Friday, May 26, 2006

Conflicted?

Admittedly as a research analyst I am sensitive to allegations of impropriety in the securities research field. So it should not be surprising that my interest was piqued by an article entitled “The Two Faces of Analyst Coverage” that appeared in the Summer 2005 issue of Financial Management. The title suggests duplicity and my personal experience is that security research is relatively forthright.

The article is the collective effort of three university professors: John Doukas of Old Dominion University in Virginia, Chansog Kim of City University of Hong Kong, and Christos Pantzalis of the University of South Florida. The trio investigated the effects of “excessive” analyst coverage, finding that high analyst coverage resulted in excess valuations and low future returns. We will come back to that astounding conclusion momentarily.

To begin their presentation, the authors described how securities analysts focus on stocks that are likely to provide trading activity and investment banking transactions. Security analysts are motivated to find stocks that will generate profits for their companies in the form of trading commissions and banking fees. The professors see this as a “conflict of interest” in the choice of companies that are followed. If an analyst were to focus on stocks that would generate losses for their firms, would that indicate objectivity?

Since the authors believe securities research is conflicted because analysts narrow their selections to those companies that could benefit their employers, I wondered how the professors got their work published. Who decides what projects are pursued? If the professors or their employers benefited economically, is their research conflicted?

Although I was not able to reach anyone at the City University of Hong Kong, I was able to reach representatives of both Old Dominion and the University of South Florida. Guess what? Neither Mr. Doukas nor Mr. Pantzalis are free to publish just anything that suits their fancy. Both have to get their research ideas past their respective department heads, who give consideration to the effective use of department resources. At the University of South Florida there is a second step at the research program level, wherein the interests and reputation of the school are considered.

After the resource and reputation hurdles are passed the next consideration is the grant application. The representative of the Old Dominion Research Foundation explained it best. An Old Dominion professor can pursue anything he or she can get approved by their boss as long as it “looks like it is a project that can get funding.” Both Old Dominion and South Florida employ full time staff assigned to do nothing but help professors construct “winning” grant applications. In other words, the professors are asked to design their research projects so as to maximize the chances of bringing money into the school.

This sounds very much like these professors “focus on research to generate profits.” Does this mean they are conflicted? Are the conclusions of their study invalidated by the fact that they receive remuneration that benefits them and their employers? I would not make that same error in logic.

Nonetheless, let’s revisit the conclusion of the professors that high analyst coverage leads to excess valuations and low future returns. They used an extensive database composed of over 1,000 companies to scrutinize excess value and excess analyst coverage, both of which are determined using industry averages. The results indicated “a significant relationship” between excess analyst coverage and stock premiums. Having established this relationship, the professors concluded that capital market allocations can be biased since analyst coverage is affected by the existence of investment banking deals.

Huh? Is this not just the usual forces of supply and demand at work? When demand in the form of analyst coverage increases, the demand curve shifts to the right and equilibrium is reached at a higher stock price. Since the number of shares in the flotation (the supply) is relatively inelastic, the increase in demand often leads to an overbought situation and a premium stock price. And yes, at a premium price future returns will be lower.

Of course, if the analysts’ employers were to assist the company with a secondary offering of new common stock shares, the reverse would occur. An increase in shares would lead to a shift in the supply curve to the right and a lower equilibrium price.

The trio used regression models to control for differences in company characteristics and for the possibility that analyst coverage relates to profit expectations. Profitable companies apparently warrant extra research coverage while those that exhibit opportunities for expansion through acquisition, merger or capital raises - the circumstances that lead to investment banking deals - do not!

Leaving aside the interests of the analyst’s employer in publishing marketable research that keeps the rent paid and the payroll funded, let us consider the interests of the investor. After more years as a small cap analyst that I care to admit, I have yet to have a client - institution or individual - ask me to bring them a stock idea in a stagnant, slow growth industry. No one has ever asked me to find a scenario where there would be no danger of any value-producing mergers or acquisition….no opportunities for expansion that might require a capital infusion….no internal cash flows to be reinvested.

Even if I could convince a portfolio manager to consider a company with bleak prospects, the next question on their lips would likely be whether there is sufficient liquidity in the stock to efficiently accumulate or divest a position. Now we have gone full circle back to that trading activity issue, which the good professors believe foments conflict of interest.

At no point in the article does it appear that the authors have given any thought whatsoever to the obligation of the analyst to serve his client. That strong trading activity and investment banking transactions are coincident with the liquidity and economic opportunity characteristics that investors seek, is a well-known capital market notion. Yet the professors suggest just the opposite.

I imagine that some securities analysts might empathize with these three professors – under pressure to write “winning” material to bring in grant funds. After all, who other than a securities analyst could better understand skipping over fundamental facts and using a salacious title to churn up interest?

I use sarcasm to underscore the point that not every allegation of impropriety in securities research is well founded. Admittedly, research coverage is uneven, particularly in the small cap sector where company size and trading volume considerations fail to attract extensive analyst interest. However, articles suggesting impropriety when analysts are simply engaged in ordinary capital market behavior should be read with some skepticism.

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