Most investors understand that sell-side analysts have a long bias, even with a ‘Chinese wall’ in effect they understand that their employers benefit from a generally sunny outlook. But that only takes an analyst’s current employer into account. According to research by UCLA Anderson School of Management PhD student Ben Lourie, analysts who go to work for companies they had been covering issue more optimistic reports, and more reports in general, in the year before they switch jobs.
“During this final year, I find that the revolving-door analysts alter their forecasts, target prices and recommendations in a direction which suggests that they are attempting to gain favor with their would-be employers. The findings raise concerns about their independence and indicate a potential benefit to tightening employment regulations in this industry,” Lourie writes.
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Analysts give more favorable reports on companies they later work for
The basic idea is straightforward. Companies are more likely to hire analysts who are optimistic about their prospects, and analysts in turn are aware both of this bias and of job openings that they might be interested in, creating a conflict of interest. Lourie looks for signs that this conflict is undermining analyst independence by looking for three changes: relative to other analysts, does the future hire become more optimistic about the target firm, more pessimistic than the target firm’s competitors, and issue a higher number of reports on the target firm in the final year of employment compared to previous years?
Based on data from 299 revolving door analysts between 1999 and 2014, the answer to all three questions is yes. Since revolving door analysts also make less accurate forecasts than their peers in the final year of employment as an analyst, we can also throw out the idea that these analysts somehow have a better understanding of the firm in question.
A Sarbanes-Oxley style cooling off period
What’s really disturbing about this conflict of interest is that it’s so hard to spot.
“In none of the analysts’ research reports examined in this study that were issued in the year prior to their move to a covered firm is a possible conflict of interests mentioned nor has the Financial Industry Regulatory Authority (FINRA, formerly NASD) taken actions against any of these analysts,” writes Lourie, noting that FINRA requires analysts to disclose if they are pursuing employment with a covered company.
But Lourie proposes what sounds like an easy solution to the problem. A similar revolving-door effect existed with external auditors in the past (in the year before going to work for a client company, their audits of that company became more lenient), but it disappeared from the data after Sarbanes-Oxley forced auditors to wait at least one year before working for a company they had previously audited. The same cooling off period for analysts could be an easy way to make sure that a job search doesn’t undermine their judgment.
See the full study here Sell-side-revolving door