Here’s a timely warning for investors navigating this earnings season: The friendlier the analysts are who get to ask company executives questions on conference calls, the more shareholders should worry.
Happy talk between corporate honchos and the Wall Street analysts who cover their companies is a regular, often grating element of quarterly Q&A sessions. But according to a recent study by Harvard Business School researchers, all those “congratulations on a great quarter” and lobbed softball questions are more than just an annoyance to skeptical investors listening in -- they are more likely to be obscuring negative company developments that eventually emerge to hurt the stock.
In “Playing Favorites: How Firms Prevent the Revelation of Bad News,” HBS associate professors Lauren Cohen and Christopher Malloy, along with Dong Lou of the London School of Economics, find evidence that companies that “cast” their conference calls by taking questions only from analysts with positive ratings on their shares are more likely to report disappointing results in future quarters, driving long-term underperformance of their stock.
“Our key finding,” they conclude, “is that firms that manipulate their conference calls by calling on those analysts with the most optimistic views of the firm appear to be hiding bad news, which ultimately leaks out in the future.”
Dialing, then smiling
It's relatively common for companies to select which analysts or portfolio managers get to pose questions on the public calls that follow earnings reports, rather than simply giving each participant a chance to speak or taking questions on a first-come-first-served basis.
The study is significant in that it covered all conference calls from 2003 to 2011, a period that followed the introduction of Regulation Fair Disclosure in 2000, which mandated simultaneous, open disclosure of material corporate information to the public. This research gets at one of the subtle ways that executives are still able to control the nature and tenor of the information they reveal to the market.
Companies with a tendency to favor bullish analysts tend to have better share performance around the time of their calls, but worse-than-average performance later – typically related to a subsequent profit shortfall upon which they no longer skew the Q&A toward pet analysts.
A hypothetical long-short portfolio that bets against companies that “cast” their calls and owns the stocks of companies that do not would have produced excess returns of about one percentage point per month over the span of the study.
The tendency to invite only upbeat voices to ask questions is often accompanied by other signs of over-managing reported earnings and trying to manipulate shares higher. These include high levels of discretionary cost accruals which can help companies fine-tune earnings results, a habit of barely beating profit forecasts by a penny a share and a plan to sell new shares in the near future. These clues to over-promotional corporate managers are frequently used by short sellers to find companies with something to hide.
While smaller companies with less analyst coverage are somewhat more likely to cherry-pick their questioning analysts, the paper features examples of big, prominent companies apparently engaging in this game.
Keep the bears out
In April, BCG Partners analyst Colin Gillis claimed he was excluded from the Q&A on the earnings call of Amazon.com (AMZN), on whose shares he had been bearish. He revealed his denied access to the Seattle Times. As it happens, in Amazon’s next quarterly report in July, the company missed estimates and guided down expectations for future profits.
More humorously, the study excerpts a series of exchanges from a 2007 call by the big chemical producer Sealed Air Corp. (SEE) to highlight extreme familiarity and joshing banter among CEO Bill Hickey and analysts:
“Operator: ‘Yes, we’ll be going back to George Staphos of Banc of America Securities.’
“Hickey: George, we missed you.’
“Staphos: Oh, well, I had another conference call as well, I apologize. Their results weren’t nearly as good as yours, Bill, I’ll let you know that.’”
For sure, analysts often know the folks who run the companies in their coverage area for years, and having a good relationship has been shown to be an advantage in producing accurate financial estimates and insight into corporate strategy.
Yet when it belies a lack of scrutiny or abets executives’ efforts to obscure negative operating results, investors can get hurt. Three months after that cheery repartee, Sealed Air missed estimates and reported its first negative free cash flow quarter in five years. As for the stock of the bubble-wrap maker – it popped, falling 7% that day and losing more than 18% of its value within two weeks.