WHEN SELL-SIDE ANALYSTS MEET HIGH-VOLATILITY STOCKS: AN ALTERNATIVE EXPLANATION FOR THE LOW-VOLATILITY PUZZLE

Jason C. Hsu, Hideaki Kudoh and Toru Yamada

Using a global equity dataset that includes emerging markets, we confirm that high-volatility stocks tend to deliver low average returns; this effect is robust to adjustments for country and style factors. We also show that sell-side analysts’ earnings growth forecasts for high-volatility stocks are more biased. It is well known that sell-side analysts are predictably optimistic; however, the relationship between the degree of optimism and a stock’s volatility has not been documented before. We hypothesize that analysts inflate earnings forecasts more aggressively for volatile stocks, in part because the inflation would be more difficult for investors to detect. Because investors are known to overreact to analyst forecasts (under-adjust to analyst bias), this contributes to systematic overvaluation and low returns for high-volatility stocks. Additionally, we find sell-side analysts’ research informative despite the biases; stocks that have high forward E/P ratios based on analyst earnings forecasts tend to outperform and produce significantly positive Fama–French alphas. This evidence rejects the cynical view of some in our industry that sell-side analysts are unskilled. More interestingly, we find high forward E/P stocks also exhibit high analyst bias, which supports an interpretation that analysts are more willing to inflate earnings forecasts for stocks that they believe are likely to deliver high returns—or for which their inflated forecasts are likely to do no harm.