first hypothesis, the information hypothesis, argues that financial analysts, by reducing information asymmetry of innovative firms, mitigate managerial myopia and encourage firm innovation.2 An alternative hypothesis makes an opposite empirical prediction. Financial analysts are often accused of creating excessive pressure on managers and exacerbating managerial myopia. Manso (2011) shows that tolerance for failure is necessary for effectively motivating and nurturing innovation.3 However, the least thing financial analysts can offer to innovative firms is to tolerate short-term failures, as their job is to forecast near-term earnings and make corresponding stock recommendations.4 Whenever they expect the firms to experience a drop in near-term earnings, they would revise their forecasts downward and make unfavorable recommendations, leading to negative market reactions and potential disciplinary actions against the managers (see, e.g., Brennan, Jegadeesh, and Swaminathan, 1993; Hong, Lim, and Stein, 2000). More importantly, just as Jensen and Fuller (2002) argued, firm managers often conform to excessively aggressive analysts earnings forecasts and accept external expectations as targets
Note that moral hazard models such as Grossman and Hart (1988) and Harris and Raviv (1988) may generate the same prediction as the information hypothesis but through a different channel. These models suggest that managers who are not properly monitored will shirk or tend to invest sub-optimally in routine tasks to enjoy private benefits. If managers derive private benefits from shirking on long-term innovation projects (as suggested by the above theories) and financial analysts serve as an external governance mechanism (Yu, 2008), the above moral hazard argument also implies that financial analysts encourage corporate innovation. 3 Recent empirical research providing supporting evidence for the implications of the failure tolerance theory includes Ederer and Manso (2011), who conduct a controlled laboratory experiment, Azoulay, Graff Zivin, and Manso (2011), who exploit key differences among funding streams within the academic life science, and Tian and Wang (2011), who examine the effect of venture capital investors attitude towards failure on firm innovation. 4 Consistent with the notion that analysts tend to focus more on shorter-term firm performance (as opposed to longer-term performance) when issuing stock recommendations, previous literature has found that stock recommendations depend heavily on analysts expectations of firms future earnings but do not account fully for the information contained in firms long-term implied cost of equity (see, e.g., Aggarwal, Mishra, and Wilson, 2010), and that the informativeness of stock recommendations mainly derives from their revisions (changes) but not their levels (see, e.g., Francis and Soffer, 1997).
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to achieve. In a survey of 401 U.S. Chief Financial Officers (CFOs), Graham, Harvey, and Rajgopal (2005) show that the majority of CFOs in the survey declared that they are willing to sacrifice long-term firm value to meet the desired short-term earnings targets due to their own wealth, career, and external reputation concerns.5 Innovation ranks high on the list that managers consider sacrificing due to its nature of being a type of high-risk, long-term, and unpredictable investment that may not generate immediate financial returns. Taken together, the alternative hypothesis we propose, the pressure hypothesis, argues that financial analysts, by imposing short-term pressure on managers, exacerbate managerial myopia and impede firm innovation. We test the above two competing hypotheses by examining whether financial analysts encourage or impede firm innovation. We make use of observable innovation outputs (i.e., the number of patents granted to a firm and the number of future citations received by each patent) to assess the success of long-term investment in innovation and intangible assets that have traditionally been difficult to observe. Our use of patenting to capture firms innovativeness has now become standard in the innovation literature (e.g., Aghion et al., 2005; Nanda and RhodesKropf, 2012; Seru, 2011). Our baseline tests show a negative relation between analyst coverage (measured by the number of analysts following the firm) and innovation outputs. The results are robust to using alternative subsamples, alternative measures of analyst coverage and innovation, alternative econometric models, and alternative empirical specifications. While the baseline results are consistent with the pressure hypothesis, an important concern is that analyst coverage is likely to be endogenous. Unobservable firm heterogeneity correlated with both analyst coverage and innovation could bias the results (i.e., the omitted variable concern), and firms with low innovation potential may attract more analyst coverage (i.e., the reverse causality concern). To establish causality, we use two different identification strategies and perform a rich set of robustness tests. Our first identification strategy is to rely on two plausible quasi-natural experiments, brokerage closures (Kelly and Ljungqvist, 2011, 2012) and brokerage mergers (Hong and Kacperczyk, 2010), which directly affect firms analyst coverage but are exogenous to their innovation productivity. Using a difference-in-differences (DiD) approach, we show that an
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The adverse consequences for managers to miss the consensus earnings forecasts include significant declines in the firms stock prices (Bartov, Givoly, and Hayn, 2002), reduced CEO bonuses (Matsunaga and Park, 2001), and an increased probability of management turnover (Mergenthaler, Rajgopal, and Srinivasan, 2011).

exogenous decrease in analyst coverage leads to a larger relative increase in innovation output for the treatment group (i.e., firms whose analyst coverage goes down due to brokerage closures or mergers) compared to that for the control group (i.e., similar firms whose analyst coverage does not change) in subsequent years. Further, the negative effect of analyst coverage on innovation is stronger for firms covered by fewer analysts. The DiD results continue to hold under numerous robustness checks using alternative matching criteria, alternative thresholds for the number of patents or analysts, alternative subsamples, and alternative matching methods. A key advantage of this identification strategy is that there are multiple shocks that affect different firms at exogenously different times, which avoids a common identification difficulty faced by studies with a single shock, namely, the existence of potential omitted variables coinciding with the shock that directly affect innovation. Our second identification strategy is to construct an instrumental variable, expected coverage, which is first introduced in Yu (2008), and to use the two-stage least-squares (2SLS) analysis. The 2SLS results confirm the negative effect of analyst coverage on innovation and, more importantly, reveal the direction of potential bias if endogeneity in analyst coverage is not appropriately controlled for. Overall, our identification tests suggest that analysts have a negative causal effect on firm innovation. In summary, our evidence is consistent with the hypothesis that analysts exert pressure on managers to meet near-term earnings targets. In response to such pressure, managers boost current earnings by sacrificing long-term investment in innovative projects that are highly risky and slow in generating revenues. In the final part of our paper, we attempt to identify possible underlying economic mechanisms through which analysts impede innovation. First of all, we consider different types of institutional ownership. We find that an exogenous reduction in analyst coverage leads to an increase in equity ownership by dedicated institutional investors but a decrease in ownership by non-dedicated institutional investors. To the extent that dedicated institutional investors encourage firm innovation to a significantly greater degree than non-dedicated ones (Aghion, Van Reenen, and Zingales, 2013), analyst coverage could impede innovation by attracting more non-dedicated institutional investors than dedicated ones. Next, we find that an exogenous decrease in analyst coverage reduces a firms exposure to takeover attempts. Since Stein (1988) suggests that a firms reduced exposure to takeovers would encourage its innovative activities,

takeover exposure could be another underlying economic mechanism. We also argue that stock illiquidity and the difficulty of implementing accrual-based earnings management techniques could be two additional possible underlying mechanisms. We then show that there exists a residual (i.e., direct) effect of analyst coverage on innovation even after controlling for the above identified economic mechanisms. The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3 describes sample selection and reports summary statistics. Section 4 presents the baseline results. Section 5 addresses identification issues. Section 6 discusses underlying economic mechanisms. Section 7 provides alternative interpretations, discusses caveats of the study, and concludes the paper. 2. Relation to the existing literature Our paper contributes to three strands of literature. First, our paper is related to the emerging literature on finance and innovation. Holmstrom (1989) shows that innovation activities may mix poorly with routine activities in an organization. Robinson (2008) shows how firms with limited internal ability to innovate can form strategic alliances to pursue innovative projects. Manso (2011) suggests that managerial contracts that tolerate failure in the short run and reward for success in the long run are best suited for motivating innovation. The model in Ferreira, Manso, and Silva (2012) argues that it is optimal for firms to be private (literally having no analyst coverage) when they want to innovate. Empirical evidence shows that various economic environment and firm characteristics affect managerial incentives of investing in innovation. Specifically, a larger institutional ownership (Aghion, Van Reenen, and Zingales, 2013), corporate venture capital (Chemmanur, Loutskina, and Tian, 2011), private instead of public equity ownership (Bernstein, 2012), and investors greater tolerance for failure (Tian and Wang 2011) alter managerial incentives and hence help motivate managers to focus more on long-term innovation activities.6 However, existing studies have largely ignored the roles played by financial analysts in motivating innovation. Our paper contributes to this line of research by filling in this gap.

Other studies have examined the effects of product market competition, bankruptcy laws, general market conditions, leveraged buyouts, firm boundaries, and stock liquidity on innovation (e.g., Aghion et al., 2005; Acharya and Subramanian, 2009; Fang, Tian, and Tice, 2012; Nanda and Rhodes-Kropf, 2011, 2012; Lerner, Sorensen, and Stromberg, 2011; Seru, 2011).

Our paper also builds on the empirical literature studying managerial myopia. This literature has shown evidence consistent with managerial myopia in publicly traded firms.7 For example, Asker, Farre-Mensa, and Ljungqvist (2011) find that publicly listed firms exhibit myopia: compared to unlisted firms, they invest less and their investment levels are less sensitive to changes in investment opportunities. Our paper complements their findings by providing a possible reason, namely, the pressure imposed by financial analysts, for why listed firms are more myopic than unlisted firms. Bushee (1998) shows that managers are more likely to cut R&D expenses in response to an earnings decline when a very large proportion of institutional ownership comes from short-term investors. Our paper instead focuses on the effect of financial analysts on managerial myopia. Finally, our paper adds to the large literature debating on the effects of financial analysts. On the positive side, existing literature generally finds that analysts help reduce information asymmetry, have superior predictive abilities, and serve as external monitors to firm managers (e.g., Brennan and Subrahmanyam, 1995; Hong, Lim, and Stein, 2000; Yu, 2008; Ellul and Panayides, 2009), and therefore affect firms investment and financing decisions, stock prices, liquidity, and valuation (e.g., Bradley, Jordan, and Ritter, 2003; Irvine, 2003; Chang, Dasgupta, and Hilary, 2006; Derrien and Kecskes, 2011; Kelly and Ljungqvist, 2011). On the negative side, studies show that analysts give overly optimistic long-term earnings growth forecasts (e.g., Dechow, Hutton, and Sloan, 2000) and near-term earnings forecasts (e.g., Dugar and Nathan, 1995; Hong and Kubik 2003). Moreover, such over-optimism has adverse consequences such as the misvaluation of a firms equity around its corporate financing activities (see, e.g., Bradshaw, Richardson, and Sloan, 2006). Further, Graham, Harvey, and Rajgopal (2005), in a survey study, find that analysts impose too much pressure on managers and induce myopic behavior. The strategy literature has also provided some empirical support to the above survey finding, using anecdotal evidence and small-sample analysis.8 By using a comprehensive and large sample of U.S. public firms and a rich set of identification strategies, our paper contributes to the above

Stein (1989) shows that managerial myopia is present even in a rational capital market, and the degree of myopic behavior will be influenced by capital market incentives that determine the extent to which managers care about short-term prices relative to long-term values. 8 Benner (2010) shows that analysts tend to ignore firms strategies of incorporating new technologies. Benner and Ranganathan (2012) find that negative analyst recommendations are associated with reductions in firm capital expenditure and R&D during times of technological change. However, it is hard to draw causal inferences from the above two papers as they fail to address the identification issue. Moreover, their sample sizes are small (fewer than 200 firms) and are limited to only a couple of industries.

