A recent study designed to decipher the “black box” of sell-side analyst decision making sheds new light on the driving forces behind two important outputs of their work: earnings estimates and stock recommendations. Based on a survey of 365 sell-side analysts and detailed follow-up interviews conducted in the first quarter of 2013, “Inside the ‘Black Box’ of Sell-Side Financial Analysts” offers insights into the sometimes conflicting inputs that influence analysts’ decision making, as well as the ethical dilemmas they regularly face.
Here are several noteworthy take-aways:
- Industry knowledge is king. Sell-side analysts consider industry knowledge to be the most important input to their earnings forecasts and stock recommendations. And while Regulation FD (which prohibits the selective disclosure of material, nonpublic information) is described by surveyed analysts as a “game changer,” private communications with management are still considered to be among the next most important inputs into earnings forecasts and stock recommendations. More than half of the analysts surveyed reported that they have direct contact with the CEO or CFO of the companies they follow five or more times a year.
- Access trumps accuracy. Industry knowledge, accessibility, and analyst rankings are the biggest compensation drivers for sell-side analysts. Interestingly, accurate earnings forecasts and profitable stock recommendations, the most prominent outputs of their work, are seen as having relatively little impact on compensation.
- Keep it simple. Sell-side analysts indicate that they use simple P/E and P/E/G valuation models to support their stock recommendations more often than more sophisticated models, such as dividend discount, EVA, or residual income models.
- Lowballing estimates lives on. Twenty-four percent of sell-side analysts report being pressured by their managers to issue an earnings forecast that is lower than what their research supports, while 17% of analysts report being compelled to issue an earnings forecast that exceeds what their research justifies.
- Caveat emptor. Twenty-four percent of analysts report being pressured by their managers to issue a stock recommendation that is more favorable than what their research substantiates, while 15% of analysts report being compelled to issue a stock recommendation that is less favorable than what their research supports.
- Avoiding the herd. The most likely consequences of issuing earnings forecasts or stock recommendations that are well below the consensus were an increase in the analysts’ credibility with their clients, followed, perhaps not surprisingly, by loss of access to management. Reduced compensation or promotion opportunities were reported to be the least likely of consequences.
- Speaking volumes. The relative importance of clients to the sell-side firms seems to be closely correlated with typical trading volumes. Hedge funds and mutual funds were considered the most important clients, followed, in order, by pension funds, insurance companies, endowments and foundations, and retail and high net worth clients.
The finding that nearly a quarter of the analysts surveyed report being pressured to lowball earnings estimates or inflate their stock recommendations is somewhat surprising and clearly evidence that Wall Street still has much work to do to regain the trust of investors.
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