Consistency between Earnings Forecasts and Stock Recommendations: The Effect of Political Connections

• In Event: Earnings Management and Market Reaction

Abstract

Financial analysts’ earnings forecasts are more consistent with stock recommendations when their earnings forecasts are more accurate (Loh and Mian 2006, Ertimur et al. 2007). This suggests that analysts use other information in their private valuation models in addition to earnings forecasts especially when earnings have greater uncertainty. Recent studies show that political connections are important for firm valuation and are associated with future positive returns and future positive operating performance (Faccio 2006, Cooper et al. 2010). In this study, I examine how a firm’s political connections affect stock recommendation informativeness as well as the efficiency with which analysts translate their earnings forecasts into stock recommendations. Using data from the Federal Election Commission through the Center for Responsive Politics from 1993 – 2011, I first show that analysts’ recommendations are less informative for politically connected firms. Second, I show that analysts’ earnings forecast accuracy is less consistent with recommendation informativeness when firms are politically connected. In additional analyses, I find that this inconsistency appears to be driven by the upgrade recommendations of non-All-Star analysts. This suggests that analysts who have less experience and more optimistic recommendations do not properly account for the firm valuation effects of political connections. The results of this study are robust to analyses that take into consideration the potential endogeneity associated with the self-selection of political connectedness.

Author

• Elio Alfonso, Florida International University