How independent are independent analysts?

Analyst relations is a niche activity. That encourages analysts relations managers to look to other communications areas to learn from and co-operate with. One of these is investor relations, which has benefitted from the US Senate Committee on the Judiciary publishing transcripts of a day hearing from experts on the relative independence of analysts from hedge funds.

Of course, equity analysts are not the same as industry analysts.

One of the first to give testimony was Owen Lamont, who teaches finance at Yale and is a faculty research fellow at the US National Bureau of Economic Research. His comments reflect some of our own, which also noted the tendency to hide bad news.

US financial markets and institutions have a substantial bias against discovery and dissemination of negative information. Bad news is suppressed while good news is accepted. This bias comes in many ways. One is the difficulty of short selling. Short selling, which today is done primarily by hedge funds, is an important channel for negative information to get into the market. A second and related element is retaliation against any public criticism of a company from anyone, including journalists, short sellers, or analysts.

What happens when negative information is suppressed? Stocks can become overpriced because only optimistic opinions are reflected in the stock price.

Indeed, there’s a similar problem facing industry analysts’ research, as we commented in a discussion about Rob Enderle.

Another discussant was Marc Kasowitz, a lawyer who represents businesses that claim to be harmed by collusion between analysts and the funds his clients have invested in. He feels that the companies he represents have been misled by analysts’ research.

Those companies have been targets of a pattern of egregious collusion between certain influential hedge funds and supposedly independent analysts — whose research, in effect, was bought and paid for by the hedge funds — in order to further illegal market manipulation schemes, typically involving short-selling.

After explaining the drive for greater regulation of investment banks research after the Enron and other events, Kasowitz describes a new problem that has arisen out of the solution to those crises.

The rules promulgated under Sarbanes-Oxley thus sought to insulate analysts from the influence of their firms’ investment banking business. However, an unintended consequence of those rules was a large increase in the number of purportedly independent research firms, certain ones of which tout their purportedly conflict-free “unbiased” analysis, but which provide anything but. Instead, certain of these firms provide supposedly independent analyses, which are bought and paid for — and even ghost-written — by the short-selling hedge funds. If anything, this has made the problem worse. Whereas, formerly, investors at least knew (or were on notice) that stock analysts had potential conflicts because of their disclosed employment by investment banking firms, now these analysts claim — falsely — that their disengagement from those firms has rendered them “independent.” Nothing could be further from the truth. Instead, these analysts provide custom-made research designed to further the goals of the short-selling market manipulators who pay them.

Compared to investment analysts, it is much more widespread that technology market analysts often get a substantial part of their revenues from vendors. Prior to the crisis of the investment analysis community, the vast majority of those analysts whose research was — ultimately — funded by the firms they covered were not corrupt. They wrote what they thoughts, but the corrective, positive, bias that Lamont mentioned was clearly there.

Generally speaking, we are in a similar position in the industry analyst community. Almost every enterprise buyer of high technology has invested in at least one technology that fundamentally fails, but this is not generally reflected in analysts’ research. There is no reason a similar backlash should not unfold against analysts in our market who are also funded by both the buyer and the seller. In particular, as ‘alternative analysts‘ move closer to the ‘real’ (collaborative, iterative) open source methods of analysts like Wikibon, the different business models will be become more open to discussion and dispute.

Don’t misunderstand us: we don’t think there’s anything corrupt about serving both sides in itself. However, unless analyst firms have comprehensive, and open, policies of separation they are exposing themselves to reputational, and operational, risks.

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