By Jason Zweig | Apr. 25, 2013 11:11 am ET
Image credit: “Four prize winners in annual beauty contest, Washington, DC” (1922), Library of Congress
As law firms have recently been reminding their clients, Wall Street analysts can get in trouble if they obtain nonpublic information from the managers of the companies they follow. The Securities and Exchange Commission, under Regulation F-D, has strict rules that seek to limit the ability of any investor to get early or private information.
But you can still dream. Consider a new study of stock analysts by a team of accounting and finance professors: The analysts rank private phone calls with management as the most useful source of information for generating earnings forecasts. And promoting private access to corporate management remains one of the best ways for an analyst to get a rise out of clients.
As one analyst told the researchers, “If I call up a money manager, a hedge fund, whoever, and I’ve got a call to make on a stock, and I’m able to say, ‘Hey, by the way, we were able to spend 20-30 minutes talking to senior management,’ boom! Their ears are just straight up.”
Earlier this year, accounting professors Laurence Brown of Temple University, Andrew Call of the University of Georgia, Michael Clement of the University of Texas at Austin and Nathan Sharp of Texas A&M University surveyed 365 sell-side analysts and did 18 direct interviews, detailing how analysts do their work and view their roles. They made the results anonymous to ensure confidentiality.
Their study draws some striking conclusions:
- Asked who was their most important group of clients, 81.5% of analysts picked “hedge funds.” Only 13.3% chose “retail brokerage clients.”
- Fewer than a quarter of the analysts said that the “accuracy and timeliness” of their earnings forecasts were very important to their compensation. Only 35% said that the profitability of their stock recommendations was crucial in determining how much they earned. Their “standing in analyst rankings or broker votes,” however – essentially how they score in media surveys, “broker votes” and other annual popularity contests among clients – was very important in shaping compensation for 67% of the analysts.
“I came into the industry thinking [success] would be based on how well my stock picks do,” one analyst told the researchers. “But a lot of it ends up being, ‘What are your broker votes?’”Another reported, “25% of the allocation of our bonus pool is based on broker votes.”
- Approximately one in four analysts has been pressured by a supervisor to lower earnings forecasts, presumably because that makes the forecasts easier for companies to beat – thereby pleasing investors and companies alike.
- Only half of analysts said that primary research, like discussions with customers and suppliers, was very useful in forecasting earnings or recommending stocks.
- Nearly 40% of analysts said that it was very likely that they would lose access to management or be “frozen out” of question-and-answer sessions on conference calls if they issued an earnings forecast well below the Wall Street average.
As one analyst put it, chillingly: “Most of the sell-side is worried more about what management thinks of them than they are about whether they’re doing a good job for investors.”
- What would happen if analysts suspect a deliberate attempt by management to misrepresent a company’s financial statements? Most said they would respond by seeking additional information. But 4% of analysts said it isn’t at all likely that they would request any further explanation from management or investigate outside the company. And 7% said there was almost no chance that they would lower their earnings forecast or downgrade the stock.
- More than two thirds said that private phone calls with management were far and away the most important factor in their work.
- It’s customary for analysts to have private phone discussions – one-on-one – with a company’s chief financial officer shortly after the company’s public conference call to discuss its quarterly earnings.
“You get details that they’re not necessarily going to go into on a public call with investors,” said one analyst. “Then we can go to clients and say, ‘This is our understanding of the situation. This is what the company says; this is what we think.’” Added the analyst: “It’s a way for them to broadcast. We’re sort of like a megaphone for them.”
- Wall Street firms will go to great lengths to try identifying the “tells” that are supposed to tip off listeners that someone is shading the truth or lying – even though much of this effort is little better than voodoo and psychobabble. One analyst said of private telephone calls with management: “You can read their body language -even on the phone – and get a feel for how optimistic they are or how realistic something might be.” One brokerage firm, said an analyst, brought in an FBI profiler who educated the research team for four hours on how to read subtle cues that can indicate deceptive behavior. (The FBI, on its website, points out that there’s no such thing as an “FBI profiler.”)
Any investor – especially any individual investor – still clinging to the delusion that Wall Street analysts provide an independent, objective and skeptical perspective on companies needs to read this study.
Source: WSJ.com, Total Return blog http://on.wsj.com/11ngEbN
Definition of ANALYST in The Devil’s Financial Dictionary:
For further reading:
Essays by Benjamin Graham on the art and science of security analysis in Jason Zweig and Rodney Sullivan (editors), Benjamin Graham: Building a Profession