The Substack blog MD&A, written by the pseudonymous “Philo,” published a posting earlier this week entitled “Intellectual Laziness.”  It concerns General Electric — the one-time “bluest of the blue chips” — and its fall from grace.

The story is told through references to two books:  William Cohan’s Power Failure: The Rise and Fall of An American Icon, about GE, and Winning Now, Winning Later by David Cote, who had been passed over for the top job at GE before becoming CEO at Honeywell.

General Electric

Philo summarizes the reverence that was given to GE.  For much of two decades it was “the most valuable company in America” and was regularly ranked as “the most admired company in the world.”  And Jack Welch was at the helm, at the top of the heap of celebrated CEOs:

Jack Welch had most of the traits we typically associate with a great executive.  He was incredibly smart (earning his PhD in chemical engineering in only three years), he was demanding of his subordinates, and he worked tirelessly.  He had deep operating experience, he was willing to buck convention, and he produced quantifiable results. He was charismatic, ambitious, and a world-class marketer and publicist.

The total package.  But here’s the last sentence from that description by Philo:

And yet, he will forever be remembered as the father of the biggest corporate disaster in American history.

The posting offers example after example of the errors that were made by Welch and by his successor Jeff Immelt, grouped into three categories:  poor operating discipline, problems at GE Capital (the engine of the firm’s apparent success and also the source of most of its accounting strategems), and poor capital allocation, which Philo describes as “GE’s biggest problem”:

Jack Welch was public in his distaste for stock buybacks, preferring to use cash for acquisitions instead.  GE’s track record demonstrates why investors so often prefer buybacks, and are particularly loathe to allow companies to invest outside their core business:  managers are high on ego and low on investment expertise.

At almost eight hundred pages, Cohan’s book covered the story in detail — and he interviewed a wide range of sources, including Welch, Immelt, and other top managers (as well as “critics, counterparties, and journalists”).  But, for Philo, the book

doesn’t really offer an overarching theory of why GE failed.  Power Failure lists many different things that went wrong at GE — bad management, bad acquisitions, bad incentives, bad accounting, bad luck — but almost all companies suffer from some of these issues without running into a GE-scale disaster.

David Cote at Honeywell

That “overarching theory” came courtesy of David Cote.  Philo termed Cote’s book about his tenure at Honeywell to be “fairly standard for the business advice genre,” but he was struck by the opening vignette in it, in which Cote summarizes an early business review of the Honeywell Aerospace unit:

We sat down in a conference room so that team members could present their strategic plan to me.  A copy of the plan had been placed on the table facing each seat.  Flipping through mine, I saw that it was thick — maybe 150 pages long, full of charts and tables.  Uh oh, I thought, not good.  I had found so far at Honeywell that executives and managers often made presentations far longer than necessary, overwhelming audience members with facts, figures, and commentary to preempt sharp, critical questioning.

Cote was to discover that it was part of a pattern:

Lacking any drive to think deeply about their businesses, and unchallenged by leadership to do so, teams held meetings that were essentially useless, their presentations clogged up with feel-good jargon, meaningless numbers, and analytic frameworks whose chief purpose was to hide faulty logic and make the business look good.  When you did a bit of digging, you found that most executives didn’t understand their businesses very well, or even at all.

Intellectual laziness

This pattern was not unique to Honeywell.  As summarized by Philo:

Cote defines this as intellectual laziness.  It is the tendency of organizations to “juke the stats” and lie to themselves instead of diagnosing and solving root problems.

Importantly, “what intellectual laziness is not”:

It is not actual sloth.  People are working hard, just not directed in a way that creates value. . . . It is not necessarily fraudulent or illegal in any way.  Yes, the organization is being dishonest with itself, but it is fundamentally a form of mismanagement rather than willful deception. . . . It is not stupidity or incompetence, either.  In this example, the Aerospace team had the capability to identify and solve root problems, but they had just never been forced to do so by senior management.  They were doing stupid things, but not because they were stupid; they were just responding to the culture and incentives in place.

In contrast:

Cote preaches that managers should instead strive for intellectual rigor, to probe deeply to identify and confront root problems and think creatively and rigorously to find solutions.  He argues that “leadership [is], at its core, an intellectual activity.”  In his framework, leadership is almost entirely about picking the right direction for the organization and getting the team to move in that direction.

