Effect of Information Opacity and Business Complexity on Star Analyst Coverage

Prior studies show that analysts tend to cover firms that provide more informative disclosures because it is less costly to acquire and analyze information about such firms. Using a simple theoretical model that maximizes the net benefit of analyst coverage, we show that the optimal level of information opacity chosen by analysts is strictly increasing with analysts’ ability of researching and analyzing firms’ information, and so is the optimal level of business complexity. For capable analysts, the high benefit resulted from the high demand of their services for firms with high information opacity and business complexity, dominates the high cost of following such firms. The empirical results show that the coverage of Wall Street Journal ranked star analysts is positively related to firms’ information opacity represented by low levels of accounting conservatism, high levels of accruals and low frequency of management forecasts. Meanwhile, star analyst coverage is positively related to the complexity of the firm’s business environment proxied by high levels of industry sales concentration and the percentage of sales from foreign segments. In addition, we predict that the adoption of Regulation Fair Disclosure has increased the marginal cost of star analysts in analyzing the firms more than that of non-star analysts because of the good relationships between star analysts and firms’ management as documented in the literature. The empirical results show that the association between star analyst coverage and information opacity has been weakened after Reg FD, suggesting that the optimal level of information opacity chosen by star analysts relative to non-star analysts decreases after Reg FD.