Analysts and CEOs: A Love Story?

A study by two B-school professors finds that executives ward off stock downgrades by currying favor with analysts that cover their companies

Perhaps all it takes to keep an analyst from downgrading a company's stock is a couple of favors from the chief executive officer. That, at least, is the conclusion of a new study by two business-school professors.

James Westphal of the University of Michigan's Stephen M. Ross School of Business and Michael Clement of the McCombs School of Business at the University of Texas found that nearly two-thirds of securities analysts receive advice, introductions to other high-powered executives, or other favors from top managers at the firms they cover.

Showing a Little Love

And when bad news strikes, top managers can blunt its impact by showing a little love to the analysts that cover their company. Westphal and Clement found, for example, that as a company's reported earnings slipped, executives became more likely to do favors for analysts covering it. A couple of well-timed favors can go a long way toward blunting the impact of disappointing results, the study found. Analysts are only half as likely to downgrade a company's stock after it announced earnings below the consensus forecast if one of the firm's executives does two or more favors for the stock picker.

The study also found that executives tend to reach out to the analysts with the most influence. After disappointing earnings news becomes public, top managers are most likely to bestow their attention on analysts who work at large brokerages, say Merrill Lynch (MER) or Morgan Stanley (MS), or those who have been named to Institutional Investor's influential All-America Research Team list of top analysts.

Both the executive and the analyst benefit from the relationship, Westphal and Clement wrote. Obviously managers want to keep their company's share price high, and stocks can take a beating after they've been downgraded. And for analysts, an executive's offer to meet with clients or introduce the analyst to other top managers can be "critically valuable to an analyst's career," Westphal and Clement wrote.

Access as a Weapon

The favors executives rendered most frequently included connecting an analyst with a high-ranking official at another company (comprising 28% of favors in surveys of analysts), providing career advice (20%), offering to meet with the analyst's clients (13%), and passing along information on industry trends (10%).

The study, to be presented to the annual meeting of the Academy of Management in Philadelphia on Aug. 6, compiled data from three rounds of surveys sent to 4,500 brokerage analysts from 2001 to 2003, and a later follow-up survey of executives at the companies they covered. Westphal and Clement then culled information on the analysts' recommendations from the Institutional Brokers' Estimate System, a database of ratings, and compiled earnings results from Standard & Poor's Compustat financial information service (S&P, like BusinessWeek, is a division of The McGraw-Hill Companies (MHP)). Westphal and Clement then looked for connections, taking into account that a certain amount of normal social interaction between the two groups was inevitable.

Analyzing the data, the pair concluded that while executives showered favors on analysts to dissuade them from downgrading their company's stock after an underwhelming earnings report or an acquisition of another firm in a different line of business, managers weren't afraid to withhold favors from analysts who lowered their ratings. "Analysts who downgrade a firm's stock elicit negative reciprocity from the firm's executives, in the form of diminished favor rendering and reduced personal access to top executives at the downgraded firm," Westphal and Clement wrote.

The Losers: Individual Investors

Professionally, the analysts may stand to gain considerably more from their access to executives at the firms they cover than they might lose by failing to downgrade a stock that truly deserves it. As Westphal and Clement point out, there isn't a very strong link between analysts' ratings and their potential for advancement in their jobs. "There's a stronger correlation between earnings forecasts and career prospects than with stock recommendations," Clement says. And for a high-ranking corporate official, keeping board members, shareholders, journalists, and, yes, securities analysts happy is all in a day's work. "This is part of an executive's job, to foster and maintain their relationships with the stakeholders in their firm," says Westphal.

So, who loses? Westphal and Clement argue that executives' favor-wielding risks undermining the objectivity of analysts' reports. For big institutional investors, who probably have their own stable of analysts, other views may not be tough to come by. But individual investors should know that analysts and executives are trading favors, Clement says.

"Stockholders should be mindful of the fact that analysts may not be purely objective," Westphal says.