When Analysts Throw in the Towel

While most finance theory assumes that decision makers are rational, anyone who has spent time in an investment organization knows that is an aspirational goal rather than a realized one.

To that point, proponents of behavioral finance have been busy over the last few decades documenting the various ways as individuals that we veer away from rationality.  The other consideration is that we are not on our own.  We operate within social structures that push us to act in certain ways.  (An earlier series on the anthropology and sociology of investment organizations provided a number of different examples of how social forces affect decision making.)

More evidence along those lines can be found in a paper, “Throwing in the towel: What happens when analysts’ recommendations go wrong?” by Kenneth Lee, et. al.  Quotes below are from the authors.

Sell-side analysts

The paper concerns sell-side analysts and what they do when their recommendations don’t work out.  Like everyone else, analysts make mistakes, but theirs are easily seen:

Every analyst will experience stock recommendation failures during their career.  Unlike many other professions, these pivotal moments occur in the full glare of clients, colleagues, equity-sales teams, and the media.

Not only are sell-side analysts monitored in real time by those parties, as a group they have been studied extensively by academics, since the quantitative elements of their work are widely available.  But such evaluations don’t provide insight into the “important social processes at play” that affect analyst behavior.

Analysts are expected to be industry experts, but some aspects of the job are performative in nature:  hold recommendations that are implicitly something else; reiterations done for promotional purposes only; earnings estimates that have over time become more and more “adjusted” in order to support a position; and target prices with varying time horizons and no clear delineation of embedded market expectations or stock-specific risk adjustments.

(If you’re interested in more readings on sell-side research, the original “research puzzle” blog featured many postings about it, including ones on the behavioral leapfrog of earnings estimates and some more leapfrogging, looking for the error price as well as the target price, and judging the best analysts.  There is also an essay from 2011 that looks at the decades of work by and about analysts, which yielded studies “of association, not behavior;” this current posting addresses the latter.)

Social structures — and the “rules of the game” — determine “the way individuals see the world and act in it.”  “Institutional and individual actors, networks, forces, and pressures” provide the environment within which choices are made.

Since the subject of the paper is the recommendations on stocks made by analysts, the authors review the academic literature in that regard.  They find “a resoundingly positive response” to the question of whether recommendation changes are “important capital market events.”  As a group, recommendations influence share prices and lead to herding behavior by investors — and much unwanted attention if they go bad.

Emotions

The interplay of two emotions affects analysts (and other market players) when it comes to decision making.  The first is confidence, “the belief that one can successfully complete a specific activity.”  Capital markets are defined by uncertainty, yet confidence is prized in the business, setting up a situation in which such confidence is shown to be unwarranted on a regular basis.

The other emotion is regret.  There is regret for decisions made that didn’t work out — and even “anticipatory regret,” which results in the avoidance of decisions that “might end up producing regret” if subsequent evidence can put them in a bad light:

Analyst recommendations would be an example of a decision where ex post a more successful alternative course of action (with a different outcome) would be very clear and so is likely to result in more intense regret if things go very wrong.

A bad call can lead to “deep-seated feelings of anxiety and shame,” so the authors argue that analysts prioritize “protecting their confidence levels and minimizing regret.”  Therefore, changing a misguided recommendation is a weighty decision.  When do you throw in the towel?

Important factors

What are “the circumstances and conditions in which revisions become more or less meaningful”?  What determines “the ‘intensity’ experienced by the analyst in a capitulation”?  The authors cite five factors that determine how much is riding on the reversal of an errant recommendation.

Franchise intensity.  If an analyst is considered the “axe” on a stock, “they are more emotional about their reputation being undermined and the perception of failure in the event of a capitulation.”  The stakes are higher or lower depending upon how influential an analyst is regarding the stock in question.

The nature of the failure.  Was the problem a “change of facts” that came out of the blue for everyone or a “flawed analysis”?  The former is dealt with much more easily.

The boldness of the recommendation.  “If an analyst has a nonconsensual position on a stock (e.g., the only buyer or seller), pressures quickly build if the recommendation is not going well.”  The more you are part of the crowd, the less it hurts when you throw in the towel.

Proximity of the recommendation.  One example in the paper cited an analyst “who started (‘initiated’) coverage of a company with a positive recommendation, marketed this heavily to the sales force, and then almost immediately had to deliver a negative message that the dividend had been cut, undermining the entire basis for the recommendation.”  A nightmare scenario for an analyst.

Reaction intensity.  Analysts operate within a social structure made up of the people in their own firms (especially those charged with marketing recommendations), the leaders of the companies that they cover, competing analysts, and clients — with their most important clients and those considered to be “the smart money” having the greatest effect on their thinking.  In considering a change in recommendation, an analyst considers how have they reacted to the previous recommendation and how they are likely to respond to a change in it:

There is both a backward-looking dimension to this (how intense was the initial reaction to the call?) and an omnipresent anticipatory element to it (how will networked others react to a future capitulation decision?).

Responses

Depending on the specific mix of those factors (and their own emotional sensitivities), an analyst may choose inaction, even in the face of trends that look to continue to go the wrong way, hoping for a change somehow (and soon).

Those who do capitulate may enter a period of paralysis.  If “the sense of failure affects them profoundly,” they can have a difficult time fulfilling their expected role:

After an intense capitulation experience, the loss of confidence an analyst experiences is antithetical to active agency.

Another possible effect after throwing in the towel is recommendation contagion.  Most sell-side analysts are industry specialists, so reversing one recommendation has ripple effects, in that the views on other covered companies may need to be reconsidered as well.  (The prospect of that contagion can be viewed as another factor that affects the capitulation decision.)

Implications for organizations

Those charged with supervising analysts need to understand the pressures and emotions that they face and to provide advice and support to them.  One of the things that draws analysts to the role is the ability to be solo practitioners of a sort and make their own choices, but they can get trapped by circumstances.  Everyone should remember that individual calls are “part of a larger, perpetual process” that can be derailed unnecessarily if one bad situation upends an otherwise sound body of work.

It is worth noting that the dynamics discussed in the paper apply to other kinds of investment professionals as well.  Consider a buy-side analyst stuck in a similar dilemma regarding a poorly performing recommendation owned in size by a number of portfolio managers.  The situation isn’t public like that of a sell-side counterpart, but the emotional toll is substantial nonetheless.

Or think about a portfolio manager who has made a big bet that is damaging performance.  Sticking with it or giving up is not just an objective decision, it’s an emotional one.

Now, imagine yourself as a client of a sell-side analyst or a buy-side one or a portfolio manager.  In the long run, gaining an understanding of their motivations and behavioral tendencies is much more important than calculating the outcome of an individual event or performance over a short time period.  It is also much more difficult.