Business professors show that one good turn elicits better stock ratings from analysts

Nov. 21, 2007

A little can go a long way—even in the big-time world of Wall Street finance.

Research conducted by Michael Clement of The University of Texas at Austin and James Westphal of the University of Michigan shows that even the smallest favors from executives to Wall Street analysts can help secure better stock ratings for their firms.

In the study, the authors examined thousands of surveys sent to analysts from 2000 to 2003. The survey results indicate that 63 percent of the analysts reported they had received favors from chief executives, chief financial officers and other top executives.

The researchers found that analysts who received at least two favors were half as likely as colleagues who did not receive favors to downgrade a company after a report of poor results. Moreover, in the wake of a diversifying acquisition by a company-a move generally frowned upon by Wall Street because it moves a company away from its core markets-providing favors reduced the likelihood of a downgrade by 65 percent.

The study also shows that the more a company missed its earnings forecast, the more favors executives tended to provide analysts covering the firm.

"We are not talking about blatant bribery, and these favors aren't illegal," said Clement, an associate professor of accounting at the McCombs School of Business. "But it is more than just socializing. In fact, in our analysis we controlled for the level of social interaction between analysts and executives."

The most-reported favor bestowed by executives, accounting for 28 percent of the total, was putting an analyst in touch with a top manager of another firm. Ranking second, accounting for 20 percent of the total, was an executive's providing an analyst with career advice, followed by an executive's offering to meet with an analyst's clients (13 percent), providing advice on a personal matter (11 percent), relaying industry information (10 percent), recommending an analyst for a job (8 percent) and helping an analyst gain access to a private club or nonprofessional organization (6 percent).

As effective as granting favors, the study finds, is withholding them or singling out analysts for disfavor, such as by refusing to respond to phone calls or to answer questions from analysts who recently downgraded the company's stock.

"Given that downgrades have a variety of negative consequences for firms and their leaders—damaging firm reputation, market value and access to capital, and harming the reputation and career prospects of the firm's leaders—they have the potential to incite retaliatory behavior by top executives," said Westphal, a former member of the McCombs School faculty.

Clement said he wasn't particularly surprised by the findings. "I don't condone it, but I think it is natural human behavior."

Large institutional investors probably won't be surprised by the study either, Clement added. However, the individual investor might be.

"I think for the individual investor the lesson is buyer beware," he said. "Probably the best thing to do is what portfolio managers do. They listen to more than one analyst and create a picture based on multiple sources."

"The bottom line is that favor-rendering to analysts is evidently widespread and that it seems to be compromising the value of the guidance these experts provide to investors," Clement said. "While there may be no simple solution to the problem, our findings certainly suggest that it deserves to be taken seriously."

For more information, contact: Rob Meyer, McCombs School of Business; Photos of Professor Clement: Sasha Haagensen