debate by studying the causal effect of analysts on innovation, a special long-term investment in intangible assets, and thus offers novel evidence on a previously under-explored adverse effect of analysts. Our paper is also related to Barth, Kasznik, and McNichols (2001) who make an important attempt to link analyst coverage to firm intangible assets. They show that analyst coverage is positively associated with firm R&D expenditures. Our paper advances this line of inquiry in two important dimensions. First, using both a DiD approach that relies on multiple exogenous shocks to analyst coverage and an instrumental variable approach, our identification strategies allow us to evaluate the causal effect of analyst coverage on firm innovation (as opposed to a partial correlation documented by their study). Second, instead of analyzing R&D expenditures, we focus on patenting activity. Patenting is an innovation output variable, which encompasses the successful usage of all (both observable and unobservable) innovation inputs. In contrast, R&D expenditures only capture one particular observable quantitative input, as argued by Aghion, Van Reenen, and Zingales (2013), and are sensitive to accounting norms such as whether it should be capitalized or expensed, as argued by Acharya and Subramanian (2009). In addition, information on R&D expenditures reported in Compustat is quite unreliable, which may introduce a significant measurement error problem.9 3. Sample selection and summary statistics 3.1 Sample selection The sample examined in this paper includes U.S. listed firms during the period of 19932005. We collect firm-year patent and citation information from the latest version of the National Bureau of Economic Research (NBER) Patent Citation database. Analyst coverage data are obtained from the Institutional Brokers Estimate Systems (I/B/E/S) database. To calculate the control variables, we collect financial statement items from Compustat, institutional holdings data from Thomsons CDA/Spectrum database (form 13F), intraday trades and quotes for constructing stock illiquidity measures from the Trade and Quotes (TAQ) database, stock price information from CRSP, and institutional investor classification data from Brian Bushees

More than 50% of firms do not report R&D expenditures in their financial statements in the Compustat database. However, the fact that a firm does not report its R&D expenditures does not necessarily mean that the firm is not engaging in innovation activities. It may do so out of strategic concerns. Replacing missing values of R&D expenditures with zeros, a common practice in the existing literature, introduces additional noise that may bias the estimated effect of analyst coverage on innovation measured by R&D expenditures.

website (http://acct3.wharton.upenn.edu/faculty/bushee). Finally, we obtain brokerage house merger information from the Securities Data Company (SDC) Mergers and Acquisitions database. The sample selection process ends up with 25,860 firm-year observations used in our baseline regressions. 3.2 Variable measurement 3.2.1 Measuring innovation We extract innovation output data and construct our main innovation variables from the latest version of the NBER Patent Citation database (see Hall, Jaffe, and Trajtenberg (2001) for more details). This database contains patent and citation information from 1976 to 2006. It provides annual information on patent assignee names, the number of patents, the number of citations received by each patent, a patents application year as well as its grant year, etc. To gauge a firms innovation productivity, we construct two measures. The first measure is a firms total number of patent applications filed in a given year that are eventually granted. The reason for using a patents application year rather than its grant year is that previous studies (such as Griliches, Pakes, and Hall, 1988) have shown that the former is superior in capturing the actual time of innovation. However, despite its straightforward intuition and easy implementation, the above measure is unable to distinguish groundbreaking innovations from incremental technological discoveries. Hence, to assess a patents impact more precisely, we construct the second measure of firm innovation productivity by counting the total number of non-self citations each patent receives in subsequent years. Given a firms size and its innovation inputs, the number of patents captures its overall innovation productivity and the number of nonself citations per patent captures the significance and quality of its innovation output. To account for the long-term nature of innovation process, our empirical tests relate firm characteristics in the current year to the above two measures of innovation productivity three years ahead. We adjust the two measures of innovation to address the truncation problems associated with the NBER patent database. The first truncation problem arises as the patents appear in the database only after they are granted. We actually observe a gradual decrease in the number of patent applications that are eventually granted as we approach the last few years in the sample period. This is because the lag between a patents application year and its grant year is significant (about two years on average) and many patent applications filed during these years were still under review and had not been granted by 2006. To adjust the truncation bias in patent
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counts, we supplement the NBER database with the Harvard Business School (HBS) patent database, which contains patents granted through 2010. To the extent that the patent application outcomes have been announced by 2010 for the patents filed by 2006, this approach largely mitigates the patent truncation concern.10 The second type of truncation problem involves citation counts. Patents tend to receive citations over a long period of time (e.g., 50 years), but we observe at best the citations received up to 2006. Following Hall, Jaffe, and Trajtenberg (2001, 2005), the truncation in citation counts is corrected by estimating the shape of the citation-lag distribution.11,12 Neither the NBER nor the HBS patent database is likely to be affected by the survivorship bias. As long as a patent application is eventually granted, it is attributed to the applying firm at the time of application even if the firm later gets acquired or goes bankrupt. Moreover, since patent citations are attributed to a patent rather than the applying firm, the patent granted to a firm that later gets acquired or goes bankrupt can still keep receiving citations long after the firm disappears. We merge the patent data with the analyst coverage sample. Following the innovation literature, we set the patent and citation counts to zero for firms without available patent or citation information from the NBER or the HBS patent database. The distribution of patent grants in our final sample is right skewed, with its median at zero. Due to the right skewness of patent counts and citations per patent, we winsorize these variables at the 99th percentiles and then use the natural logarithm of patent counts (LnPatent) and the natural logarithm of the number of non-self citations per patent (LnCitePat) as the main innovation measures in our analysis. To avoid losing firm-year observations with zero patents or zero citations per patent, we add one to the actual values when calculating the natural logarithm. 3.2.2 Measuring analyst coverage and other control variables We obtain analyst information from the I/B/E/S database. For each fiscal year of a firm,
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For robustness, we follow Hall, Jaffe, and Trajtenberg (2001, 2005) to correct for the truncation bias in patent counts using the weight factors computed from the application-grant empirical distribution. The results are qualitatively similar. 11 Note that the HBS patent database does not help too much to correct for the truncation bias in citation counts, because the HBS database only contains patent information up to 2010 while patents filed in our sample period may keep receiving citations over a long period of time that is well beyond 2010. 12 In an untabulated analysis, we construct an alternative proxy for patent quality that is based on the total number of non-self citations a patent received in the first N (N = 0, 1, 2, 3) years after it is granted. All our results are robust to using this alternative patent quality proxy.

we take the average of the 12 monthly numbers of earnings forecasts given by the summary file and treat that as a raw measure of analyst coverage (Coverage). This measure relies on the fact that most analysts following a firm issue at least one earnings forecast for that firm during the year before its fiscal year ending date and that a majority of them issue at most one earnings forecast in each month.13 We then take natural logarithm of (one plus) this raw measure to construct our main measure of analyst coverage (LnCoverage). Following the innovation literature, we control for a vector of firm and industry characteristics that may affect a firms future innovation productivity. We compute all variables for firm i over its fiscal year t. The controls include firm size (the natural logarithm of book value assets), firm age (the number of years since IPO date), investments in intangible assets (R&D expenditures over total assets), profitability (ROA), asset tangibility (net PPE scaled by total assets), leverage, capital expenditures, growth opportunities (Tobins Q), financial constraints (the Kaplan and Zingales (1997) five-variable KZ index), industry concentration (the Herfindahl index based on sales), institutional ownership, and stock illiquidity (the natural logarithm of relative effective spreads). To mitigate non-linear effects of product market competition on innovation outputs (Aghion et al., 2005), we also include the squared Herfindahl index in our regressions. We provide detailed variable definitions in Table 1 Panel A. 3.3 Summary statistics To minimize the effect of outliers, we winsorize all independent variables at the 1st and 99th percentiles. Table 1 Panel B provides summary statistics. On average, a firm in our sample has 9.8 granted patents per year and each patent receives 3.9 non-self citations, and is followed by 7 analysts. Regarding other variables, an average firm has book value assets of $3.59 billion, R&D-to-assets ratio of 5%, ROA of 9.5%, PPE-to-assets ratio of 29.7%, leverage of 21.8%, capital expenditure ratio of 6.5%, Tobins Q of 2.1, and is 17.1 years old since its IPO date. 4. Baseline empirical results To assess how analyst coverage affects innovation, we estimate various forms of the following model using the ordinary least squares (OLS):
To control for the possibility that a given analyst may make multiple forecasts within one month, we also calculate the total number of unique analysts issuing earnings forecasts for this firm during the 12-month period before its fiscal year ending date by using the historical detail file of I/B/E/S and find that the two measures of analyst coverage are highly correlated (with a Pearson correlation coefficient of 0.96). All our results remain unchanged if we use this alternative definition of analyst coverage.
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LnPatenti ,t 3 ( LnCitePati ,t 3 ) LnCoveragei ,t Z i ,t Yeart Firmi i ,t

(1)

where i indexes firm and t indexes time. The dependent variables capture firm innovation outcomes: the natural logarithm of one plus the number of patents filed (and eventually granted) (LnPatent) and the natural logarithm of one plus the number of non-self citations per patent (LnCitePat). Since the innovation process generally takes longer than one year, we examine the effect of a firms analyst coverage on its patenting three years ahead.14 The analyst coverage measure, LnCoverage, is measured for firm i over its fiscal year t. Z is a vector of firm and industry characteristics that may affect a firms innovation output as we discussed in Section 3.2.2. Year captures year fixed effects and Firm captures firm fixed effects. We cluster standard errors at the firm level. We start with a parsimonious model that regresses the number of patents filed in three years only on the key variable of interest, LnCoverage. We find that the coefficient estimate (untabulated) is 0.331 (p-value < 0.001), suggesting a positive raw association between analyst coverage and the firms innovation output. We then add year fixed effects to absorb any aggregate time effect and report the results in column (1) of Table 2 Panel A. The coefficient estimate of LnCoverage is still positive and significant at the 1% level. However, the coefficient turns negative and significant at the 10% level in column (2) when we include firm fixed effects, suggesting that a higher level of analyst coverage is associated with a lower level of three-yearahead innovation output. This result also suggests that certain time-invariant variables omitted from the regression positively affect both analyst coverage and firm innovation and thus bias the coefficient estimate of LnCoverage upward. For example, a corporate culture that tolerates failures could encourage innovation (Tian and Wang, 2011) while at the same time may attract more analysts. In this case, corporate culture is unobservable but positively correlated with both analyst coverage and innovation, biasing our coefficient estimates of LnCoverage upward. Including firm fixed effects removes the effects of such time-invariant omitted variables, and the coefficient estimate of LnCoverage decreases, i.e., becomes negative and marginally significant. Existing literature has shown a number of time-varying firm characteristics that directly affect firm innovation. Omitting these characteristics from the regression could lead to biases as well. In column (3), we add a set of controls that are important determinants of firm innovation

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For robustness, we examine the effect of a firms analyst coverage on its patenting one, two, and five years ahead, and obtain both quantitatively and qualitatively similar results.

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documented by existing studies: firm size, age, profitability, R&D expenditures, asset tangibility, leverage, and capital expenditures. The coefficient estimate of LnCoverage is still statistically significant but becomes much more negative, i.e., -0.051 (p-value < 0.001). The finding suggests that these time-varying firm characteristics omitted from column (2) bias the coefficient estimate upward. In column (4), we further include in the regression Tobins Q, financial constraints (proxied by the KZ-index), and the HerfindahlHirschman Index as well as its squared term, motivated by the existing literature showing how these firm characteristics affect innovation (Hall, Jaffe, and Trajtenberg, 2005; Aghion et al., 2005). The coefficient estimate of LnCoverage continues to be negative and significant at the 1% level with a slightly larger magnitude, i.e., 0.053. Finally, recent work by Aghion, Van Reenen, and Zingales (2013) and Fang, Tian, and Tice (2012) show that institutional ownership and stock liquidity are important determinants of firm innovation. Hence, we add these two control variables in column (5). The coefficient estimate of LnCoverage remains negative, i.e., -0.052, and significant at the 1% level. With regards to control variables, firms that are larger, older, more profitable, and those with more tangible assets, higher Tobins Q, and lower leverage are more innovative. Larger R&D expenditures are associated with more innovation output.15 Further, institutional ownership and stock illiquidity are positively related to innovation, consistent with the existing literature. Table 2 Panel B reports the regression results from estimating equation (1) with the dependent variable replaced by LnCitePat. We observe a very similar pattern for the coefficient estimates of LnCoverage as we introduce controls gradually. We observe a positive coefficient estimate of LnCoverage in the parsimonious regression without any controls or controlling only for year fixed effects. The coefficient becomes significantly negative after we introduce firm fixed effects that control for time-invariant omitted variables. Finally, the coefficient remains negative and significant as we gradually add time-varying firm-specific and industry-specific innovation determinants in the regressions. The above finding suggests that omitted variables bias the coefficient estimate of analyst coverage upward. The negative coefficient estimate of

Since we control for R&D expenditures in our baseline regression, we have actually identified the effects of analyst coverage on innovation mainly through its impact on R&D effectiveness (i.e., the efficiency of R&D expenditures in generating innovation outputs). If, however, we do not include R&D expenditures in our baseline regression, the coefficient estimate of LnCoverage will then capture both the R&D effectiveness effect and any additional effect of financial analysts on firms investments in R&D. In Panel K of Table A1 in the Internet Appendix, we re-estimate equation (1) without including R&D expenditures on the right hand side and get both quantitatively and qualitatively similar results. For example, the coefficient estimate of LnCoverage is -0.050 (pvalue = 0.004) in model (5) of Table 2 Panel A and is -0.075 (p-value < 0.001) in model (5) of Table 2 Panel B.

