Analyst Ratings and the Institutional Imperative

Posted on Posted in General Thoughts, Investment Quotes, Think Differently, Warren Buffett

Buffett talks a lot about the concept he calls the “institutional imperative”. In his 1989 shareholder letter, when he was describing his mistakes of the first 25 years managing Berkshire, he outlines what he means by this (emphasis mine):

“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

“For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

“Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.”

There was a really interesting article in the Wall Street Journal on Friday that highlight a few examples of the conflicts of interest that exist in the relationship between Wall Street analysts who write research and make recommendations, the clients who pay for that research, and the companies that are the subject of the research.

The institutional imperative in this case is the emphasis and importance that publicly traded companies place on what Wall Street analysts think about the stock price of their company. Focusing on your stock price and caring about what other people think about it is counterproductive, as it creates a major distraction to focusing on what is important: running the business.

Here are a few quotes from the article outlining the value companies place on “buy” ratings:

Analysts who want top executives at Coach Inc. to attend private events with their investor clients have to show they are “brand ambassadors,” as the luxury handbag retailer dubs it. You can’t be a brand ambassador if you have a sell rating on Coach’s stock.

I’m not sure how much analysts care about being “brand ambassadors”, but often times their pay is directly linked to their ability to get clients access to top-level management:

Many securities firms tally the number of times their analysts take company executives on the road to meet clients and use the number to help decide analysts’ annual bonuses.

At some firms, as much as one-third of analysts’ yearly pay can be tied to corporate access…

So analysts are much more incentivized to write glowing reports about companies with “buy” ratings than risk getting their access to management (and their bonuses) cut off:

“It’s a decision I have to make on my sell-rated stocks: whether I will forgo the opportunity for corporate access, which clients will explicitly pay for,” says Laura Champine, a retail analyst at Roe Equity Research. Some previous bosses at other firms told her to “just drop coverage” instead of putting out sell ratings, she says, while declining to comment on where that happened.

“When your compensation is in part based on how many meetings you set up in a given year, it’s really tough to stick to your guns,” says Eric Hollowaty, a former analyst at Stephens Inc. who covered consumer companies.

With a collection of some of the most valuable media and entertainment assets in the world that will be producing sizable royalty fees for decades to come, you wouldn’t think Disney would care all that much about where someone thinks the stock price will go over the next few quarters, but unfortunately that doesn’t seem to be the case:

Media analyst Richard Greenfield of BTIG LLC says his emails, phone calls, and a request for an investor meeting with Walt Disney Co. have gone unanswered since he issued a sell rating on the company in December 2015.

The rating went out on the same day as the world-wide release of “Star Wars: The Force Awakens.” Before then, when Mr. Greenfield had a buy rating on the stock, he was regularly invited to Disney events and once hosted a meeting between a group of investors and a Disney executive, the analyst says.

“Everything changed when we went to a sell,” says Mr. Greenfield. When Disney invited more than 50 analysts and investors to the opening of its Shanghai Disneyland resort last summer, Mr. Greenfield was left out.

Here is a clip that exemplifies how important information is to large investors (and this info is almost always short-term info that could impact the stock this quarter):

Banks and brokerages often poll large investors on the services they value most highly. Private meetings arranged by analysts are cited among the top reasons why investors steered trades through the banks and brokerages.

That decision is important because commissions from such trades are part of the lifeblood at many financial firms. Competition has intensified since the financial crisis because the pool of available commissions is shrinking from price cuts and the rise of automated trading.

Christopher King, a former Stifel Financial Corp. analyst, recalls asking Sprint Corp. for meetings with clients when he had a hold rating on the wireless telecommunications company a few years ago. He says a Sprint investor-relations officer asked why it should oblige when he didn’t have a buy rating.

Two analysts who still follow Sprint say their investor-meeting requests also were been rebuffed when their ratings were negative. Twenty analysts have a buy or hold rating on Sprint, while nine rate the stock a sell, according to Thomson Reuters.

The Edge Gained From Thinking Long-Term

I have talked recently about the concept of time arbitrage. See this post, which outlines my thoughts on where investors can find an edge (note: it’s not in reading Wall Street research or even acquiring hard-to-get pieces of information). But the fact that so many market participants are focused on getting access to company management in hopes to pluck nuggets of useful information (that almost always is related to attempting to predict short-term market movements) means that investors who pay no attention to this noise and just leapfrog this short-term time horizon can gain a significant behavioral edge.

