Security Analysis, Agency Costs, and Company Characteristics

John A. Doukas, Chansog Kim and Christos Pantzalis

Financial Analysts Journal, 2000, vol. 56, issue 6, 54-63

Abstract: We appraise the monitoring activity of security analysis from the perspective of the manager–shareholder conflict. Using a data set of more than 7,000 company-year observations for manufacturing companies tracked by security analysts over the 1988–94 period, we found that security analysis acts as a monitor to reduce the agency costs associated with the separation of ownership and control. We also found, however, that security analysts are more effective in reducing managerial non-value-maximizing behavior for single-segment than for multisegment companies. In addition, the shareholder gains from the monitoring activity of security analysis are larger for single-segment than for multisegment companies. In spite of the general belief that the activities of security analysts affect firm value, little is known about whether analysts act as a monitoring mechanism in reducing the agency costs of manager–shareholder conflict. If security analysis exerts positive influence on firm value by restricting managers' non-value-maximizing activities, it should decrease agency costs. Thus, we carried out a direct testing of the relationship between security analysis and agency costs.Little is known also about whether the effectiveness of security analyst monitoring is related to the structure (diversification) of the company. This issue is important because recent studies have documented that diversified companies destroy shareholder value. Although a diversification discount is generally accepted, the mechanism through which diversification destroys firm value is not understood. Possible causes are that diversification encourages overinvestment, that it invites agency costs, and that diversified companies suffer from internal-capital-market inefficiencies associated with the misallocation of resources. We studied whether security analysis as an external monitor of managerial conduct, in the sense of reducing agency costs arising from informational asymmetries, works as well, less well, or better for nondiversified companies than for diversified companies.We examined the monitoring effectiveness of security analysts with a data set of 7,485 manufacturing company-year observations over the 1988–94 period. Based on the number of analysts following a company for forecasting horizons of (fiscal) one quarter, one year, and two years, our results consistently show that security analysis reduces agency costs (i.e., managers' non-value-maximizing behavior) while it increases firm value. We also found that the effectiveness of analysts' monitoring activity declines with industrial diversification, despite the fact that the number of analysts following diversified companies is substantially greater than the number following nondiversified companies. In addition, we show that the shareholder gains from the monitoring activity of security analysis are larger for nondiversified than for diversified companies.

Date: 2000
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DOI: 10.2469/faj.v56.n6.2403

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