For the past few weeks I’ve been mulling over an article by Martin Waller. Waller reports some research into equity analysts that shows that analysts’ confidence about the market, as tracked by the ratio between buy and sell recommendations, is a counter-indicator. He argues that analysts have no idea what they are talking about when analysts look up, the market goes down, and vice versa.
This basic argument is frail, because it neglects a number of possible explanations, including causality. If every analyst recommends your firm, for example, then demand for your stock rises. Your firm’s cost of capital falls, because people are happier to invest more in it, even if the underlying risk in the business is changes. This then changes the rate of return you need to make on projects to justify starting them: since investment is cheaper, less promising projects get the go-ahead. As a result, the overall return on the business goes down as these lower-value projects some on line.
However, the big issue is this: why are companies not able to better communicate their performance to analysts, considering the substantial investments in investor- and analyst-relations programmes?