The WSJ article also exemplifies company behavior that is counterproductive to creating long-term value. Why would long-term owners of Disney care about whether analysts think the stock will go lower over the next 12 months? And more significantly—why would Disney’s management team care where analysts think the stock price will go this year? Any time spent considering analysts’ opinions is time spent not being focused on operating the business.

There are some cases where companies need cooperation from Wall Street because their business model relies on accessing the capital markets (MLP’s, real estate investment trusts, companies engaged in serial acquisitions, to name a few). These aren’t ideal business models because the future of those companies depends in large part on how Wall Street and the capital markets view them. But for most companies, especially one with the brand and the assets that Disney has, I think any time spent reacting to analysts’ opinions is a distraction and carries a fairly significant opportunity cost over time.

I realize there are very few publicly traded companies that act the way Berkshire Hathaway does (in terms its relationship with Wall Street, executive pay, corporate governance, stock options, etc…), but it’s still a point worth making. If you’re a long-term owner (or manager) of a business, you should focus on running your business. Market and promote your products and services, not your stock price.

To Sum It Up

At the 2004 Berkshire Annual Meeting, Buffett was asked “Why don’t you meet with analysts or large shareholders?”

“I have some problems with having meetings with some sub-groups of investors. If we had them, I’d want meetings with everyone. We try to convey a lot about our business in our annual report.

“I don’t think it fits our temperament at all. Many corporations spend a lot of time talking to analysts. One of our strengths is not doing this. It’s very time-consuming and gives some shareholders an advantage. We’re very egalitarian.

“We’re not trying to appeal to people who care about next quarter or year. We want to appeal to people who view this as a lifetime investment. There are relatively few investors who think about buying and putting it away forever like a farm.”

It would be beneficial if more companies followed this type of attitude. Ironically, the thing many companies seem to care about the most (its stock price) would likely do much better over the long run if the distraction of worrying about analysts’ ratings was eliminated.

__________________

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

11 thoughts on “Analyst Ratings and the Institutional Imperative

  1. I would frame this differently. Why do companies care about analysts, and why do analysts care about companies? For both parties it’s good for business.

    Companies don’t care about equity investors after their stock is sold. They care about two things:
    1) Selling more equity
    2) Issuing debt

    For both actions a company needs favorable ratings in the research industry. They want people talking about how great they are. So it makes sense for a company to cater to individuals or groups that help with this.

    For firms they make some money off asset management, but most research shops help:
    1) Sell equity
    2) Sell debt

    In this sense the interests of the companies and banks/ratings/research shops are aligned. They are both doing the same thing. They’re both providing information that allows them to sell more equity and sell more debt.

    The patsy at the table is the investor who doesn’t quite understand this process and falsely believes that research is for their benefit. Most research is nothing more than thinly veiled marketing material for equity or debt issuance. Think of it as a glossy brochure.

    Not meeting with analysts is a bit of a red herring. Companies that live on outside capital need to meet with analysts. But companies that can fund themselves internally don’t need to worry about the Wall Street establishment. Berkshire is internally funded, so he doesn’t have to meet with analysts, whereas other companies aren’t so lucky.

    There’s a second aspect to this as well. It’s that the market exists for companies to fund themselves and nothing else. As investors we simply benefit from this mechanism, but if companies didn’t ever need to fund themselves then there would be no market. In a sense the selection of potential investments is poor for investors because we’re only allowed to pick from companies that have at some point required outside capital. There are hundreds/thousands of better companies that have never needed funding and as such haven’t ever issued equity or sold debt giving outsiders a chance to invest.

