Reporter-Analyst Relationship Requires Vigilance

It was the fall of 2002, and the world was buzzing with talk about the chances of war in Iraq. Among the talkers were securities analysts, the oracles of the financial age, some of whom offered opinions wrapped in certitude.

"We don't think a war in Iraq will happen in the near term," Ian Scott, a market analyst for Lehman Brothers, told The Observer in London. But if fighting were to break out, he added, "there is the specter of a deflationary situation - as has occurred in Japan."

At Deutsche Bank, analyst Bob Semple offered the reporter a different assessment. War "will be bad for financial markets," he said. "On the other hand, if there is a clear military victory and a friendly regime takes over in Baghdad, there could be a sudden abundance of Iraqi oil - bad for the oil companies, but good for the western economies as a whole."

Now let's look at what really happened. There was, and is, a war. Deflation never came; in fact, prices have crept up steadily in the past four years. The conflict has not hurt the U.S. financial markets. On the contrary, the S&P 500 has risen nearly 40 percent since Semple's analysis. And oil never grew abundant, thanks to the Iraqi insurgency and a voracious appetite from developing economies like China. In fact, a barrel of crude costs twice as much as it did four years ago - and rising.

None of this should suggest that Scott and Semple did anything wrong. They presumably used the best information they could find to make judgments about essentially unknowable events. They are like journalists in that sense.

But the pre-war exercise in forecasting does raise a point about the relationship between financial writers and analysts. We turn to analysts when we write about a company's struggle to satisfy the requirements of the Sarbanes-Oxley Act, or about an industry's prospects in emerging markets, or when we're piecing together a story about the direction of the economy. We need them when a troubled company's managers won't go beyond their press release and deadline is approaching.

But how much credence should we give to what they tell us?

"I think they are good sources, provided you recognize where they are coming from," says Jerry Knight, a columnist at The Washington Post and a veteran financial reporter and editor who wrote about the research conflicts of the dot-com era. Despite the changes brought by those scandals, "It remains obvious that many analysts are still in the tank for their investment banking clients," he says.

"I wouldn't rely on the analyst as an unbiased source of information," says Mark J. Lane, a Chicago attorney and author who also runs an investment firm and teaches law and finance as an adjunct professor at Northwestern University. "The evidence shows that securities analysts still do a pretty lousy job of predicting what's going to happen to stock prices. The correlation between an analyst's forecast and the outcome is not as strong as it ought to be."

A recent study by Zacks Investment Research Inc. drives that point home. It found that analysts' earnings estimates for more than half the companies making up the S&P 500 were wrong by more than 5 percent in the fourth quarter. It also discovered that there were "buy" or "strong buy" recommendations on 42 percent of the more than 4,500 companies it follows and sells on just 3 percent - perhaps a sign of boosterism.

Lane, a frequent contributor to Crain's Chicago Business, Forbes and other publications, sees two problems. First, "there is still too cozy a relationship between analysts in the big investment houses and the investment banking folks," he says. "There are still too many opportunities for incest." Secondly, he adds, analysts rely heavily on numbers, which may tell only part of a company's story.

"Analysts usually have a buy mentality or a sell mentality, and it comes out pretty stark," Lane says. "If you dig deeper, you'll find there is more texture to the story. The stories that are more interesting and credible tend to be the more nuanced stories."

Of course, efforts have been made to eliminate the conflicts that helped create the dot-com debacle. In 2002, the 10 largest investment banks settled charges of research bias by paying $1.44 billion and instituting new policies for disclosure. And anyone who has tried recently to contact a sell-side analyst - the most plentiful kind - has felt the change.

"Analysts who used to just pick up the phone now have to call their compliance officer just to chat," Knight says. "And it is now routine for analysts to e-mail you a disclosure statement spelling out their connections. To a certain extent, that's good because it does remind us that these guys have various axes to grind."

Some firms, Knight adds, don't allow personal access to their analysts but make most of their research public. "One advantage of just publishing the research reports, of course, is that the analyst cannot go off the reservation and say something inappropriate or candid in a phone call," he says.

In some instances, it has become harder just to find an analyst, let alone an independent one. Those who follow smaller companies - the "small caps" that have been hot investments in the past year - are especially rare, their numbers having been reduced by investment company mergers and cost-cutting measures.

Does all this mean that securities analysts should be avoided? Hardly. As Knight notes, they can be good sources, and some can provide excellent insights once you get approval to talk to them.

But it's important to pay attention to those disclosure statements that the compliance managers insist on sending you. If there is a conflict - if, say, the investment banking side of the company does business with the company in question - then by all means, note it. And don't shirk away from asking the tough questions.

As always, skepticism is mandatory.

Knight, for example, noticed recently that an analyst had downgraded a stock to "sell," only to be returned to a "hold" recommendation the next day. The official explanation, he says, was that "it had fallen so much that it was now too cheap to sell. I don't believe it. I think somebody leaned on him."

Yet even when their motivations are suspect, Knight adds, "Analysts can help you understand how a company works and what it does. And these days, that can be difficult. There are all kinds of companies out there whose business is difficult to describe in a simple declarative sentence."

Beyond requiring vigilance, the complex reporter-analyst relationship points at the need for more knowledge about business and finance. Business writers can hardly be expected to become chartered financial analysts (can they?), but they can and should learn as much as possible about the methods of analysis.

"It seems to me that analysts and reporters essentially have the same job," Lane says. "They are supposed to follow market trends, examine financial reports, talk to management and draw conclusions. They are also both supposed to be objective. But in reality, I don't think analysts are the best place to get real information. These are not oracles, and I think there are better sources.

"Talk to the middle management people on the firing line. Talk to competitors and union leaders and customers. Talk to past officers of the company. And there's a lot of direct information that's pretty unvarnished from SEC filings and annual reports.

"So I'm not really a great believer in talking to analysts, because I don't think they have anything particularly novel if you do your homework," Lane explains. "The journalist has the job of separating the wheat from the chaff and ensuring that the analyst's report is just that - a report, and not a cheerleader for a given company."

Copyright © 2008 Donald W. Reynolds National Center for Business Journalism