Business Exposed90
starts covering a rm, his colleagues at other investment banks
are inclined to start doing the same (irrespective of this rm’s
performance), thus creating a “cascade” of analyst coverage.
Remember the residents of the Californian community discussed
in Chapter 1 who all started conserving energy because everybody
else was doing it – or so they thought? It seems analysts are the
same: they follow the crowd, although they might not even
realize it.
Subsequently, however, in their research project, Huggy and his
colleagues also showed something else. Their models’ ndings
revealed that, in such cascades, the imitating analysts were prone
– more than usual – to overestimate the rm’s future performance.
And this made it very much a mixed blessing for the rm. Because
analysts are inclined to cease coverage of companies which are
underperforming in comparison to their predictions – which was
very likely in this case, given the analysts’ over-optimism – rms
that initially beneted from increased analyst coverage were also
more likely to suffer from analysts abandoning them.
The analysts, much like lemmings, jumped in, only to nd out
that the place they landed in wasn’t as rosy as they had expected.
This prompted them to jump out again, saving their skin, but
leaving the rm trampled and bruised.
Conflicts of interest – do analysts rate their bank’s
clients’ stock more favorably?
Have you ever heard that you can see the Great Wall of China
from outer space? Well, it’s a myth.
Have you ever heard of “Chinese walls” inside professional organ-
izations, such as management consultants or solicitors, who face
a potential conict of interest, for instance, because some of their
employees are working for different clients that compete in the
same line of business? They claim they have “Chinese walls”
inside their rms because their consultants or solicitors are not
allowed to even talk to each other, let alone share information.
Well, believe me, those are usually a myth as well.
915
n
Liaisons and intrigues
Take investment banks. Investment banks often have a research
department that employs analysts who provide recommenda-
tions on whether we should buy or sell the shares of a particular
company. A recommendation to sell by such an analyst is
quite a pain (in all sorts of body parts) for a company because
their inuence can be substantial, in the sense that the rm’s
share price will likely fall as a result of this recommendation.
A recommendation to buy is obviously a much more cheerful
event.
Such investments banks, however, often also have a corporate
nance department which is trying to secure deals to advise
companies on things like debt, equity, or M&A transactions. The
potential conict of interest is clear: if a bank’s analyst gave a sell
recommendation for a (potential) client company, this is going
to be one valued client who is “not amused”!
Some companies are known to select only those investment
banks to represent them on their deals who have awarded them
positive stock recommendations in the past. In any case, if a
bank is chatting up a client on the left side but recommending
“sell their shares; now!” on the right side, this client might just
tell them to f-off.
So how do investment banks deal with such potential conicts of
interest? “Chinese walls!” they’ll so rmly declare that you will
almost believe it. “We have Chinese walls in our rms, so that the
corporate nance guys cannot pressure or even have lunch with
the security analyst dudes”. Yeah, right . . .
Professors Mathew Hayward and Warren Boeker – at the time
based at the London Business School – investigated exactly this
issue. They selected 70 companies from a variety of industries
(e.g., biotech, oil and gas, restaurants, telecom), collected a total
of 8,169 analyst ratings that had been issued for them, and
analyzed the investment banks that had been involved in their
equity, debt, and M&A deals. Then they statistically examined
whether analysts made more positive recommendations for those
rms who their banks were also serving as clients. The answer
was “heck, yes”; in 80 percent of the cases, analysts would rate
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