Inside the Mind of a Stock Analyst

By Markets Fool.com

Whether or not you follow the analyst recommendations for the stocks you like, they do carry a certain amount of influence. Of course, much as they might want to be, analysts are not completely unbiased observers of the companies they follow. Like all of us, they face incentives and preferences that shape their opinions.

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So, what's going on in the mind of a stock analyst?

Private conversations are essential
A recent survey of 365 analysts reveals that private conversations with company management are a critical part of their job. Almost all of the analysts speak privately with executives of the firms they follow at least once a year, and over 50% speak to them five times a year.

These conversations are a very important part of the analytical process -- more important, in fact, than any other research source. Private talks give the analyst insights they might not otherwise have gleaned and the ability to ask detailed questions away from the listening ears of the competition. From the survey:

There are three things that can happen when you ask a question on an earnings conference call: One, you sound like a complete idiot; two, they give you no information at all; and three, you get a really insightful answer except you've just shared it with all your competition. So I don't ask questions on calls.

There's also the enhanced credibility that results from having had direct access. One survey respondent said that when mentioning a private call with executives to money managers, their ears go "straight up".

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The conflicts of close relationships
Of course, there are some obvious conflicts with these kinds of close ties.

You might point out that an analyst has incentive to state an overly optimistic outlook on a company he or she is trying to build a good relationship with. This might be true, except that it seems it's actually the company management teams that are eager to ingratiate themselves with analysts, not the other way around.

The survey respondents point out that many private phone calls occur just after the public earnings call, and that management teams prioritize their calls based on who valued the company the lowest. Another analyst described the calls as a way to clarify and elaborate on public information, saying: "It's a way for them to broadcast. We're sort of like a megaphone for them."

On the other hand, another much larger potential problem is that companies with large research houses also tend to offer investment banking services. While great pains are taken to assure the public that these two businesses are wholly separate, 44% of the analysts said that a "very important" part of their compensation is tied to an ability to encourage underwriting business and trading commissions.

That means analysts face an incentive to ingratiate themselves with companies not just for their own access, but for their firm's larger interests as an investment bank. This could lead to some very skewed incentives, particularly if you're talking about making a large (and thus potentially very profitable) public company into a client.

Credibility with clients
Of course, alongside these potential conflicts of interest is also the importance of remaining a credible source of insight and information for investment clients.

The survey respondents note that their credibility is likely to go up when they issue "unfavorable earnings forecasts and stock recommendations." It implies that these sorts of conclusions signal a willingness to go against the pressures of relationship-building with company management and the ability to generate underwriting business for the investment bank.

It also suggests that analysts operate somewhere in between a rock and a hard place, balancing several competing interests to earn more, gain credibility, all while getting the best information.

Whatever we have to say about it, it can't be easy -- and it means that a lot more than numbers are going into each report. In other words, remember what's going on in the minds of analysts, and take their forecasts with a grain of salt.

The article Inside the Mind of a Stock Analyst originally appeared on Fool.com.

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