Inside the black box of analyst decision making

A pair of large-scale surveys of buy-side and sell-side analysts has uncovered an array of valuable and perhaps surprising insights into the different inputs and incentives that shape their respective research. Among the findings:

‒ Sell-side analysts rank private communication with management as more important than their own primary research, recent earnings performance or the latest 10K and 10Q reports when determining earnings forecasts and stock recommendations.

‒ Buy-side analysts say recent 10K or 10Q reports are more useful than quarterly conference calls, management earnings guidance and recent earnings performance when determining their stock recommendations.

‒ Less than 3 percent of buy-side analysts believe sell-side stock recommendations are very useful.

‘Financial analysts are in the academic spotlight,’ says study co-author Nathan Sharp, associate professor of accounting at Texas A&M University. ‘Until now, however, little was known about the context in which they made their decisions. We wanted to penetrate that ‘black box’.’

To do so, Sharp, along with colleagues Andrew Call at Arizona State University, Michael Clement at the University of Texas at Austin, and Lawrence Brown at Temple University, surveyed more than 700 US buy-side and sell-side analysts, following up with 32 detailed interviews to shed light on the more intriguing data.

For Sharp, perhaps the most notable revelation is the enduring impact private communication with management has on the sell side’s earnings forecasts and recommendations. ‘We thought Reg FD would have rendered private conversations of limited use,’ he says. ‘But it appears managers give valuable information selectively to certain analysts in private communications.’ He adds that the findings may be consistent with an aspect of Reg FD that allows managers to disclose immaterial information to an analyst that helps complete a ‘mosaic’ of information, which, taken together, is material.

One analyst interviewee describes the information discussed on the private calls as follows: ‘It’s not non-public material information; it’s clarification of points. They help you digest the information a little bit better.’

Another analyst reports that buy-side clients believe the insights of sell-side analysts are more valuable when analysts have direct contact with management: ‘Regardless of Reg FD, investors value analysts’ direct contact with management more than anything. As an analyst, 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, then boom! Their ears are just straight up.’

For their part, many buy-side analysts consider talking to management to be far less important. One describes the risks of getting to close to management members: ‘Some buy-siders don’t even want to touch management because they feel it’s going to bias them. If I become friends with this guy, I don’t want to bias my objective outlook on the fundamentals.’

Sharp says these divergent views underscore a range of fundamentally different inputs affecting each class of analyst’s professional outputs. ‘Buy-side analysts emphasize fundamentals like financial reports more than they emphasize relationships with management,’ he says. ‘Critics have said financial reports lack timeliness and have lost relevance. As accounting professors, we were surprised and pleased to discover that this isn’t the case.’

Study results also point to stark contrasts between how buy-side and sell-side analysts evaluate the integrity of financial statements. ‘Essentially, sell-side analysts tell us, We take the statements on faith. If auditors can’t catch problems neither will we,’ says Sharp. ‘The buy side, on the other hand, has real skin in the game. We find it is much more willing to scrutinize statements looking for red flags of intentional misrepresentation.’

The researchers further find that buy-side analysts give little consideration to either brokerage size or Institutional Investor-style all-star status when deciding which sell-side analyst’s information to use. Instead, they value sell-side analysts’ industry knowledge and the frequency with which they communicate with management.

‘Buy-side analysts report they often rely on the sell side to quickly get up to speed on a new industry they cover,’ says Sharp, adding that divergent financial incentives to produce profitable stock recommendations may partially explain the buy side’s lack of interest in sell-side recommendations.

‘Although the profitability of the recommendations buy-side analysts submit to their portfolio managers is the most important determinant of their compensation, sell-side analysts’ compensation is less closely tied to the profitability of their stock picks,’ explains Sharp. ‘Interestingly, sell-side analysts’ recommendations are less valuable to the buy side than information the sell side provides about other investors’ opinions or holdings.’