What equity analysts’ self-interest means for AR

Many industry analyst relations managers get approaches from equity analysts working in the investment community. Equity analysts often approach industry analyst relations staff at stockmarket-listed firms when corporate investor relations cannot supply the information they need. At private firms, they are often the only obvious point of contact.

Equity analysts need to be handled with care, and not only because sell-side analysts (those whose firms sell stocks) are powerfully self-interested. Because this point is not widely accepted, I explain three principal reasons why below.

  1. They typically put their own interests before clients’. Equity analysts often work for organisations that buy or sell shares. Since these organisations make more money if there are more transactions, it seems to be in their interest to encourage investors to move their investments around regularly. Such a policy is not in investors’ interests; the major firm that encourages investors to hold stocks the longest, AG Edwards, produces the best returns for its clients; AG Edwards educates its customers in the wisdom of constructing portfolios with balancing risks. Many investment advisors prefer instead to encourage their clients to frequenctly shift their holdings. Ironically, this is self defeating even when based on good intelligence: stongly performing firms experience greater demand for their stock, which lowers their cost of capital. However, this in term reduces the internal ‘minimum rate of return’ threashold used to evaluate the firm’s opportunities, encouraging it to take on more projects at lower average rates of return. This is turn reduces overall profitability in the firm: investors more often will suppress strong trends than benefit from them.
  2. They benefit from both ups and downs. Equity analysts, therefore, generally rely on providing a stimulus for change, since their organisations typically collect a fraction of the overall trading volume regardless of whether the prices are rising or falling. This presents a risk to public companies, those listed on stock exchanges, since analysts’ employers benefit if the analyst can find grounds on which to change their rating of a firm in any direction.
  3. Communication already favours the sell-side against the buy-side. It is astonishing that few communications professionals are able to act in this knowledge. Far more effort is expanded in communicating to sell-side analysts than those fund managers and others who might actually buy stocks. Buyers are interested in the good fortune of the firm in which they are invested; sellers are not as interested. Nevertheless, the greater concentration of the sell-side couples with managers’ disinterest in travel to ensure that many firms communicate mainly with banks and brokers in the city in which they are listed, rather than the more widespread buyer community. This, of course, makes buyers more dependent on sellers for their information and has generated many of the problems of independent equity research which have been in the headlines for several years. In a nutshell: much of what passes for “investor relations” in facts favours sellers rather than investors.

These features of the equity analyst community, coupled to the increased regulation of market information, mean that investor relations is a troublesome field steeped in conservatism and under-optimisation. Most AR managers find the two fields quite different, and few firms have the two functions under one roof (BearingPoint, Vitria and Plexus are partial exceptions): most of those who do have been agencies rather than enterprises, such as Saatchi or Oake Communications. Generally, IR is separate from AR, and IR is often part of the CFO’s empire rather than the communications function. While a strong flow of information should exist between AR and IR, we approve of this separation somewhat. The risks and skill sets are different.

However, what should happen at private firms in which the CFO’s office typically involves no formal communcations function? The terrain is rather unfavourable. Investment analysts’ material interests are that equity should remain in the markets rather than be invested in private firms. Private firms are a substitute investment opportunity that generally competes with their own services. As a result, equity analysts have a material interest in down-playing all private firms against any public firm. They benefit from increasing the cost of capital experienced by private firms in order to increase liquidity in the stock markets, in the same way that every supermarket benefits when the local restaurant closes.

Not all equity analysts are mercinary, but the nature of their work attracts people with mercinary facets. Private firms should understand the opportunies presented by the high industry profile that many equity analysts have. However, they should also understand that equity analysts have a tendency to support change in itself which is generally not in vendors’ interests. As a result, AR professionals in private firms should be suitably cautious when contacted by equity analysts and would often be well advised to hand such interactions to the CFO’s office.

P.S. I’ve updated the bits in italics.

Duncan Chapple

Duncan Chapple is the preeminent consultant on optimising international analyst relations and the value created by analyst firms. As the head of CCgroup's analyst relations team, Chapple directs programs that increase the value of relationships with industry analysts and sourcing advisors.