Should CEOs lose sleep over broker recommendations?

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Dear readers,

Investors have, on occasion, been likened to wildebeest: frequently guilty of adopting a herd mentality. Yet unlike the hoofed mammals that traverse the African plains, investors have many information sources to consider before they migrate out of one stock and into another.

As well as relying on their experience and acumen to second-guess macroeconomic trends and the resulting impact on their portfolios, investors receive wisdom from the analyst community. A valuable resource, you would think, but it begs the question: how much attention do investors really pay to analyst recommendations?

Given the amount of time issuers spend with the analyst community, the question is one well worth pondering, yet it remains one difficult to resolve in one way or another. Some increasingly feel recommendations have less and less effect on investor behavior. This was particularly the case in the midst of the financial meltdown when one of my IR contacts complained that his company’s share price sank dramatically on the same day all his firm’s analysts issued a buy rating on the stock.

A recent study conducted by hedge fund GLG Partners analyzed European share price movements and broker recommendations. Among the anecdotal critiques from fund managers is the assertion that analysts tend to act as unreliable stock pickers, providing a more useful function as an information source on companies. Another criticism is that analysts are also prone to herd mentality, tending to be momentum-driven. In other words, they have a tendency to put buy recommendations on outperforming stocks – a conclusion ultimately refuted by the GLG report’s authors.

The question of how much influence recommendations actually have is a tough one to answer, because relationships of causality are difficult to establish. Firstly, because brokers tend to issue recommendations immediately after news announcements such as earnings, it is hard to determine how much the share price would have moved on the basis of the recommendation alone. Secondly, no fund manager with any sense would admit to relying solely on the recommendations of analysts to do his or her job satisfactorily.

Perhaps the most interesting assertion, however, is that the really good investment ideas come from equity salespeople. The report argues that information gleaned from sales teams helps fund managers achieve better performance than recommendations directly from research departments. While the performance of research salespeople is clearly strongly affected by the performance of the broader research function, the authors find that recommendations from salespeople outperform the broader universe of all analyst ideas.

This is worth bearing in mind when it comes to roadshows, when issuers can end up spending a great deal of time on the road with analysts. If this research is to be believed, it is arguably worth putting a greater onus on cultivating a closer relationship with the sales team.

It is also worth thinking about how you organize your time with analysts. When there is disagreement between analysts about a stock, the recommendations of certain analysts are more likely to influence your stock price. Perhaps unsurprisingly, the GLG study finds recommendations from large, global brokerage firms have more of an impact on stock prices than smaller brokerage firms when they disagree with the consensus.

Another dilemma for some listed companies is what to do about ‘rogue’ analysts who don’t engage with issuers. IR people occasionally complain that investors ring up citing an analyst report the issuer isn’t on the distribution list for. Increasingly, IROs need to acknowledge these reports and proactively engage with the analysts in question to avoid any nasty surprises. As the number of research houses increases, the case for responding directly to these analysts could gain momentum.

By Clare Harrison
IR magazine