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LnCoverage in column (5) suggests that firms with more analyst coverage generate patents with a lower impact. Once again, older firms, more profitable firms, and firms with larger innovation input, lower leverage, greater institutional ownership, and higher stock illiquidity are associated with higher-impact patents. We conduct a rich set of robustness tests for our baseline results and discuss the details of these tests in the Internet Appendix. We find that our baseline results are robust to alternative subsamples based on the number of patents or the number of analysts a firm has, alternative proxies for analyst coverage, alternative proxies for innovation activities, alternative econometric models that deal with the right-skewed and non-negative nature of patent and citation data, and alternative empirical specifications. Overall, our baseline results suggest that analyst coverage is negatively related to a firms innovation output, consistent with the pressure hypothesis. 5. Identification In this section, we address the endogeneity concern that omitted variables correlated with both analyst coverage and corporate innovation could bias our results. To that end, we adopt two different identification strategies. Section 5.1 discusses our first identification strategy that uses a DiD approach by relying on two quasi-natural experiments: brokerage closures and brokerage mergers. Section 5.2 discusses the second identification strategy that uses the 2SLS approach based on a plausibly exogenous instrumental variable, expected coverage. 5.1 Quasi-natural experiments 5.1.1 Experiments Our first identification strategy is to use two quasi-natural experiments that generate plausibly exogenous variation in analyst coverage. The first experiment, brokerage closures, first adopted in Kelly and Ljungqvist (2011, 2012), relies on the fact that brokerage firms often respond to adverse changes in revenue generation from trading, market-making, and investment banking by closing their research operations. In other words, brokerage closures are motivated largely by business strategy considerations of the brokerage houses themselves rather than by the characteristics of the firms covered by their analysts. This event provides us a nice quasi-natural experiment on how financial analysts affect firm innovation. Similar to their role in Kelly and Ljungqvist (2011, 2012), brokerage closures in our setting serve as a source of exogenous variation in analyst coverage, which should affect a firms subsequent innovation productivity
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only through its effect on the number of analysts following the firm. The second experiment is brokerage mergers, which is first introduced by Hong and Kacperczyk (2010) to identify an exogenous reason for a drop in analyst coverage. When brokerage houses merge, they typically fire analysts because of redundancy and potentially lose additional analysts for other reasons like merger turmoil and culture clash (Wu and Zang, 2009). Hong and Kacperczyk (2010) argue that if a stock is covered by both brokerage houses before the merger, they will get rid of at least one of the analysts following the stock, usually the target analyst, which will in turn reduce the covered stocks analyst coverage. Therefore, brokerage mergers generate a plausibly exogenous variation in analyst coverage that affects a firms innovation only through its effect on the firms analyst coverage. 5.1.2 Identifying treatment and control firms Since innovation involves long-term projects, we require both the treatment and the control firms to have three years of innovation data before and after the event. Thus we focus on brokerage mergers and closures that occur between 1996 and 2002 (given that our baseline sample is 1993-2005). To make our analysis consistent with previous studies, we extract the list of brokerage mergers during 1996-2002 from Hong and Kacperczyk (2010) and the list of brokerage closures during 2000-2002 from Kelly and Ljungqvist (2012).16 Both studies have carefully verified that their brokerage closure and merger events are exogenous to the characteristics of affected firms, which makes our analysis less prone to endogeneity concerns. Note that the above two lists of events may overlap because Kelly and Ljungqvist (2012) classify the closure of target brokers due to mergers and acquisitions as a type of brokerage closures (as opposed to independent brokerage closures). Hence, we use 12 out of the 15 brokerage mergers from Hong and Kacperczyk (2010) since the other three brokerage mergers are outside our sample period (which took place in 1984, 1988, and 1994, respectively). Kelly and Ljungqvist (2012) report a total of 43 brokerage closures between Q1, 2000 and Q1, 2008. Out of the 23 brokerage closures within our sample period (2000-2002), three overlap with the list of the 12 brokerage mergers extracted from Hong and Kacperczyk (2010). Thus, we retain 20 unique brokerage closures from Kelly and Ljungqvist (2012). Among them, 9 are independent brokerage closures and 11 are brokerage closures due to mergers and acquisitions that are different from the
16

We thank the authors of the above two articles for making the data on brokerage mergers and closures publicly available.

14

ones reported in Hong and Kacperczyk (2010). Finally, as Kelly and Ljungqvist (2012) only cover brokerage closures starting from January 2000, we manually collect brokerage closures during 1996-1999 by adopting the following procedure. We first find out brokers whose last appearance in the I/B/E/S database falls between 1996 and 1999. We then search for press releases and news articles in Factiva and manually check that the disappearance of brokers is due to brokerage closures. We read the news articles carefully to identify the brokerage closure event dates. If the exact date of a closure is not provided, we use the date of the first press release that covers the news of the closure as a proxy. We are thus able to identify 6 additional brokerage closures during 1996-1999. Our final sample of brokerage disappearances consists of 23 mergers and 15 independent closures. Given the fact that many brokerage closures and mergers span a long time (usually several months), it is difficult to pin down a precise disappearance date for many of the events in our sample. Therefore, following previous studies that face a similar problem, we treat the six months symmetrically around our identified disappearance dates as the event period. We then measure analyst coverage one year before (after) the broker disappearance as the number of different analysts following a firm between 15 and 3 months before (after) our identified event (closure or merger) dates. Hence, there is a six-month gap between the end of year -1 and the beginning of year +1. For all other variables (such as innovation variables and control variables), we construct a twelve-month disappearance period symmetrically around our identified disappearance dates and treat that as the event year because these variables are measured on an annual basis and we have to avoid overlapping them in year -1 and year +1. To construct a sample of treatment firms that are covered by the closed or merged brokerage houses prior to the events and that lose analysts due to these exogenous shocks, we adopt similar procedures to those described in Hong and Kacperczyk (2010) and Kelly and Ljungqvist (2012). For brokerage closures, we first identify analysts who work for these brokerage houses but disappear from the I/B/E/S tape (by not issuing any earnings forecasts) during the year after the brokerage closure date. Then we obtain all firms which are covered by these analysts before the event. For brokerage mergers, we identify firms covered by both the target and acquirer brokerage houses before the event and for which one of their analysts disappears. This procedure ensures that the loss of analyst coverage for these firms is indeed due to brokerage mergers. Following Kelly and Ljungqvist (2012), we drop firms that are covered by

15

one or both brokerage houses before the merger but are no longer covered by the surviving brokerage house after the merger. The reason for imposing the last restriction is that such coverage terminations may be endogenous since the surviving brokerage house makes a choice to cease covering the firm. Finally, for a firm to be classified into our treatment group, we need it to have nonmissing matching variables (to be discussed below) for year -1 and non-missing innovation variables (patents and non-self citations) for at least three years before and after the event (years -3 to +3). The choice of a seven-year window (from year -3 to year +3) reflects a trade-off between relevance and accuracy. On the one hand, choosing too wide a window may incorporate too much noise irrelevant to the events and may unnecessarily reduce the sample size (because the treatment firms then need to have non-missing data for more years) and thus lower the power of our test. On the other hand, there is usually a gap between the change of a firms innovation policy and its innovation output. Hence, unlike the case of analyzing innovation inputs such as R&D expenditures, choosing a window that is too narrow may limit our ability to identify any meaningful changes in innovation outputs. Given the above considerations, we use a seven-year window, though our results are qualitatively similar (but statistically weaker) if we use a threeyear or five-year window. We then proceed to construct a control group of firms that are matched to the treatment group on important observable characteristics one year prior to the events but that do not lose analyst coverage due to the exogenous shocks. We require potential control firms to have been traded for at least three years before the broker disappearance date, and to have Compustat data both in years -1 to -3 and years +1 to +3. Following Hong and Kacperczyk (2010), we require that candidate control firms be in the same market capitalization tercile, book-to-market ratio tercile, past return tercile, and analyst coverage tercile in the matching year (year -1). In addition, since Kelly and Ljungqvist (2012) show that stocks experiencing brokerage closures are generally more volatile and have more turnover than average stocks in the CRSP universe, we include these two additional variables in our baseline matching process by requiring candidate control firms to be in the same stock return volatility tercile and stock turnover tercile in the matching year.17 We compute the difference between treatment firms and candidate control firms

17

Market capitalization is a firms stock price times its shares outstanding at the end of year t. Book-to-market ratio is a firms book value divided by its market cap at the end of year t. Past return is the average monthly stock return

16

according to their analyst coverage in year -1 and retain, for each treatment, five control firms with the smallest difference in analyst coverage. We then construct portfolios of these five control firms and use them as benchmarks. We end up with 1,165 unique pairs of treatmentcontrol matches. 5.1.3 The DiD estimation After obtaining a closely matched sample of control firms, we use a DiD approach to ensure that the difference in innovation activities between the treatment and control firms are not driven by their cross-sectional heterogeneity or common time trends that affect both groups of firms. As long as our treatment and control firms are similar ex ante except for the loss of an analyst for our treatment, our approach ensures that the changes in innovation are caused only by the exogenous change in analyst coverage. The success of a DiD approach hinges on the satisfaction of the key identifying assumption behind this strategy, the parallel trend assumption, which states that in the absence of treatment, the observed DiD estimator is zero. To be precise, the parallel trend assumption does not require the level of innovation variables to be identical across the treatment and control firms over the two eras because these distinctions are differenced out in the estimation. Instead, this assumption requires similar trends in innovation variables during the pre-shock era for both the treatment and control groups. Therefore, before we carry out the DiD estimation, we perform two diagnostic tests to ensure that the parallel trend assumption is satisfied. The first piece of evidence to support the satisfaction of the identifying assumption is reported in Figure 1. Panel A shows the difference in the number of patents between the treatment and control groups over a 7-year event window surrounding the exogenous shock. It shows that the difference between the treatment and control groups is stable in the 3 years leading up to the exogenous shock, suggesting that there are no pre-trends present for patents. Panel B reports the difference in the number of non-self citations per patent between both groups of firms surrounding the exogenous shock.18 We observe a similar trend in patent citations. We present the second piece of evidence indicating that the parallel trend assumption is

during year t. Stock return volatility is the standard deviation of a firms daily stock returns multiplied by 252. Stock turnover is a stocks average monthly volume divided by shares outstanding. 18 Consistent with the main DiD analysis that we discuss later, we normalize each treatment or control firms patents (non-self citations per patent) by the average annual patents (non-self citations per patent) between treatments and their corresponding controls over the three-year pre-event period.

