Rob Swystun, Pristine Advisers
This is probably going to come as a surprise to approximately zero people, but a new study says that Wall Street equity analysts who regularly give positive ratings to a company’s stock are more likely to end up working for that company. (I’ll take that lack of a shocked gasp as proof that this is something you strongly suspected was happening anyway.)
Wall Street analysts hold quite a bit of sway with investors, as they tend to get a lot more access to company management than most investors do and they make recommendations on whether to buy or sell a given company’s stock.
As Myles Udland, writing for Business Insider, says, their recommendations can influence a large number of people one way or the other and this leads to conflicts of interest. If an analyst is too negative on a company’s stock, they risk alienating that company and getting less access to its management. To avoid this, many analysts will give companies favorable ratings even if they don’t fully back those ratings.
But, constantly giving companies favorable outlooks could be an indication of a different kind of conflict of interest: the Revolving Door Phenomenon.
Ben Lourie of UCLA explores this so-called revolving door phenomenon in a recently released paper that found when sell-side analysts are more bullish on a company they cover, particularly in their final year as an analyst, they are more likely to be hired by that company.
Based on a sample of 299 revolving-door analysts over the period from 1999 to 2014, Lourie found that in the last year of being an analyst, “these analysts issued higher target prices and more optimistic recommendations for their would-be employing firms relative to other analysts covering these firms.”
In that last year, the revolving door analysts consistently gave their future employers:
- higher price targets on the company’s stock,
- more optimistic recommendations about the company,
- a more pessimistic view about the prospects of the company’s competitors, and
- an increased number of reports compared to other analysts.
Why, you could almost say that analysts drop some hefty hints when they wanna work for a company.
“The findings raise concerns about [analyst] independence and indicate a potential benefit to tightening employment regulations in this industry,” Lourie writes in the report.
Even more troubling is that after dropping those hints, analysts can be hired by a company immediately. There is no actual law that states an analyst has to have a “cooling off” period between covering a company and being hired by that company. A cooling off period would be a mandated amount of time between when an analyst stops covering a company and when they can begin working for that company. So, for example, if they wrote their last research report on a company in December of this year, a cooling off period of a year would mean they would not be eligible to work for that company until December of next year.
The only FINRA regulation specifically addressing this problem of having no cooling off period states that when “a research analyst is pursuing employment or has accepted a job with a covered company, NASD rules require that information concerning such a clear conflict of interest must be disclosed in research reports.”
The problem with that is dropping huge hints about one’s desire to work at a company via bullish ratings and forecasts and actually pursuing a job there aren’t exactly the same thing and, therefore, analysts can avoid this disclosure.
There has only been a single case of an analyst being charged with violating this regulation, according to Lourie, and that person was fined $20,000 and suspended from analyst work for two years, which Lourie called a “weak deterrent to avoid disclosing the conflict of interests.”
Maybe it’s Something Different
Giving revolving door analysts and the companies that hire them the benefit of the doubt, Lourie looks at three possible other reasons that a company might hire an analyst who has been especially bullish on that company.
1. Companies hire analysts who provide more accurate earnings per share forecasts and these analysts just happen to be more accurate than others.
Lourie found that revolving-door analysts are, on average, less accurate than other analysts.
2. The analysts’ change in behavior in their final year as an analyst had nothing to do with future employment and their behavioral change and hiring were just coincidental.
Lourie found that analysts who did have the aforementioned cooling off period by spening at least one year in a different job before going to work for a firm they had previously covered as an analyst displayed no change in their behavior during their final year as an analyst.
3. Revolving door analysts actually are more optimistic about a firm (rather than just sucking up) and those firms tend to want to hire analysts that are more optimistic about them.
Maybe (but probably nope).
“While the true opinion of the analyst is non-observable,” Lourie writes, “the fact that the change in the analyst behavior occurs in the year just prior to their move to the covered firms makes this explanation less likely.”
To be perfectly fair, Lourie also does note that companies do tend to take revolving door analysts’ general qualifications into account and the former analysts do tend to perform better in their new positions than people hired from other professions.
So, what to do about it, then?
It would be difficult to get an analyst to disclose in their research that they had had a phone conversation or some kind of informal meeting with a company, so it would theoretically be difficult to tighten the FINRA regulation already in place.
However, a mandatory cooling off period has merit. Other professions which the public rely on for objectivity and independence, like auditors, have these mandatory cooling off periods. The the Sarbanes-Oxley Act of 2002, for example, mandates that publicly-held companies cannot hire their auditor’s former employees in key positions for at least a year.
This might work with analysts. Because they know so much about the companies they report on, analysts happen to know when ripe job opportunities are going to become available. If there was that mandatory cooling off period, those job opportunities would likely be filled by the time the analysts’ cooling off period was up.
But, as Udland points out, it’s not yet known how much of an impetus the SEC even has to try and stop the revolving door phenomenon.
So, for the foreseeable future, it’s likely that the door will just keep spinning.