Wall St research: garbage in = garbage out: James Saft

October 7, 2015

Oct 7 (Reuters) – Regulation and legislation have failed in
the attempt to improve Wall Street company research, at least if
accuracy is the measure of success.

Following scandals such as Enron and the dotcom debacle, a
host of new measures was put in place, most notably 2002’s
Sarbanes-Oxley Act, which took a hack at reforming company
accounts, and 2000’s Regulation Fair Disclosure, forcing
companies to release material information to all at the same

Though earlier studies showed an improvement in the wake of
the measures, a new report looking at 1993 to 2013 makes
depressing reading.

“Analyst forecast error and dispersion significantly
increased over the long-term post-regulation period. Therefore,
even if we assume that the regulations caused the improvement in
the observed analyst forecast properties in the short run, they
did not have a lasting effect,” write Hassan Espahbodi and
Pouran Espahbodi of the University of Texas Rio Grande and Reza
Espahbodi of Washburn University.

Their study, published in the current edition of the CFA
Institute’s Financial Analysts Journal, shows that although
accuracy and dispersion improved in 2003-05, after the new regs
were in place, they have since deteriorated significantly. (here)

The regulations were intended to end widespread abuses such
as selective disclosure of important information to analysts, as
well as practices which gave stock analysts an incentive to put
the wellbeing of their firms’ investment banking operations over
those of their supposed buy-side clients.

The abuses may have been curbed, but analysts’ product did
not improve.

“We conclude, therefore, that these regulations did not
collectively improve the information environment in the long
term, despite the reduction in analyst conflicts of interest.
The continued problem with the information environment,
therefore, seems to be due to the quality of financial reports,”
the authors write.

To be sure, the research does not prove that company
accounts are less useful, only that analyst estimates based on
them are less accurate and more all over the map. Certainly the
improvement just after the scandals and regulations may be
because attention and criminal prosecution put banks and
analysts in fear of putting a foot wrong.

It seems possible, too, that analysts are less accurate
because they are being steered less well by management. Given
the inherent corruption in that system, that may be an
improvement, though not if you want to be able to stop thinking
and just trade in reaction to analyst reports.


It may however, be a classic case of “garbage in, garbage
out” as the study indicates that it is not so much that the
analysis is worse but that company reports are less reliable.

While Sarbanes-Oxley was intended to stamp out fraud, fraud
in company accounting ultimately comes not from poor controls
but poor ethics on the part of agents – company executives – who
can benefit from such fraud.

A survey of nearly 400 chief financial officers recently
found they believe that 20 percent – yes, 20! – believe that
firms intentionally distort earnings. The economic magnitude of
the distortion was big – 10 percent – and a significant
proportion of the fibbing was underselling earnings.

That survey didn’t have a pre-Sarbanes-Oxley benchmark, but
given the growth in executive compensation tied to share options
there is certainly probable cause for motivation.

And while the new study did account for factors such as
leverage which may stand as a proxy for motivation to distort,
this is far from a full picture.

Remember, company executives, especially the top ones with
the power to distort, are paid largely in share options. Options
rise in value with increased volatility. It could therefore
be lucrative, if dishonest, for a company executive to engineer
an earnings miss around the time an option is to be priced
followed by a strong showing above expectations later down the

Share analysts could have been the instrument, wittingly or
not, of a strategy like this before Sarbox. Now that they must
rely more on company accounts with less “color” from insiders
the same aims may be achieved through different means.

More highly dispersed and inaccurate analysts’ earnings
reports would certainly be useful for self-dealing insiders.
Those may simply be the natural outgrowth of a deterioration in
company information. Or perhaps analysts were just poor all
along at interpreting company accounts, something now unmasked
as they cannot be spoon fed.

This is not to say that the reforms were a failure. In many
ways they succeeded, especially in eliminating some forms of
conflict of interest and forcing accounting firms to concentrate
on accounting rather than consulting.

It seems possible that sell-side analysts had limited value
to their ultimate clients all along.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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