17

satisfied in Table 3 Panel A, which reports the univariate comparisons between the treatment and control firms innovation growth variables as well as other important characteristics in the preevent year. The univariate comparisons indicate that there are no statistically significant differences in the three-year growth rates of innovation variables between the treatment and control firms before the event, suggesting that the parallel trend assumption is satisfied. Moreover, all the differences in the matching variables and almost all other important firm characteristics between the treatment and control firms are insignificant before the event, although control firms appear to be marginally more profitable than treatment firms. Overall, the univariate comparisons reported in Panel A suggest that the matching process has successfully removed meaningful observable differences between the treatments and the controls before the event, and thus ensured that the change in innovation output are caused only by the exogenous shock to analyst coverage. Table 3 Panel B reports the results from the DiD analysis using the size, book-to-market, past return, coverage, volatility, and turnover matched sample. We compute the DiD estimator by first subtracting the total number of patents counted over the three-year period preceding the event from the total number of patents over the three-year period post the event for each treatment firm. The difference is then averaged over the treatment group and reported in column (1). To evaluate the quality of the patents, we first compute the non-self citation ratio for each treatment firm by counting the total number of patents it generated three years before (or after) the event as well as the total number of non-self citations received by these patents, and dividing the latter by the former. We then calculate the difference in non-self citation ratios before and after the event and average it over all treatment firms. We report it in column (1). To facilitate the interpretation of the economic significance for the DiD estimators, we need to compare all treatment-control pairs on an equal basis.19 Hence, following the spirit of Kelly and Ljungqvist (2012), we normalize each treatment firms difference in the total number of patents (non-self citation ratios) by the average total number of patents (non-self citation ratios) between this treatment and the matched control portfolio over the three-year pre-event period. We repeat the same procedure for control portfolios and report the average changes in the total number of patents (non-self citation ratios) surrounding the event date in column (2).
19

For instance, some firms may be more innovative (e.g., having 100 patents to begin with) than others, so an increase in the same number of patents (say, 10 patents) due to an exogenous loss of analyst coverage may matter less for these firms than for less innovative ones (e.g., firms having 20 patents to begin with).

18

The DiD estimator is simply the difference in the differences for the treatment and the control groups, and is reported in column (3). Following Hong and Kacperczyk (2010), we cluster standard errors of the DiD estimators at the event (brokerage closure or merger) level. The average change in the three-year total number of patents for treatment firms is 0.236, while that for control firms is much smaller, 0.054. The DiD estimator for the total number of patents is 0.182 and significant at the 1% level. In terms of economic significance, our analysis suggests that an exogenous average loss of one analyst following a firm causes it to generate 18.2% more patents over a three-year window than a similar firm without any decrease in analyst coverage. The average change in non-self citation ratios (the number of non-self citations per patent) for treatment firms is -0.357, and that for control firms is -0.651. The DiD estimator for non-self citation ratios is 0.294 and significant at the 1% level, suggesting that an exogenous average loss of one analyst following a firm leads it to generate patents receiving 29.4% more non-self citations than a similar firm without any decrease in analyst coverage. Note that we observe a generally downward trend of patent citations over the years in Panel B. This observation is mainly due to the fact that most brokerage closures and brokerage mergers occurred in 19992001, coinciding with the burst of the dot-com bubble that gave rise to a large drop in investment in groundbreaking innovation activities during that time period.20 In untabulated analysis, we also check the DiD estimator for analyst coverage to verify the premise of the natural experiments: exogenous shocks to analyst coverage due to brokerage closures or mergers should lead to an average reduction of one analyst for the treatment group relative to the controls. Consistent with this conjecture, we observe a relative drop in coverage by around 1.06 analysts in the year before and after the event (i.e., from year -1 to +1), which is comparable to that reported in Hong and Kacperczyk (2010), i.e., 1.02 analysts. This effect is significant at the 1% level. Next, we perform a subsample analysis to understand whether the negative effect of analyst coverage on innovation depends on the number of analysts currently following the firm. Put differently, we examine whether there is a non-linear effect of analyst coverage on

20

An alternative possibility that explains the generally downward trend of patent citations is the limitations of the empirical method that corrects for the truncation bias in citation counts. While estimating the shape of the citationlag distribution to correct for the citation count truncation bias is the standard method used by existing innovation literature, it has its own limitations. In contrast, by using the HBS patent database that contains patents granted through 2010, we are able to effectively mitigate the truncation bias in patent counts to a much larger degree, which may explain why we do not observe a generally downward trend for patent counts.

19

innovation. Intuitively speaking, losing one analyst (due to the exogenous shock) should make a bigger difference for firms that are covered by few analysts before the shock than for the firms that are covered by many analysts before the shock. To examine this conjecture, we first classify the treatment firms into three groups based on their analyst coverage in the pre-event year: firms with 10 or fewer analysts, those with 11 to 25 analysts, and those with more than 25 analysts. We then compare each group of these treatment firms to their corresponding matched controls and report the DiD results in Panel C. Column (1) of Panel C reports the results for patent counts. The DiD estimator is 0.253 and significant at the 5% level for the group of firms with the smallest number of analysts following. The DiD estimator goes down to 0.159 but continues to be significant at the 5% level for the group of firms with moderate analyst coverage. The magnitude of the DiD estimator further goes down and becomes statistically insignificant for the group of firms followed by the largest number of analysts. We observe a similar pattern of patent quality in column (2). Overall, we observe a monotonically decreasing pattern for the DiD estimator as the number of analysts following a firm goes up, which suggests that the negative effect of analyst coverage on innovation is stronger for firms covered by fewer analysts. 5.1.4 Robustness We conduct a rich set of robustness tests for the DiD analysis and report the results in Table 4. First, we address the concern that the main DiD results may be driven by the specific set of matching variables used in our baseline matching procedure. To that end, we use alternative combinations of matching variables to select the control firms and report the results in Panel A. We start with a nave matching procedure that only requires both treatment and control firms to have non-zero patents over the sample period and present the DiD estimators in row (1). The DiD estimator for patent counts is 0.271 and significant at the 1% level, and that for non-self citations per patent is 0.477 and significant at the 1% level. Next, we add an additional matching criterion that requires both treatment and control firms to have a similar number of patents (i.e., both firms are in the same patent tercile) in the matching year.21 The results are reported in row (2). The DiD estimators for both patents and non-self citations are positive and significant at the

21

Given the nature of our patent data, we define the bottom tercile of firms as those with zero patent in a given year and the top tercile of firms as those whose total number of patents in that year exceed the sample median among those firms with non-zero patents (i.e., after excluding the bottom tercile of firms).

20

1% level. Third, instead of using the six main matching variables in our baseline matching procedure (in Section 5.1.3), we rely on the four matching variables used in Hong and Kacperczyk (2010), namely, size, book-to-market, past return, and analyst coverage, to select control firms and report results in row (3). The DiD estimators for patents and citations are still positive and significant at the 1% level. Fourth, in addition to the six main matching variables used in our baseline DiD analysis, we include patent counts and non-self citations per patent as additional matching criteria. In row (4), the DiD estimator for patents is 0.595 and significant at the 1% level, while the DiD estimator for citations is 0.287 and significant at the 5% level. Fifth, we drop book-to-market and past returns from the matching criteria and only use size, analyst coverage, stock volatility, and stock turnover as matching variables, and report results in row (5). The DiD estimators for both patents and citations continue to be positive and significant at the 1% level. Sixth, besides the six matching variables (size, book-to-market, past return, analyst coverage, stock volatility, and stock turnover) used in the baseline DiD analysis, we require both treatment and control firms to be in the same Fama-French 49 industries. In row (6), the DiD estimators of patents and citations are positive and significant at the 1% and 5% level, respectively. Finally, we use size, book-to-market, past return, analyst coverage, and FamaFrench 49 industries as matching variables and obtain similar results, which are reported in row (7). The DiD estimators for patents and citations are positive and significant at the 10% and 5% level, respectively. Overall, we find that our DiD results are robust to alternative matching criteria for selecting control firms. Second, we address the concern that the main DiD results might be driven by the rightskewed distribution of the patent variable. We impose various thresholds for the number of patents that the treatment and control firms need to have up to the matching year. We report the results in Panel B of Table 4. In row (1), we start with the restriction that the treatment and control firms need to have at least one patent up to the matching year. The DiD estimator for patents is 0.331 and that for citations is 0.242. Both are significant at the 1% level. In terms of economic significance, our analysis suggests that an exogenous average loss of one analyst following a firm that has at least one patent before the event year causes it to generate 33.1% more patents and 24.2% more non-self citations per patent than a similar firm without any decrease in analyst coverage. The DiD estimator in this subsample has a larger economic impact compared to the one that is obtained from the full sample in Section 5.1.3 because this subsample

21

excludes firms that generate zero patents before the event and is a more innovation-relevant subsample. In rows (2), (3), and (4), the threshold for the minimum number of patents up to the matching year is two, three, and five, respectively. The DiD estimators for patents and citations continue to be positive and significant at the 1% level. Third, we examine whether our main DiD results are robust to using firms with various thresholds for the number of analysts and report the results in Panel C. In row (1), we require the firms to have at least five analysts in the matching year. The DiD estimator for patents is 0.185 and that for citations is 0.290. Both are significant at the 1% level. We impose an alternative threshold, a minimum of 15 analysts (with results reported in row (2)), and continue to observe positive and significant DiD estimators for both patents and citations. Finally, we restrict our sample of firms to be covered by at least 25 analysts and report the results in row (3). The DiD estimators are still positive but lose significance. This result is consistent with our earlier findings reported in Panel C of Table 3 that the negative effect of analyst coverage on innovation is absent when the firm is already covered by a large number of analysts. Fourth, one might worry that our main DiD results could be driven by certain subsamples of firms. For example, a reasonable concern is that many of the brokerage closures and mergers occurred after the burst of the internet bubble (e.g., 40% of our sample of brokerage closures and mergers took place in 2001 and 2002). Therefore, high-tech firms that are generally active innovators are more likely to experience a decrease in analyst coverage due to brokerage closures or mergers. To address this concern, we exclude the brokerage closures and mergers that occurred in 2001 and 2002 and redo the DiD analysis. Row (1) of Panel D reports the results. The DiD estimator for patents is 0.299 and that for citations is 0.549. Both are significant at the 1% level.22 Another reasonable concern is that our main DiD results may be driven by firms that experience only brokerage closures or only brokerage mergers. To address this concern, we exclusively focus on firms that experience a decrease in analyst coverage due to the brokerage mergers shown in Hong and Kacperczyk (2010) that overlap with our sample period (12 of them) and report the results in row (2). The results are robust. The DiD estimator for patents is 0.159 and significant at the 1% level, and that for citations is 0.465 and significant at the 5% level. Finally, we examine whether our baseline DiD results are robust to using an alternative
22

In an untabulated analysis, we exclude the events occurred in 2000, 2001, and 2002, and obtain similar results. The DiD estimators for patents and citations continue to be positive and significant at the 5% and 1% level, respectively.