Which brings us back to GE.  One of the stories in Cohan’s book is when Comcast bought NBCUniversal from GE and Steve Burke took over as CEO:

Burke quickly concluded that NBC had been terribly managed under GE and the culture was abysmal. . . . [Burke] quickly ascertained . . . that the incentive at NBCU wasn’t to make money.  “The game here was to keep GE, to keep Connecticut, happy,” he said.  “So the game then became telling a story, as opposed to running businesses, and the incentives were to do that.”

And there was one behavior prized above all at headquarters.

Earnings management

Welch was known for the incredibly smooth and growing earnings stream that he could produce, “the art of making reported earnings grow consistently each quarter, even as the underlying business produces volatile results.”  Investors worshipped Welch for delivering that pattern of earnings, but the mandate within the company to produce the façade was a cultural rot that led to its downfall:

According to Power Failure, almost every time GE made a major decision that destroyed shareholder value, the obsession with manipulating earnings was front and center in the thought process.

No attention to shareholder value, just “earnings, earnings, earnings,” an all-too-common path for companies, supported by sell-side analysts and buy-side acolytes.  Beyond that:

Even putting aside the obsession with reported earnings, GE’s culture seems to have been generally lacking in intellectual rigor.  GE’s strategies were supported by narratives that sounded compelling at a superficial level, but fell apart under any kind of scrutiny.

There’s a lot of that going around.

Business theater

Philo draws some conclusions for those evaluating businesses.  One is that CEOs should not be judged based only upon their outstanding strengths, as they often are, but in light of their weaknesses, since “intellectually lazy managers are eventually doomed to produce bad results, no matter how hard they work or how exceptionally smart they are.”  Therefore, it is “important to identify underrated managers” and avoid overrated ones.

Many of them “are able to assemble a narrative that sounds convincing to a layman, peppered with vanity metrics and impenetrable business-speak”:

However, the narrative is usually all form and no substance, pure business theater.  It leans heavily on rhetorical tricks:  accounting chicanery employed to meet previously announced financial targets might be rationalized as “exceptional dedication to meeting our public commitments.”

It is through intellectual rigor — the willingness to ask tough questions and not fall for the rhetorical tricks — that you can crack the narrative and get at the underlying reality:

The goal of an analyst is to become knowledgeable enough to “separate the bluffers from the doers,” to borrow a phrase from Shelby Davis.

This is true in every corner of the investment ecosystem, for analysts studying companies, portfolio managers grilling analysts, allocators and advisory firms vetting asset managers, and on and on.  Outsiders face a whole host of hurdles in trying to understand what is happening, but quality research involves getting beyond the play being presented on the stage to understand the nature of the actors and how they perform when no one is looking.

Please read the posting, which provides much more detail.  You can see the archives of other postings from Philo or subscribe to the Substack here.

Approaching the end of a series of postings on social science research into investment culture, we come to the question of the lack of diversity in the ranks of investment professionals.

This time the research concerns hedge funds; it is the work of Megan Tobias Neely, in an article she wrote for Socio-Economic Review (“Fit to be king: how patrimonialism on Wall Street leads to inequality”) and her 2022 book, Hedged Out: Inequality and Insecurity on Wall Street.  (Quotes in this posting come from those two sources.)

Any academic-goes-into-the-investment-world endeavor presents the opportunity for an experienced practitioner to nitpick about this and that, including little details and big conclusions.  Neely’s work is no exception, as you’ll see in the comments on her big conclusions further down.  Of importance, though, is how well she captures the cultural dynamics at hedge funds regarding gender, race, and socioeconomic status.  (For the sake of brevity, this posting primarily will deal with issues related to gender.)

Homophily

Literally meaning “love of sameness,” homophily can be more thoroughly defined as “the tendency to form strong social connections with people who share one’s defining characteristics, [such] as age, gender, ethnicity, socioeconomic status, personal beliefs, etc.”  Through her interviews, Neely documents the homophily that pervades most hedge fund cultures.

Hedge funds are not alone in that regard — many investment firms are essentially monocultural, even as that condition has become much less common in other professions.  Some investment organizations, especially larger ones, have made strides in diversifying their employee ranks.  Others have not changed their historical hiring practices, looking and functioning much as they always have.  That is most prominently the case among “alternative” asset managers, including hedge funds.

While not all of those firms would fit under the common definition of “shadow banks,” they usually stand apart from more mainstream entities, fitting the ethos expressed here:

Growth in shadow banking is perhaps a sign of a retreat from bureaucratic institutions and a shift toward smaller firms funded through trust networks. . . . To guard against risk and uncertainty, people place trust in tight-knit forms of social organization.

