Despite regulations, financial analysts say private calls with executives are essential

Nathan Y. Sharp, Assistant Professor at Mays Business School

A new study of 365 sell-side financial analysts shows that private phone calls with managers remain an essential source of analysts’ earnings forecasts and stock recommendations — even in light of regulations limiting businesses’ selective disclosure of financial information.

More than half of the analysts surveyed by a team of accounting researchers said they make direct contact with executives of companies they cover five or more times per year. The direct contact with management is so important that one analyst said his company hired an FBI profiler to train analysts “to read management teams, to tell when they’re lying, to tell when they were uncomfortable with a question. That’s how serious this whole issue has become.”

“Our intent was to peer inside the “black box’ and provide new insights about the pressures and incentives analysts face. One key finding is that more than a decade after the passage of Regulation Fair Disclosure (FD), analysts report that private conversations with managers are among their most valuable sources of information,” said Nathan Y. Sharp, assistant professor at Texas A&M University’s Mays Business School, who conducted the study with professors at Temple University, The University of Georgia and The University of Texas at Austin.

The survey also finds that accurate earnings forecasts and profitable stock recommendations have relatively little direct impact on analysts’ compensation. These findings are derived from a study titled Inside the Black Box of Sell Side Financial Analysts, which presents results of a 23-question survey focused on analysts’ incentives, as well as 18 detailed follow-up interviews.

The study offers insights into an area that is understudied by researchers of the financial industry. While hundreds of articles have sought to predict financial analysts’ choices using models and statistics, few have peered into the “black box” of the organizational contexts and personal psychologies that drive analysts’ decision-making.

The study’s findings also serve as a potential commentary on the Securities and Exchange Commission’s Regulation Fair Disclosure (Reg FD), launched in 2000 to limit selective disclosure of market-moving information to analysts or other key stakeholders prior to the general public.

But respondents noted that companies’ public conference calls discussing quarterly earnings are often followed by one-on-one conversations between analysts and chief financial officers. According to one analyst: “We’re almost back to where we were pre-Reg FD, but not quite because that backroom chatter is shut down. It’s just now it’s not in the backroom; it’s everywhere.”

More insights from the survey include:

• Approximately one quarter of analysts feel pressured by supervisors to lower their earnings forecasts, presumably because outperforming forecasts pleases investors.
• Approximately one quarter of analysts feel pressured by supervisors to raise their recommendations, presumably because it is easier to get their clients to buy rather than to sell the stocks they recommend.
• While only 35 percent of analysts said the profitability of their stock recommendations were a very important determinant of their compensation, 67 percent cited “standing in analyst rankings or broker votes” as central to their compensation.
• Only half of analysts considered primary research “very useful” in forecasting earnings or recommending stocks.

The study was conducted by Nathan Y. Sharp, Assistant Professor at Texas A&M University’s Mays Business School; Lawrence D. Brown, Seymour Wolfbein Distinguished Professor of Accounting at Temple University’s Fox School of Business; Andrew C. Call, Assistant Professor at University of Georgia’s Terry College of Business; and Michael B. Clement, Professor at the University of Texas at Austin’s McCombs School of Business. The full text is available on Social Science Research Network at http://ssrn.com/abstract=2228373.

About Mays Business School

Texas A&M University’s Mays Business School educates more than 5,000 undergraduate, master’s and doctoral students in accounting, finance, management, management information systems, marketing and supply chain management. Mays consistently ranks among the top public business schools in the country for its undergraduate and MBA programs, and for faculty research. The mission of Mays Business School is creating knowledge and developing ethical leaders for a global society.