22

matching methodology when selecting the control group, the propensity score matching method, which matches control firms to treatment firms on all important observable characteristics prior to the exogenous shocks. We first run a probit regression of a dummy variable that equals one if a particular firm-year belongs to our treatment group (and zero otherwise) on a comprehensive list of observable characteristics, including all the independent variables in our baseline regression as well as stock volatility and turnover. We also include year and Fama-French 49 industry dummies. Further, to ensure that the parallel trends assumption is satisfied, we also match firms on growth measures of innovation variables (patents and citations). After estimating the probit model, we use the predicted probabilities, or propensity scores, from this probit estimation and perform a nearest-neighbor matching with replacement to form the control group.23 We report the DiD estimators based on this matched sample and report the results in Panel E of Table 4. The DiD estimator for patents is 0.190 and significant at the 5% level and that for citations is 0.449 and significant at the 1% level, suggesting that the baseline DiD results are robust to alternative matching methods. Overall, the DiD analysis suggests that an exogenous decrease in analyst coverage leads to a larger relative increase in innovation output (in terms of both quantity and quality), and that the negative effect of analyst coverage on innovation is stronger for firms followed by fewer number of analysts. The evidence from the quasi-natural experiments suggests a negative causal effect of analyst coverage on firm innovation and is consistent with the pressure hypothesis. 5.2 Instrumental variable approach Our second identification strategy is to construct an instrument for analyst coverage and use the 2SLS approach to correct for the potential bias due to endogeneity in analyst coverage. The ideal instrument should help to capture the variation in analyst coverage that is exogenous to firms innovation productivity. The instrument we use is expected coverage, introduced by Yu (2008), which captures the change of brokerage house size.24 As argued by Yu (2008), the size of a brokerage house, usually depending on the change of its own revenue or profit, is unlikely to be related to the innovation productivity of certain firms that the brokerage house covers.

Since the number of potential control firm-years is considerably larger than the number of treatment firm-years, we choose to find 3 controls for each treatment. This will allow us to avoid relying on too little information or including vastly different observations. However, our results are robust to any number of matches between 1 and 5. 24 For robustness, we construct the second instrument suggested by Yu (2008), which is a firms inclusion in the Standard & Poors 500 index, and use it in the 2SLS regressions. We find that our baseline results continue to hold.

23

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Therefore, the change of coverage driven by the change of brokerage house size is a plausibly exogenous variation that helps us to identify the direction of causality. This argument can also be illustrated by the following three real-world examples. On June 6, 2007, Prudential Financial Inc. announced that it would substantially wound down its equity research group by the end of the month. During that year, the equity research division reported only $260 million in revenue and $137 million in total assets. By comparison, the parent company, Prudential Financial, generated $32.5 billion in revenue and owned 454 billion in assets. Mary Flowers, the company spokeswoman, commented on the decision saying that we dont have the scale to compete and added that the parent company was focusing on business where we can be a top-tier player. (USA Today 2007) In August 2012, Barclays expanded its Taiwan-based equity research team that covered non-tech companies by recruiting a senior hire as the managing director and a bunch of analysts from Credit Suisse Group AG. The expansion was due to Barclays considerations of increasing its own revenue. According to Barclays statement, the expansion of its equity research team was driven by continuous earnings growth in its brokerage, advisory and foreign-exchange derivative businesses. (Wall Street Journal 2012) Williams Capital Group, a New York-based brokerage firm, expanded its equity research group for the second time in less than two years in January 2011. Its goal was to get 12 to 15 analysts by the end of the year. Besides, each analyst is expected to be covering about 15 stocks in all market caps. The head of the equity research group, Mr. Matt Rochlin, made it clear that the decision reflected competitive pressure and strategic considerations: clients are under pressure to get as much as they can for their commission dollars. For us to add value and to compete for those commission dollars, research is very important. (Traders Magazine, 2011) Following Yu (2008), we use the equations below to calculate expected coverage:
ExpCoverag ei,t, j ( Brokersize t , j / Brokersize 0, j ) * Coverage i , 0, j ExpCoverag ei,t ExpCoverag ei,t, j
j 1 n

(2)

where ExpCoveragei,t,j is the expected coverage of firm i from broker j in year t. BrokerSize0, j and BrokerSizet, j are the number of analysts employed by broker j in the benchmark year 0 and year t, respectively. Coveragei,0,j is the size of the coverage for firm i from broker j in year 0. ExpCoveragei,t is the total expected coverage of firm i from all brokers in year t.

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In the spirit of Yu (2008), we use 1993, the beginning year of our sample, as the benchmark year. To construct a meaningful measure of expected coverage, we require a firm to be covered by at least one analyst in the benchmark year. In our 2SLS analysis, we drop all observations in the benchmark year because the expected coverage for that year will automatically be set to one by design. One concern of this instrument is that in reality brokers choose which firms to stop covering and thus may introduce a potential selection problem. However, as Yu (2008) points out, this selection issue will only affect the realized but not the expected coverage, since the expected coverage measures the tendency to keep the coverage before the broker actually decides which firms to keep. Column (1) of Table 5 shows the first-stage regression results with LnCoverage as the dependent variable to check the relevance of the instrument. The main variable of interest is the instrument, ExpCoverage. All other control variables are the same as those in the baseline regression equation (1). To save space, we suppress the coefficient estimates of all controls. Year and firm fixed effects are included and standard errors are clustered at the firm level. The coefficient estimate of ExpCoverage is positive and significant at the 1% level, consistent with that reported in Yu (2008). Since the t-statistic of the instrument is large (75.8), the instrument is highly correlated with LnCoverage. Based on the rule-of-thumb with one instrument (for one endogenous variable), we reject the null hypothesis that the instrument is weak. Therefore, the coefficient estimates and their corresponding standard errors reported in the second stage are likely to be unbiased and inferences based on them are reasonably valid. Columns (2) and (3) of Table 5 report the results from the second-stage regressions estimating equation (1) with the main variable of interest replaced by the fitted value of LnCoverage from the first-stage regression. We report within-firm R2 for the second-stage regressions. To save space, we only report the coefficient estimates of the instrumented LnCoverage and suppress those of all other controls. Column (2) presents the results with LnPatent as the dependent variable. Consistent with the findings from the OLS analysis, the coefficient estimate of LnCoverage is negative and significant at the 1%. Column (3) reports the regression with patent quality, LnCitePat, as the dependent variable. The coefficient estimate of LnCoverage is negative and significant at the 1% level, reinforcing our baseline findings. To gauge the direction and the magnitude of the bias due to the endogeneity in analyst coverage, we run OLS regressions on the same set of firms as those used in the 2SLS regressions

25

(Table 5) and compare the (untabulated) results with those obtained from the 2SLS regressions. It is interesting to observe that the magnitudes of the 2SLS coefficient estimates (-0.115 for LnPatent and -0.137 for LnCitePat) are considerably larger (i.e., more negative) than those of the OLS estimates (-0.062 for LnPatent and -0.088 for LnCitePat), even though the coefficient estimates from both approaches are negative and statistically significant, suggesting that OLS regressions bias the coefficient estimates of LnCoverage upward due to the endogeneity in analyst coverage. This finding suggests that some omitted variables simultaneously make firms more innovative and more intensively covered by analysts. Management talent, if time varying within a firm, could be an example of such omitted variables. For instance, high quality managers may tend to manage companies attracting more analyst coverage, while in the meantime may also actively engage in more long-term innovative projects that result in more patents and citations. This positive correlation between analyst coverage and firm innovation caused by omitted variables is the main driving force that biases the coefficient estimates of analyst coverage upward. Once we use the instrument to clean up the correlation between analyst coverage and the residuals (the firms unobservable characteristics) in equation (1), the endogeneity of analyst coverage is removed and the coefficient estimates decrease, i.e., become more negative. In summary, the identification tests based on both the DiD approach and the instrumental variable approach reported in this section suggest that there appears to be a negative causal effect of analyst coverage on firm innovation, consistent with the pressure hypothesis. 6. Possible mechanisms Our evidence so far is consistent with the implication of the pressure hypothesis that analyst coverage impedes firm innovation. In this section, we discuss possible underlying economic mechanisms through which this occurs and examine whether there exists a residual effect of analyst coverage on firm innovation after controlling for such mechanisms. Section 6.1 argues that different types of institutional ownership could be an underlying economic mechanism. A reduction in analyst coverage leads to an increase in institutional ownership by dedicated investors who serve as a shield against short-term pressure and promote innovation (Aghion, Van Reenen, and Zingales, 2013). Meanwhile, a reduction in analyst coverage leads to a decrease in institutional ownership by non-dedicated investors who chase short-term financial returns and impose pressure on firm managers. In Section 6.2, we show that a firms exposure to
26

takeovers is another possible underlying mechanism. A reduction in analyst coverage reduces a firms exposure to takeovers, which in turn lowers the managers short-term pressure and encourages them to make long-term investments (Stein, 1988). Section 6.3 argues that stock illiquidity and the difficulty in implementing accrual-based earnings management techniques are two other possible underlying mechanisms.25 Both stock illiquidity and accrual-based earnings management practices are able to partially insulate firm managers from the short-term pressure to meet earnings targets and thereby motivate innovation. In Section 6.4, we show that there exists a direct (residual) effect of analyst coverage on firm innovation after controlling for all the above possible economic mechanisms. 6.1 Different types of institutional ownership In this section, we examine whether different types of institutional ownership could help explain the negative effect of analyst coverage on firm innovation. Kelly and Ljungqvist (2012) find that an exogenous reduction in analyst coverage leads to a higher degree of information asymmetry among investors, which in turn results in an increase in institutional ownership and a decrease in retail ownership. Their rationale is that institutional investors have access to private information that is unavailable to retail investors who mainly rely on public sources of information such as analyst reports. Therefore, the increase in information asymmetry due to an exogenous drop in analyst coverage crowds out the demand by retail investors. To the extent that this argument also applies to different types of institutional investors, we expect that after an exogenous drop in analyst coverage there will be an increase in holdings from dedicated institutional investors, who actively collect information about firm fundamentals, concentrate their portfolios in a few firms, and thus have access to more private information. In contrast, an exogenous reduction in analyst coverage should lead to a decrease in holdings by non-dedicated institutional investors, who chase short-term profits instead of collecting information about firms fundamental values, hold highly diversified portfolios with small stakes in many
25

Note that while Kelly and Ljungqvist (2012) find a causal effect of analyst coverage on institutional versus retail investor ownership, we are not aware of any studies that show the causal effect of analyst coverage on different types of institutional ownership (i.e., equity holdings by dedicated versus non-dedicated institutional investors). Similarly, no previous studies have directly examined the causal effect of analyst coverage on a firms takeover exposure. Therefore, we conduct the DiD tests for these two economic mechanisms and report the results in Table 6 Panels A and B. However, since existing literature has already shown the causal effect of analyst coverage on stock liquidity (Kelly and Ljungqvist, 2012) and on accrual-based earnings management (Yu, 2008), we rely on their findings and only discuss these two economic mechanisms in Section 6.3 without conducting the DiD analysis ourselves.

27

companies, and thus have less access to private information. Meanwhile, the model of Aghion, Van Reenen, and Zingales (2013) implies that dedicated institutional investors encourage firm innovation to a greater extent than non-dedicated ones. Thus, the equity ownership by different types of institutional investors could be an underlying economic mechanism through which analyst coverage impedes firm innovation. To test this conjecture, we first calculate the changes in equity ownership by different types of institutional investors surrounding the exogenous shocks to analyst coverage for the treatment and control firms. We follow the classification scheme created by Bushee (1998, 2001) and classify institutional investors into one of three categories: dedicated investors, quasiindexers, and transient investors.26 We then merge Bushees institutional investor classification file with quarterly institutional investors holdings of U.S. securities from Thomsons 13F database. Since Porter (1992) argues that a higher presence of transient investors and quasiindexers have weak incentives to produce information about firm fundamentals, we group these two types of investors together as the non-dedicated institutional investors and compare their equity ownership to that of the dedicated institutional investors. We examine the effect of analyst coverage on equity ownership by different types of institutional investors in the DiD framework, using the matched sample constructed in Section 5.1.2. Specifically, we compare the change in equity ownership by different types of institutional investors in the year before (year -1) and after (year +1) the shock for the treatment firms and their matched controls. Reported in Table 6 Panel A, the DiD estimator for the dedicated institutional ownership (DedOwn) is 0.013 and significant at the 1% level, suggesting that dedicated investors increase their equity holdings by 1.3 percentage points more for the treatment group than for the control group. At the same time, the DiD estimator for the non-dedicated ownership (TraQixOwn) is -0.009 and significant at the 5% level, suggesting that non-dedicated investors decrease their ownership by 0.9 percentage points more for the treatment group than for the control group. The above DiD analysis shows that an exogenous decrease in analyst coverage due to brokerage closures or mergers increases a firms equity ownership by dedicated institutional investors and decreases that by non-dedicated institutional investors. Based on the arguments of
26

Based on the classifications of Bushee (1998, 2001), dedicated investors are characterized by concentrated portfolio holdings and low portfolio turnover; quasi-indexers are those that follow indexing strategies and hold fragmented diverse portfolios; and transient investors are characterized by high portfolio turnover and momentum trading.

