Due Diligence and Strategic Behavior

Abstract

We provide a general model of due diligence and strategic behavior that can be applied to a wide array of situations with asymmetric information and apply this model to an Analyst's Forecasts about a Studied Firm as a function of Publicly available information and the Studied Firm's unobserved (to the Empiricist) information, when the Studied Firm provides Management Guidance to the market as well. Due diligence requires that the Analyst acquire and analyze Studied Firm-specific information, even potentially information that is not available to the Studied Firm itself, we measure Due-Diligence using the Hausman Specification Test. Under non-strategic behavior, the Analyst provides as Forecast its best estimate of the Studied Firm's earnings, we measure Strategic-Behavior using the Wald Test. We calculate the Z-Score of Due-Diligence and Strategic-Behavior, and each regressand and regressor, which follows standard normal distribution, and report, for ease of empirical interpretation, empirical results corresponding to these Z-Scores. We find that over 1994-2018, Due-Diligence is significantly increasing (at 5% level) in first Analyst Forecast after Management Guidance, log of difference in days between Management Guidance and Analyst Forecast, and log of Analyst's experience, and that Strategic-Behavior is significantly increasing (at 5% level) in first Analyst Forecast after Management Guidance, log of difference in days between Management Guidance and Analyst Forecast, and log of Analyst's experience, and significantly decreasing (at 5% level) in log of mean trading volume of Studied Firm, mean bid-ask spread of Studied Firm's equity, and standard deviation of Studied Firm's daily equity return. Under the additional information assumption that the Actual Earnings (per share) of the Studied Firm are available to the Public at the beginning of the next period as Announced Earnings (per share), ex post Normalized Accuracy -- measured by the negative of the absolute difference between Analyst Forecast (per share) and Announced Earnings (per share), divided by Announced Earnings (per share) if positive -- is positively related to Due-Diligence and Non-Strategic-Behavior.

Keywords: Analyst Forecasts; Management Guidance; Due Diligence; Strategic Behavior; Instruments; Hausman Specification Test; Announced Earnings; Actual Earnings; Normalized Accuracy; Adverse Selection; Moral Hazard

JEL Classification: G12; G14; G24; C23; C26