  2. Thanks for posting – this is something I think about a lot. Talking to management/IR is usually an extremely important part of my process. Obviously I’m not focused on next quarter and am not seeking “material non-public information” – rather just trying to understand the business in more depth, but I think Matt Levine always provides the best point of view on this – if the thousands of totally legal IR calls/meetings that go on a day don’t contain something that analysts find *material*, then why would they bother having them in the first place? It’s a quandary – they don’t contain anything subsumed under the legal definition of “material nonpublic information” (at least not the vast majority of them, one would hope) and yet investors spend tons of time on them and, as the WSJ piece notes, clearly value this management access very highly…

    That said, unless I’m misinterpreting your conclusion, I don’t think the solution is for most companies to spend less time communicating with their investor base – but rather to do so in a more egalitarian way. I don’t understand why more companies, for example, don’t make their (investor conference) webcasts and transcripts more available, or why they don’t have more shareholder-facing materials written for humans (quarterly shareholder letters a la Greg Strakosch at TTGT) rather than lawyers (most 10-Ks and 10-Qs are near unreadable and don’t provide very much or any useful information on where the business is going – they’re history, not strategy.)

    The one potential caveat is things like competitive information – particularly for some of these smaller companies that operate in smaller niches – there are a few that are notoriously cagey on public calls (since they know their competitors are listening) but are willing to provide more color when speaking one on one with shareholders.

    Anyway, on the whole, the way the industry works has always been frustrating to me because it doesn’t seem like it is in the spirit of Reg FD even if it is within the letter – but that’s the way the world is set up and I think most professional investors would be doing themselves a disservice by *not* talking to IR or mgmt because the qualitative insights you gain, as well as just your assessment of what kind of people you’re dealing with, are often extremely valuable in determining whether or not the company is a good investment of LP capital. I think it’s not such a big deal in small caps where everyone who wants a call can get one and it’s totally on you, but as you get into the bigger companies that are only willing to converse with billion-dollar funds, it’s more annoying…

  3. Nice read. But this implies that investors actually blindly rely on ratings issued by analysts. Analysts often convey much else than the ratings in their reports. Negative commentary, followed by a gloomy target price, but accompanied by a buy rating, can convey as much as a sell rating. A sell rating, if the call goes right quickly, will have to be reversed, else the stock price will fall below the target price and hence an upside get generated, which looks odd will a sell rating. Likewise with a buy rating. Hence investors often look at everything in the report written by a few serious analysts, understand their arguments, look at the quality of numberwork, and don’t just go by a rating. Companies however fell much better if their stock has a BUY from 20 analysts out of 25, since that is what newspapers tend to pick up. So serves everyone to keep a buy rating, but not lose the accuracy in the numbers and arguments. Ultimately, the good analyst is one who enables good quality decision making on part of the client, not one who maintains a right righteousness and loses corporate access. Investors often prefer a bland analyst with excellent relations with big companies to get meetings and prepare for such meetings with incisive analysts who may not be in the good books of the company. So there are so many angles to it, and investors are generally smart.

  4. Good post John. I’d like to see correlations (or lack thereof) on holding conference calls, analyst ratings, issuing press releases, etc to long-term stock performance. Your post reminded me of one chapter in McKinsey’s Valuation that talks about this stuff: “In the long term, the facts clearly show that individual stocks and the market as a whole track ROIC and growth… [Many] myths have grown up about how the market values companies that have nothing to do with the company’s economic performance. None stand up to scrutiny. There is no value premium for diversification, from cross-listing, or from size for size’s sake. Conversely, there is no conglomerate discount, only a performance discount for many diversified companies.”

    I have a feeling it’s the same with a lot of things that managers think are important to the share price, but ultimately aren’t. I recently started tracking how many press releases companies put out. It’s obviously not perfect, but managers that put out several press releases every month (that are inevitably about small deals that don’t really matter) is a turn off to me. It’s a sign they’re focused on the stock price and not the business performance.

  5. Thanks John.
    I am a seasoned and senior credit risk executive and my entire work is on BB and below names includes those in default.
    I have long resisted the urge to go and meet companies. Unless there is a specific reason.
    – If it is a private name, unknown to people, real estate, or sometimes to meet the key guys to see how they behave in person
    – I seldom look for information from the company through a meeting. I want them in writing as reports or memos beforehand. Being on the private side helps a bit.

    Your note is interesting – a) analyst’s livelihood is related to access to company management and the “adjusted” view, b) investors believing that such access accords them an advantage. What all we believe in!
    I am seeing the institutional equities business get compressed. Low costs from newer technologies are making this an extremely tough business.

  6. Executives of Disney and other companies care about the ratings primarily for one reason:
    A large part of their total compensation is in the form of stock options typically struck @ market at the time of them being granted. Thus even short term stock price “performance” unfortunately becomes imperative.

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