28

Aghion, Van Reenen, and Zingales (2013) that dedicated institutional investors should enhance innovation to a significantly greater extent than non-dedicated institutional investors by providing a better shield to managers against short-term pressure, our evidence suggests that the equity ownership by different types of institutional investors is an underlying mechanism through which analysts impede innovation. 6.2 Takeover exposure A second possible economic mechanism is a firms exposure to takeovers. Yu (2008) finds that firms covered by a smaller number of analysts engage in more accrual-based earnings management and thus reduce the quality of their financial and accounting statements. Since poor accounting quality widens the information gap between firm insiders and outside investors (Bhattacharya, Desai, and Venkataraman, 2010; Kravet and Shevlin, 2010) and increases the costs of adverse selection for potential bidders, Amel-Zadeh and Zhang (2010) show that firms with poor accounting quality are less likely to become a takeover target. Hence, this literature suggests a positive relation between analyst coverage and takeover exposure. Meanwhile, Stein (1988) argues that since shareholders cannot properly evaluate a managers investment in longterm intangible assets, a vibrant takeover market will induce managers to invest more in shortterm projects that offer quicker and more certain returns than long-term innovative projects. Thus, takeover exposure could be an underlying economic mechanism that helps explain the negative effect of analyst coverage on innovation. To test this conjecture, we first obtain both attempted and completed mergers and acquisitions (M&As) announcements from the SDC M&A database and calculate firms takeover exposure. We use firms takeover exposure instead of actual takeovers in this test because according to the theory of Stein (1988), it is the threat (or likelihood) of takeovers instead of actual takeovers that alter managers ex-ante incentives to invest in innovation. Following Cremers, Nair, and John (2009), we estimate a firms takeover exposure by running a logit regression as follows: Targeti ,t 1 1Qi ,t 2 PPEAssetsi ,t 3 LnCashi ,t 4 Blocki ,t 5 LnMVi ,t 6 IndMAi ,t 7 Leveragei ,t 8 ROAi ,t Industry j Yeart i ,t (3)

where i indexes firm, t indexes time, and j indexes industry. The dependent variable, Target, is a dummy equal to one if a firm is the target of an attempted or completed acquisition and zero
29

otherwise. All independent variables are constructed in the same way as those in Cremers, Nair, and John (2009). We also include Fama-French 49 industry fixed effects to control for timeinvariant industry characteristics. We estimate a firms takeover exposure (Takeover) by calculating the predicted value of Target based on the coefficients estimated in the logit regression.27 Next, we examine the effect of analyst coverage on a firms takeover exposure in the DiD framework, using the matched sample constructed in Section 5.1.2. Reported in Panel B of Table 6, the DiD estimator for takeover exposure is -0.001 and significant at the 5% level. It suggests that treatment groups exposure to takeovers decreases by 0.1 percentage points more than the control group surrounding the exogenous shock to analyst coverage. Given that an average firms unconditional takeover exposure is 4.7 percentage points in our sample, the economic significance is nontrivial: a reduction of takeover exposure by 2.2% associated with an average loss of one analyst. The DiD analysis reported above shows that an exogenous drop in analyst coverage decreases a firms exposure to takeovers. The model of Stein (1988) implies that reduced takeover exposure encourages firm innovation because takeover exposure imposes short-term pressure on managers to boost current stock price and thus prevents them from investing in longterm innovative projects. In line with their arguments, our finding suggests that takeover exposure is another plausible underlying economic mechanism through which analyst coverage impedes firm innovation. 6.3 Other possible mechanisms In this section, we discuss two other possible mechanisms through which analyst coverage adversely affects firm innovation. First, stock illiquidity could be an economic mechanism. Brennan and Subrahmanyam (1995) and Brennan and Tamarowski (2000) argue that more analyst coverage results in a greater number of informed traders in the market for a stock. Hence, prices are more informative for stocks covered by a larger number of analysts. With more informative stock prices, uninformed investors face smaller expected losses from trading against informed investors, which reduces bid-ask spreads, a standard measure for stock illiquidity. Consistent with the above argument,
27

The current specification considers all kinds of takeovers including both hostile and friendly deals. In untabulated DiD analysis, we construct Target by using only hostile takeovers and find qualitatively similar results.

30

Irvine (2003) finds that analyst coverage initiations reduce firm stock illiquidity, and Kelly and Ljungqvist (2011) show that an exogenous decrease in analyst coverage leads to an increase in stock illiquidity.28 Therefore, the extant literature suggests a negative relation between analyst coverage and stock illiquidity. Meanwhile, motivated by the theoretical arguments of Porter (1992) and Bhide (1993), Fang, Tian, and Tice (2012) find that higher stock illiquidity leads to a higher level of firm innovation output. Therefore, stock illiquidity could be an underlying economic mechanism through which analyst coverage impedes firm innovation. Second, analyst coverage could affect the level of difficulty of implementing accrualbased earnings management techniques. Yu (2008) argues that financial analysts serve as external monitors to managers and shows that firms followed by more analysts use discretionary accruals (as an earnings management method) less frequently. Given managers enhanced pressure to meet near-term earnings targets and their reduced abilities to adopt accrual-based earnings management techniques when they are followed by more analysts, a natural alternative way of handling the increased pressure is to manipulate earnings through real earnings management, which involves changing the timing or structure of operations, investments, and/or financing activities that have cash flow consequences. Previous studies, such as Cohen, Dey, and Lys (2008), show that accrual-based earnings management and real earnings management are substitutes. Cutting investments in innovation (e.g., cutting R&D expenditures or other unobservable inputs) is one of the major real earnings management tools that managers often use to raise their firms probability of meeting near-term earnings targets. Hence, analyst coverage can impede firm innovation through its impact on managers abilities to implement accrual-based earnings management techniques. 6.4 The residual effect of analysts on innovation While we have identified four possible underlying economic mechanisms through which analyst coverage affects firm innovation, there remains an unanswered question, namely, whether there exists a residual (or direct) effect of analysts on firm innovation beyond the effect taking place through the above four mechanisms. In other words, we need to determine whether analysts affect innovation only through these underlying mechanisms or in a more direct way.
28

In an untabulated analysis, we examine the effect of an exogenous reduction in analyst coverage on stock illiquidity in the DiD framework, using the matched sample constructed in Section 5.1.2. We find that the DiD estimator for stock illiquidity measured by the natural logarithm of relative effective spreads is positive and significant at the 5% level, consistent with the finding reported in Kelly and Ljungqvist (2011).

31

Disentangling the direct vs. the indirect effect of analyst coverage on innovation allows us to determine whether the causal relation between analyst coverage and firm innovation identified in our paper is merely a compilation of established facts (such as the documented relation between analyst coverage and the above four mechanisms, which have also been shown to affect patenting) or goes beyond the existing literature to suggest a novel role financial analysts play in motivating firm innovation.29 To achieve this goal, we perform a regression analysis in the DiD framework that relies on the two quasi-natural experiments discussed in Section 5.1. Specifically, we examine whether the DiD estimator, which captures the causal effect of analyst coverage on firm innovation, is purely driven by the four mechanisms identified in Sections 6.1 6.3, or it has a statistically significant component that cannot be fully absorbed by these mechanisms. To that end, we directly control for the above four economic mechanisms by estimating the following model based on the matched sample described in Section 5.1.2:
Patenti ,t (CitePati ,t ) 1Treat * Post 2Treat 3 Post ' Mechanismi ,t i ,t

(4)

where i indexes firm and t indexes pre or post event (brokerage closure or merger) period. The dependent variable is either Patent, which is the normalized total number of patents generated over the three years before (or after) the event, or CitePat, which is the normalized number of non-self citations per patent over the three years before (or after) the event. Both variables are defined in details in Section 5.1. Treat is a dummy that equals one for treatment firms and zero for control firms. Post is a dummy that equals one for the post-event period and zero for the preevent period. Mechanism is a vector of variables that proxy for the four economic mechanisms discussed before. We use DedOwn and TraQixOwn to capture different types of institutional ownership, Takeover to capture firms exposure to takeovers, and Illiquidity to capture firms stock illiquidity. These three measures are defined in details in Section 6.1 6.3. We follow the procedure adopted in Yu (2008) to construct a proxy, DisAccrual, for the fourth economic mechanism, the extent of accrual-based earnings management practices. The details of constructing this variable are provided in Table 1 Panel A. The key variable of interest is the DiD estimator, 1. If there is a residual treatment effect of analyst coverage on firm innovation, we should observe that 1 continues to be positive and
29

We thank an anonymous referee for suggesting this analysis.

32

significant even after controlling for the four economic mechanisms. If, however, analysts and innovation are related only through the four mechanisms, we should observe that 1 loses its significance once the four economic mechanisms are controlled for. We report the results in Table 6 Panel C. The dependent variable is Patent in the first two columns. In column (1), we estimate equation (4) without controlling for any mechanism variables to get the benchmark DiD estimator. The coefficient estimate of 1 is 0.204 and significant at the 5% level.30 In column (2), we estimate equation (4) and control for all four mechanism variables. The coefficient estimate of 1 continues to be positive but becomes smaller in magnitude (i.e., goes down to 0.122), which reflects an approximately 40% drop from the benchmark DiD estimator in column (1). This finding suggests that the proposed economic mechanisms are able to explain about 40% of the total effect of analyst coverage on firm innovation measured by patent counts. In columns (3) - (4), we replace the dependent variable with CitePat and repeat the analysis above. We observe a similar pattern for the DiD estimator 1: it continues to be positive and significant in column (4) in which all four economic mechanism variables are controlled for. However, its magnitude (i.e., 0.277) is smaller compared to the benchmark DiD estimator reported in column (3), i.e., 0.362. This finding suggests that the economic mechanisms explain about 28% of the total effect of analyst coverage on firm innovation measured by patent quality. The other mechanism variables affect the innovation outcomes as predicted by theories. Specifically, both the quantity and quality of a firms innovation output increase with its equity ownership of dedicated institutional investors, its stock illiquidity, and its level of discretionary accruals, but decrease with its takeover exposure. Overall, we find that the DiD estimator, which captures the causal effect of analyst coverage on firm innovation, continues to be positive and significant even after controlling for its dependence on the four proposed economic mechanisms. Our findings suggest that while the proposed economic mechanisms are able to explain a significant proportion of the causal effect of analysts on innovation, there is still a sizeable direct (or residual) effect of analyst coverage on

30

Note that the magnitude of 1 is different from the DiD estimator reported in Table 3 Panel B because we restrict the sample used in this analysis only to firms with non-missing mechanism variables. Doing this allows us to compare the magnitudes of 1 across columns on an equal footing. If, however, we remove this restriction, we will get a DiD estimator identical to that reported in Table 3 Panel B.

