Industry analysts are vital conduits of information between the firms they cover and the investors in those firms. Despite their central role in capital markets, little is known about how analysts make their coverage decisions and how they gain their industry knowledge—the resource that investors value above all. Filling this important gap, HKUST’s Charles Hsu and co-researchers examine the role played by competition in the industries that the analysts follow.

By covering competing firms, Hsu and colleagues argue that analysts “enhance their knowledge about industry competition and thus improve their understanding of firm performance.” They “gain in-depth knowledge of firms’ products,” helping them cover different firms efficiently, because competitors tend to produce goods with similar inputs, technologies and markets, and have “correlated costs and revenues,” they write.

The researchers also examine the effect of the competition between the companies they follow on the analysts’ own careers. Covering competitors “should improve analysts’ ability to rank firm performance among competitors, a key area of expertise for high-performing analysts,” they write.

To test what is “ultimately an empirical question,” the researchers departed from the usual technique of creating a sample of competitors using Standard Industry Classification (SIC) codes (which group Apple, Dell and IBM together as computer makers, for example). Instead, they used the descriptions of their products that firms filed with market regulators. This allowed them to establish product-similarity scores, identify competitors and group them into industries. By gauging the “extent of overlapping product competition between firm pairs,” the authors could “investigate analysts’ decisions to add/drop a firm to/from their portfolios,” depending on whether it competed with the analyst’s other firms, which would not have been possible using SIC codes.

The researchers tapped databases to retrieve stock prices, returns, earnings, analyst forecasts and recommendations between 1998 and 2019. They used Institutional Investor’s star rankings—which are “crucial to both brokers’ status and reputation and analysts’ compensation”—to establish investors’ views of analysts’ industry knowledge.

The authors show that an analyst is more likely to add a firm to their coverage portfolio or drop it depending on the number of competitor firms and the intensity of the “product market competition with the other firms the analyst covers.” They add that their results “support the conclusion that analysts adjust their coverage portfolios to cover evolving industry competitors.” The intensity of competition, i.e., “the degree of product similarity among competitors,” is also important in deciding on coverage. “Covering firms with competing products enhances analysts’ industry knowledge,” the authors write.

Competition between the firms covered also affects analysts’ careers, the authors found. On the basis that bigger firms are generally more prestigious and can attract the most talented analysts, the authors also followed those who moved to a smaller brokerage or left the industry altogether. “Analysts with portfolios of firms having greater product competitor overlap and higher competition intensity with each other are more likely to be nominated Institutional Investor stars and are less likely to be fired,” they conclude.

These insightful findings will benefit not only analysts themselves but also firms and their investors in an increasingly competitive market.