Finance

Why Most Analysts Don’t Rock the Boat

Research suggests they fear a “sell” warning would reduce their status with top sources.

May 01, 2001

| by Stanford GSB Staff

When securities analysts, who advise investors about what stocks to buy, realize that a company’s prospects are beginning to sink, you’d think they would scream to their clients: “Sell!” But that’s rarely the case. When stocks fizzle, analysts may signal a problem by issuing a “Hold” recommendation. When the going gets really tough, they often silently drop the issue from their coverage, rather than broadcast sell-off advice, a kiss of death for any stock. Analysts often fear that a “Sell” warning will result in severed ties to top management sources upon whom they rely for forecast information.

Investment bankers, eager to win lucrative underwriting business from the same corporations that their analysts cover as stocks for the trading side of the bank, have long tolerated these conventions-especially during a bull market of easy gains. Other Wall Street insiders have observed these practices for years. And academics, such as Business School accounting professor Maureen McNichols, have documented the rosy picture painted by analysts.

When the stock market bubble burst last year, however, how information is disseminated to and by Wall Street came under renewed scrutiny. Partly to protect retail investors as well as more sophisticated institutional investors, the Securities and Exchange Commission issued a new disclosure regulation requiring corporations to make their financial information more widely available to the public, not just to Wall Street professionals.

A bear market and the SEC may influence change, but why has analyst reluctance to report negative information persisted so stubbornly in the first place? Profit-making is surely one reason. The answer also lies partly in sociology, according to Ezra Zuckerman, an economic sociologist. Working with Damon Phillips, PhD ‘98 and now assistant professor of strategy at the University of Chicago Graduate School of Business, Zuckerman has found Wall Street to be a perfect environment in which to test theories of social status and conformity. They also tested those ideas in a separate model involving Silicon Valley lawyers.

Zuckerman and Phillips’ recent study builds on the long-standing sociological idea that there is a nonlinear relationship between status and conformity. As you move up in a status hierarchy, you become more committed to your role or community, and therefore less likely to deviate from convention. However, as you move to the very top, you become more secure and feel freer to deviate. Those at the very bottom are most free to deviate because they realize at some point they will not advance and have nothing to gain by conforming. “The idea has a lot of intuitive appeal,” Zuckerman says.

He and Phillips looked at both a ranking of analysts and a database of analyst forecasts during 1996. They found that less than 5 percent of all recommendations explicitly advised investors to sell stock. Overall, 85 percent of analysts voiced only positive or neutral opinions. And it was the highest and lowest ranked analysts who were the most likely to issue a sell recommendation. In their study of lawyers, the researchers examined the rate at which 516 Silicon Valley law firms adopted family law, a specialty regarded as less prestigious than corporate law, over a 50-year period ending in 1996. The findings paralleled that of the Wall Street analysis. Firms at the top and bottom of the hierarchy were the most willing to deviate and offer family law services.

Zuckerman’s research suggests that when change happens it will come from the bottom of a hierarchy. It’s next most likely to come at the top and least likely to come from the middle. Of course, in the case of securities markets, bear market forces and government regulations may help bend the system too.

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