33

firm innovation.31 In the Internet Appendix, we offer a possible rationale for why analysts could have a direct effect on managers incentives to invest in innovative projects: the adverse consequences of missing earnings targets. We show that the cumulative abnormal returns (CARs) upon a negative earnings surprise (i.e., missing analysts consensus forecast targets) are larger in magnitude (i.e., more negative) when a firm is covered by a larger number of financial analysts, which could lead to a reduction in the managers compensation and a loss of his reputation. 7. Discussion and conclusion In this paper, we have examined the effect of analyst coverage on firm innovation and tested two competing hypotheses. We find that firms covered by a larger number of analysts generate fewer patents and patents with lower impact. To establish causality, we use a DiD approach and an instrumental variable approach. Our identification tests suggest a causal effect of analyst coverage on firm innovation. The evidence is consistent with the hypothesis that analysts exert too much pressure on managers to meet short-term goals, impeding firms investment in long-term innovative projects. Finally, we discuss possible underlying mechanisms through which analysts impede innovation and show that there is a residual effect of analyst coverage on firm innovation even after controlling for such mechanisms. Overall, our study offers novel evidence of a previously under-explored adverse consequence of analyst coverage, namely, its hindrance to firm innovation. While we have shown a negative effect of analyst coverage on firm innovation, one must be cautious in drawing a normative (as opposed to a positive) inference from our results. Since a firms optimal level of investment mix (short-term vs. long-term) is usually firm-specific and unobservable, it is virtually impossible to determine whether firm managers, in the absence of analyst coverage, overinvest in the long-term innovative projects. If financial analysts actually prevent firm managers from investing suboptimally by squandering too many resources on longterm activities, then they may be performing a good deed for the shareholders. In that case, our
31

An important caveat is that the direct (or residual) effect of analysts on innovation we have shown could be due to unidentified channels that are measured as direct effect. In other words, an important assumption of our analysis is that the four identified economic mechanisms represent all the major indirect channels through which analysts impede firm innovation. To address this concern, we conduct a comprehensive search of alternative economic theories but cannot identify other major economic mechanisms that can help explain the negative effect of analysts on innovation. Therefore, it is reasonable to believe that there exists a direct effect of analysts on innovation. However, caution still needs to be exercised when interpreting or generalizing our results.

34

results would be consistent with the bright side of analyst coverage. To take one step further towards a normative conclusion, we rely on two findings. First, Hall, Jaffe, and Trajtenberg (2005) find that patent citations are significantly positively related to a firms market value, measured by its Tobins Q. Specifically, they show that an extra citation per patent boosts a firms market value by 3%. Second, we repeat the tests in Hall, Jaffe, and Trajtenberg (2005) with an augmented set of control variables and find that both the number of patents and the citations per patent have a significantly positive effect on firm value.32 Overall, these two pieces of evidence suggest that the financial market appreciates firms innovative activities and rewards successful innovation outcomes (such as high-impact patents) with a higher valuation. Together with the main finding of our paper that analysts impede firm innovation, the above evidence seems to reveal one possible dark side of financial analysts: their negative impact on firm value by discouraging innovative activities. However, we need to bear in mind two important caveats when interpreting or generalizing our results. First, while our findings are consistent with the pressure hypothesis, we cannot rule out the possible positive role played by financial analysts in motivating firm innovation, as suggested by the information hypothesis. This is because our evidence only reflects the net effect of analyst coverage on firm innovation. It is possible that analysts play both a positive role (by reducing innovative firms information asymmetry) and a negative role (by imposing short-term pressure on managers) in motivating firm innovation but in practice the former is dominated by the latter, so that we observe a net negative effect of analyst coverage on firm innovation. Second, while we have demonstrated one particular dark side of financial analysts, we are agnostic about how analyst coverage affects firm value in many other ways (some of which might be positive). Hence, it is inappropriate to conclude, if based solely on the evidence provided by our study, that analysts are detrimental to shareholder value or social welfare. Further, although financial analysts are a key ingredient of the public financial market and our paper examines their influence on individual firms incentives to innovate, a proper evaluation of the overall impact of the financial and capital investment system on a nations innovativeness and competitive advantage is beyond the scope of this study and calls for more future research.

32

These results are reported in Panel L of Table A1 in the Internet Appendix.

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Table 1 Variable definition and summary statistics. Panel A: Variable definition Variable

Definition

Measures of innovation Natural logarithm of one plus firm is total number of patents filed (and LnPatentt+3 eventually granted) in year t+3; Natural logarithm of one plus firm is total number of non-self citations received LnCitePatt+3 on the firms patents filed (and eventually granted), scaled by the number of the patents filed (and eventually granted) in year t+3; Measures of analyst coverage and other variables The arithmetic mean of the 12 monthly numbers of earnings forecasts for firm i Coveraget extracted from the I/B/E/S summary file over fiscal year t; Book value of total assets (#6) measured at the end of fiscal year t; Assetst Research and development expenditure (#46) divided by book value of total R&DAssetst assets (#6) measured at the end of fiscal year t, set to 0 if missing; Firm is age, approximated by the number of years listed on Compustat; Aget Return-on-assets ratio defined as operating income before depreciation (#13) ROAt divided by book value of total assets (#6), measured at the end of fiscal year t; Property, Plant & Equip (net, #8) divided by book value of total assets (#6) PPEAssetst measured at the end of fiscal year t; Firm is leverage ratio, defined as book value of debt (#9 + #34) divided by book Leveraget value of total assets (#6) measured at the end of fiscal year t; Capital expenditure (#128) scaled by book value of total assets (#6) measured at CapexAssetst the end of fiscal year t; Firm is market-to-book ratio during fiscal year t, calculated as market value of TobinQt equity (#199 #25) plus book value of assets (#6) minus book value of equity (#60) minus balance sheet deferred taxes (#74, set to 0 if missing), divided by book value of assets (#6); Firm is KZ index measured at the end of fiscal year t, calculated as -1.002 KZindext Cash Flow ((#18+#14)/#8) plus 0.283 Q ((#6+#199#25-#60-#74)/#6) plus 3.139 Leverage ((#9+#34)/(#9+#34+#216)) minus 39.368 Dividends ((#21+#19)/#8) minus 1.315 Cash holdings(#1/#8), where #8 is lagged; Herfindahl index of 4-digit SIC industry j where firm i belongs, measured at the Hindext end of fiscal year t; The institutional holdings (%) for firm i over fiscal year t, calculated as the InstOwnt arithmetic mean of the four quarterly institutional holdings reported through form 13F; Natural logarithm of relative effective spread measured over firm is fiscal year Illiquidityt t, where relative effective spread is defined as the absolute value of the difference between the execution price and the mid-point of the prevailing bidask quote divided by the mid-point of the prevailing bid-ask quote; Natural logarithm of the sum of expected analyst coverage from all brokers ExpCoveraget covering firm i in year t, where the expected coverage from broker j is the product of the analyst coverage from broker j for firm i in year 0 multiplied by the ratio of broker js size (total number of analysts employed by the broker) in
40

DedOwnt TraQixOwnt DisAccrual

year t divided by broker js size in year 0; The institutional holdings (%) for firm i over fiscal year t held by dedicated institutional investors, per Bushee (2001) classification; The institutional holdings (%) for firm i over fiscal year t held by transient institutional investors and quasi-indexers, per Bushee (2001) classification; The absolute value of the difference between TA/Assets and NDA. TA/Assets is estimated by TAi,t/Assetsi,t-1 =11/Assetsi,t-1 + 2REVi,t/Assetsi,t-1 + 3PPEi,t/Assetsi,t-1 + i,t, where TA equals Net Income (#172) minus Cash Flow from Operations (#308) and REV is the changes in sales revenues (#12). NDA is 1 1/Assetsi,t-1 + 2 (REVi,t/Assetsi,t-1 - ARi,t/Assetsi,t-1) + estimated by NDAi,t= 3 PPEi,t/Assetsi,t-1, where AR is the change in receivables (#2).

Panel B: Summary statistics This panel reports the summary statistics for variables constructed based on the sample of U.S. public firms from 1993 to 2005. Definitions of variables are listed in Panel A of Table 1. Variable Patent CitePat Coverage LnCoverage Assets R&DAssets Age ROA PPEAssets Leverage CapexAssets TobinQ KZindex HIndex InstOwn Illiquidity ExpCoverage DedOwn TraQixOwn P25 0.000 0.000 2.083 0.734 0.111 0.000 6.000 0.066 0.104 0.030 0.025 1.120 -5.104 0.094 0.221 -5.691 1.386 0.015 0.151 Median 0.000 0.000 4.583 1.522 0.426 0.000 11.000 0.125 0.225 0.192 0.047 1.521 -0.891 0.236 0.443 -4.850 1.946 0.073 0.333 Mean 9.785 3.884 7.041 1.515 3.593 0.050 17.087 0.095 0.297 0.218 0.065 2.141 -6.306 0.325 0.438 -4.854 1.923 0.097 0.345 P75 2.652 3.579 9.583 2.260 1.859 0.061 27.000 0.183 0.443 0.346 0.083 2.392 0.771 0.467 0.647 -3.970 2.580 0.150 0.515 S.D. 30.044 8.375 6.697 0.964 10.690 0.096 14.701 0.182 0.239 0.198 0.064 1.788 19.427 0.282 0.255 1.150 0.740 0.095 0.224 N 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 25,860 13,673 25,860 25,860

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Table 2 Baseline regression of innovation outcomes on analyst coverage. This table reports regressions of the innovation outcome variables (three-year-ahead number of patents and number of non-self citations per patent) on analyst coverage and other control variables. Definitions of variables are listed in Panel A of Table 1. Each regression includes a separate intercept. Robust standard errors clustered by firm are displayed in parentheses. ***, **, and * indicate significance at the 1, 5, and 10 percent levels, respectively. (1) LnPatentt+3 0.371*** (0.025) Panel A (2) (3) (4) (5) LnPatentt+3 LnPatentt+3 LnPatentt+3 LnPatentt+3 -0.026* (0.015) -0.051*** (0.016) 0.040** (0.020) 0.093* (0.048) 0.244*** (0.072) 0.705*** (0.200) 0.283*** (0.106) -0.336*** (0.067) -0.014 (0.114) -0.053*** (0.016) 0.050** (0.020) 0.100** (0.048) 0.180** (0.072) 0.693*** (0.200) 0.330*** (0.105) -0.324*** (0.067) -0.051 (0.113) 0.019*** (0.005) -0.001** (0.000) 0.226 (0.163) -0.128 (0.139) -0.052*** (0.017) 0.058*** (0.022) 0.086* (0.048) 0.186** (0.072) 0.719*** (0.201) 0.327*** (0.105) -0.331*** (0.067) -0.016 (0.115) 0.020*** (0.006) -0.001** (0.000) 0.225 (0.163) -0.129 (0.138) 0.174*** (0.067) 0.040** (0.020) Yes Yes 25,860 0.833

Dep. Var. LnCoverage LnAssets R&DAssets LnAge ROA PPEAssets Leverage CapexAssets TobinQ KZindex HIndex HIndex Squared InstOwn Illiquidity Firm fixed effects Year fixed effects Observations R2

No Yes 25,860 0.097

Yes Yes 25,860 0.832

Yes Yes 25,860 0.833

Yes Yes 25,860 0.833

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Dep. Var. LnCoverage LnAssets R&DAssets LnAge ROA PPEAssets Leverage CapexAssets TobinQ KZindex HIndex HIndex Squared InstOwn Illiquidity Firm fixed effects Year fixed effects Observations R2

(1) LnCitePatt+3 0.124*** (0.011)

Panel B (2) (3) (4) (5) LnCitePatt+3 LnCitePatt+3 LnCitePatt+3 LnCitePatt+3 -0.070*** (0.018) -0.083*** (0.018) -0.011 (0.025) 0.221*** (0.061) 0.286*** (0.085) 0.668*** (0.221) 0.287** (0.134) -0.300*** (0.074) 0.432*** (0.155) -0.080*** (0.018) -0.015 (0.025) 0.225*** (0.061) 0.261*** (0.087) 0.765*** (0.222) 0.318** (0.133) -0.288*** (0.074) 0.426*** (0.155) -0.000 (0.006) -0.002*** (0.001) 0.304 (0.187) -0.117 (0.163) -0.077*** (0.019) -0.005 (0.027) 0.212*** (0.061) 0.269*** (0.088) 0.791*** (0.224) 0.313** (0.133) -0.298*** (0.075) 0.466*** (0.157) 0.001 (0.006) -0.002*** (0.001) 0.304 (0.187) -0.118 (0.163) 0.162* (0.087) 0.043** (0.021) Yes Yes 25,860 0.620

