When security analysts talk, who listens?

Regulators' interest in analyst reports stems from the belief that small investors are unaware of the conflicts sell-side analysts face and may, as a consequence, be misled into making suboptimal investment decisions. We examine who trades on security analyst stock recommendations by extending prior research to focus on investor-specific responses to revisions. We find that both large and small traders react to analyst reports; however, large investors appear to trade more than small traders in response to the information conveyed by the analyst's recommendation and earnings forecast revision (proxied by the magnitudes of the recommendation change and the earnings forecast revision, respectively). We also find that small investors do not fully account for the effects of analysts' incentives on the credibility of analyst reports, as captured by the type of recommendation (i.e., upgrade versus downgrade or buy versus sell). In particular, small investors not only trade more than large investors following upgrade and buy recommendations, but also trade more following upgrade and buy recommendations than they do following downgrade and hold/sell recommendations. Furthermore, we observe that, on average, small traders are net purchasers following recommendation revisions regardless of the type of the recommendation; large traders tend to be net sellers following downgrades and sells. Consequently, large traders generate statistically positive returns from their trading, while small traders generate statistically negative returns from their trading. These findings are consistent with large investors being more sophisticated processors of information, and provide some support for regulators' concerns that analysts may more easily mislead small investors.