No Yes 25,860 0.157

Yes Yes 25,860 0.615

Yes Yes 25,860 0.618

Yes Yes 25,860 0.619

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Table 3 Difference-in-differences test results. This table reports diagnostics and results of the DiD tests on how exogenous shocks to analyst coverage (brokerage closures and mergers) affect firm innovation activities. The sample begins with all firm-years from 1993 to 2005 with non-missing matching variables and non-missing innovation outcome variables during a seven-year window (from year -3 to year +3) around the (actual or matched) event year. For brokerage closures, the treatment firms are those covered by disappearing analysts before the event and whose analyst coverage from these closed brokerages goes down by one. For brokerage mergers, the treatment firms are those covered by both the target and acquirer brokers before the event and for which one of their analysts disappears. The benchmark control portfolios are found by first matching treatment firms to candidate control firms on terciles of market capitalization (MKT), book to market (BM), average monthly stock returns (RET), number of analyst following (NOAN), average monthly stock turnover (TURN), and annualized daily stock return volatility (VOL) in the year prior to the event (year -1). For each treatment firm, five controls with the closest analyst coverage in the matching year are then averaged to form a benchmark control portfolio. Panel A reports the univariate comparisons between treatment and control firms characteristics and their corresponding t-statistics. Panel B gives the full sample DiD test results. Panel C reports the subsample DiD test results based on the number of analysts following the treatment firm in the matching year. Patent is firm is total number of patents in the three-year window before or after the event year. CitePat is firm is total number of future non-self citations received by all patents generated in the three-year window before or after the event year divided by the total number of patents in the corresponding period. To facilitate interpretation, both Patent and CitePat are normalized by pre-event averages over the treatment and the control as described in the main text. Standard errors are clustered at the event (deal) level. ***, **, and * indicate significance at the 1, 5, and 10 percent levels, respectively.

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Panel A: Post-match differences Patent_growth CitePat_growth MktCap (MKT), in billions BookMkt (BM) Return (RET) Coverage (NOAN) Turnover (TURN) Annualized Volatility (VOL) LnAssets LnAge ROA R&DAssets InstOwn Illiquidity Treatment 0.077 -0.132 9.737 0.393 0.020 15.254 1.289 0.492 8.005 2.962 0.137 0.034 0.581 -5.824 Control 0.066 -0.121 10.049 0.388 0.020 15.299 1.288 0.491 7.977 2.921 0.149 0.028 0.569 -5.768 Differences 0.011 -0.011 -3.12.8 0.005 0.000 -0.045 0.001 0.001 0.028 0.041 -0.012 0.006 0.012 -0.056 T-statistics 0.46 -0.67 -0.65 0.48 -0.52 -0.57 0.03 0.24 0.41 1.31 -1.88* 1.64 1.31 -1.51

Panel B: Full sample DiD estimators Mean treatment Difference (after - before) (1) 0.236 (0.042) -0.357 (0.021) Mean control Difference (after -before) (2) 0.054 (0.033) -0.651 (0.023) Mean diff-in-diffs (treat - control) (3) 0.182*** (0.053) 0.294*** (0.035)

Patent (standard error) CitePat (standard error)

Panel C: DiD estimators conditioning on initial coverage Patent (1) 0.253** (0.106) 0.159** (0.068) 0.112 (0.117) CitePat (2) 0.432*** (0.063) 0.269*** (0.047) 0.106 (0.093)

MKT/BM/RET/NOAN/TURN/VOL-matched (coverage10) MKT/BM/RET/NOAN/TURN/VOL-matched (10<coverage25) MKT/BM/RET/NOAN/TURN/VOL-matched (coverage>25)

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Table 4 Robustness tests for Difference-in-differences analysis. This table reports robustness test results for the difference-in-differences analysis. Panel A presents test results using alternative matching criteria. Panel B and C repeat the DiD analysis for subsamples of firms with different thresholds of number of patents and analyst coverage, respectively. Panel D reports test results using alternative subsamples. Panel E adopts a one-tothree propensity-score matching method. We first run a probit regression of a dummy variable that equals one if a particular firm-year belongs to our treatment group (and zero otherwise) on a comprehensive list of observable characteristics, including all the independent variables in our baseline regression, stock volatility and turnover, year and Fama-French 49 industry dummies, and the growth measures of innovation variables (patents and citations). We then use the predicted probabilities from this probit estimation and perform a nearest-neighbor matching with replacements to form the control group. Patent and CitePat are defined in Table 3. Standard errors are clustered at the event (deal) level. ***, **, and * indicate significance at the 1, 5, and 10 percent levels, respectively. Panel A: Alternative matching criteria Patent (1) Nave-matched 0.271*** (0.054) (2) Patent-matched 0.840*** (0.181) (3) MKT/BM/RET/NOAN-matched 0.286*** (0.060) (4) MKT/BM/RET/NOAN/TURN/VOL/PAT/CITEPAT-matched 0.595*** (0.172) (5) MKT/NOAN/TURN/VOL-matched 0.293*** (0.042) (6) MKT/BM/RET/NOAN/TURN/VOL/FF49-matched 0.302*** (0.108) (7) MKT/BM/RET/NOAN/FF49-matched 0.201* (0.110) Panel B: Different thresholds for the number of patents (1) (2) (3) (4) MKT/BM/RET/NOAN/TURN/VOL-matched (Patent1) MKT/BM/RET/NOAN/TURN/VOL-matched (Patent2) MKT/BM/RET/NOAN/TURN/VOL-matched (Patent3) MKT/BM/RET/NOAN/TURN/VOL-matched (Patent5) Patent 0.331*** (0.078) 0.327*** (0.063) 0.345*** (0.057) 0.343*** (0.065) CitePat 0.242*** (0.068) 0.212*** (0.055) 0.172*** (0.051) 0.155*** (0.048) CitePat 0.477*** (0.045) 0.768*** (0.076) 0.805*** (0.071) 0.287** (0.108) 0.805*** (0.076) 0.155** (0.057) 0.111** (0.051)

46

Panel C: Different thresholds for analyst coverage (1) (2) (3) MKT/BM/RET/NOAN/TURN/VOL-matched (coverage5) MKT/BM/RET/NOAN/TURN/VOL-matched (coverage15) MKT/BM/RET/NOAN/TURN/VOL-matched (coverage25) Patent 0.185*** (0.065) 0.172** (0.071) 0.115 (0.083) CitePat 0.290*** (0.033) 0.227*** (0.049) 0.105 (0.080)

Panel D: Different subsamples (1) (2) MKT/BM/RET/NOAN/TURN/VOL-matched (excluding 2001-2002) MKT/BM/RET/NOAN/TURN/VOL-matched (Only broker mergers in Hong and Kacperczyk (2010)) Patent 0.299*** (0.045) 0.159*** (0.046) CitePat 0.549*** (0.083) 0.465** (0.146)

Panel E: Propensity-score matching Propensity-score-matched Patent 0.190** (0.076) CitePat 0.449*** (0.067)

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Table 5 Two-stage least-squares regression with the instrument of expected analyst coverage. This table reports the 2SLS regressions of the innovation outcome variables (three-year-ahead number of patents and number of non-self citations per patent) on analyst coverage, with expected analyst coverage (ExpCoverage) as the instrumental variable. Panel A reports results for the first-stage regression, which generates the fitted (instrumented) value of LnCoverage for use in second-stage regressions as reported by Panel B. Definitions of variables are listed in Panel A of Table 1. Each regression includes year and firm fixed effects. Robust standard errors clustered by firm are displayed in parentheses. The R2 in Panel A is a pooled one, and the reported R2 for second-stage regressions in Panel B is a within-firm one. ***, **, and * indicate significance at the 1, 5, and 10 percent levels, respectively. Panel A (1) LnCoverage 0.909*** (0.012) Yes Yes Yes 13,443 0.698 -0.115*** (0.029) Yes Yes Yes 13,443 0.147 -0.137*** (0.034) Yes Yes Yes 13,443 0.253 Panel B (2) LnPatentt+3 (3) LnCitePatt+3

Dep. Var. ExpCoverage LnCoverage (instrumented) Controls Firm fixed effects Year fixed effects Observations R2

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Table 6 Possible Mechanisms. This table reports test results on possible mechanisms through which analyst coverage affects innovation, as well as any residual effects of analyst coverage after controlling for direct mechanisms. Panel A and B present the DiD results on different categories of institutional ownership and takeover exposure, respectively. Takeover is the predicted value of Target for the following logit regression: Targeti,t+1 = a + 1Qi,t + 2PPEAssetsi,t + 3LnCashi,t + 4Blocki,t + 5LnMVi,t + 6IndMAi,t + 7Leveragei,t + 8ROAi,t+ Yeart + Industryj + errori,t, where Target equals one if a firm is the target of an attempted or completed acquisition and zero otherwise. All independent variables are constructed in the same way as those in Cremers, Nair, and John (2009). Standard errors are clustered at the event (deal) level. Panel C conducts the DiD analysis on our matched sample (defined in Table 3) in a multivariate framework, after controlling for the dependence of the DiD estimator on possible mechanisms. Column (1) regresses Patent on a treatment dummy (Treat), a dummy to indicate post-event period (Post), and the interaction between Treat and Post (Treat*Post). Column (2) regresses Patent on Treat, Post, and Treat*Post and controls for DedOwn, TraQixOwn, Takeover, Illiquidity, and DisAccrual. Column (3) regresses CitePat on Treat, Post, and Treat*Post. Columns (4) regresses CitePat on Treat, Post, and Treat*Post and controls for DedOwn, TraQixOwn, Takeover, Illiquidity, and DisAccrual. Patent and CitePat are defined in Table 3. DisAccrual is constructed in the same way as in Yu (2008) and we describe the variable construction in Table 1 Panel A. ***, **, and * indicate significance at the 1, 5, and 10 percent levels, respectively. Panel A & B: Changes in different categories of institutional ownership and takeover exposure Panel A DedOwn TraQixOwn 0.013*** -0.009** (0.003) (0.004) Panel B Takeover -0.001** (0.000)

MKT/BM/RET/NOAN/TURN/VOL-matched

Panel C: DiD tests when controlling for possible mechanism variables Dep. Var. Treat*Post Treat Post DedOwn TraQixOwn Takeover Illiquidity DisAccrual Constant Observations R2 0.997*** (0.043) 3,863 0.011 (1) Patent 0.204** (0.090) -0.292*** (0.063) 0.097 (0.061) (2) Patent 0.122* (0.072) -0.292*** (0.050) -0.017 (0.054) 0.765*** (0.274) 0.255 (0.160) -0.107*** (0.013) 0.063* (0.038) 0.275* (0.160) 1.516*** (0.113) 3,863 0.027 (3) CitePat 0.362*** (0.035) -0.488*** (0.025) -0.783*** (0.024) (4) CitePat 0.277*** (0.040) -0.415*** (0.028) -0.667*** (0.030) 0.614*** (0.154) 0.039 (0.090) -0.036*** (0.007) 0.103*** (0.021) 0.171* (0.090) 1.376*** (0.064) 3,863 0.459

1.042*** (0.017) 3,863 0.301

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Figure 1 Trends of innovation activities in the treatment sample (net of control). This figure shows the trend of innovation activities for the treatment sample net of the control group three years before and after the event (broker closure or merger) year. Panel A shows the trend for the number of patents and Panel B shows the trend for the number of non-self citations per patent. Consistent with the baseline DiD analysis, both measures are normalized by the preevent averages over the treatment and control firms. Panel A

Panel B

51