The firms eschew diversity in the name of “meritocracy,” although a close look at how they operate indicates that is often an illusion.

The pipeline and the hurdle

Much of Hedged Out is organized around chapters about stages in the careers of hedge funders.  The first of them, “Getting the Job,” deals with the difficulties of those who are viewed as not having the typical profile for someone at a hedge fund.  That is, lacking “fit.”  According to the author, “Fit is a euphemism for social class but also contains implicit meanings about gender and race.”  The norm is hiring white men; “men blend in more and are routinely endorsed by other men, which is naturalized and framed as fit.”

Homophily is self-perpetuating.  Interviews of job candidates are often conducted by practitioners, who are not trained to look for true potential and how to develop it, but instead heavily weight “shared social and cultural experiences” when recommending or selecting someone for a role.  That often leaves out women, minorities, and those further down the socioeconomic ladder, all of whom are less likely to have had experiences that emotionally connect with interviewers.  Of the four main tracks by which people get into hedge funds, the “most common route to the industry” is the “social circle track.”  The book is full of examples of that in practice.

An additional challenge for women is the a stubborn belief in some quarters (famously articulated by Paul Tudor Jones) that motherhood disqualifies them from being great investors.  As a result, some firms have unwritten rules about not hiring women for direct investment roles.  And the kinds of informal activities at which social bonds can be formed (and job opportunities shared) are often men-only.  (A common explanation for that reality is that girlfriends and wives think it would be inappropriate to invite women to be included in such activities.)

When interviewing people about the lack of women and minorities in influential positions in the investment world, Neely found that they usually pointed to “a tried-and-true dismissive argument:  there are just too few members of these groups in the promotion pipeline or they aren’t interested in finance careers.”  Those are problems, but the larger issue is that firms don’t evaluate candidates on an equal footing; homophily creates a high hurdle that is difficult to clear for those who don’t fit the profile.

Internal barriers

Speaking of pipelines, should a woman land a job at a hedge fund it is likely to be in marketing, client service, or operations, rather than in an investment role.  (A tour of the “our team” sections of investment firm websites illustrates that this pattern is not limited to hedge funds.)  Investment duties tend to be gendered as well.  One story in the book is of “the girl” among eight incoming analysts, who was assigned coverage of retail companies (a traditional “girl” position in the industry) despite the fact that she had training in geology, while the men given responsibility to analyze energy and metals/mining had no relevant experience.

Overt discrimination and sexual harassment may not be as common today as they were during the time of Tales from the Boom-Boom Room, although the recent events at Odey Asset Management (covered in the last issue of the Fortnightly) remind us that they haven’t gone away.  That presents a dilemma for the wronged; in a tight-knit, reputation-based industry, those seen as rocking the boat by calling out bad behavior are likely to be black-balled.  (And when a perpetrator is let go, he usually shows up at another firm, an act of “passing the trash” that we’ve seen in other realms.)

Even when they are on the inside, women are often on the outside:

A fraternal environment and a hyper-masculine culture dominate the industry, limiting women’s ability to find mentors and networks.

Since the organizations are largely made up of men, informal activities and team-building events reflect their interests and athletic pursuits.  In interviews, even men acknowledge that it is hard to be a woman at a hedge fund — and founders often pass off their firms to sons but not to daughters.  One said he didn’t want his daughters to go into the business, “because it’s very much an old boys’ industry.”

The organizations

Hedge funds range in size from the proverbial “two guys and a Bloomberg Terminal” to very large firms, so generalizations are challenging, but there are common tendencies.  Organizations tend to be flat and often one person is the ultimate decision maker regarding investments (and most everything else too).

That entrepreneurial approach brings with it a lack of leadership and management expertise.  Leaders (who are primarily interested in and adept at the investment side of things) are “poorly equipped to provide training and mentoring.”  One significant problem is that “performance-based pay, throughout the industry, is subjectively determined and negotiated in what is, for the employee especially, a low-information environment.”  (Those with compensation arrangements explicitly tied to the performance of a portfolio are spared that murkiness.)  The result is two very different points of view at work in an organization:

Executives believed eschewing title and evaluations fostered meritocracy and creativity.  Employees, however, said procedural ambiguity led to dysfunction, bias, and unnecessary competition.

Ultimately, the success and sustainability of an organization is dependent upon building a culture that gets the most out of its employees — and brings in new talent that can help it grow in its capabilities.  A culture of homophily doesn’t do either.

Independent thinking

Neely relates the story of her own interview at a hedge fund in 2007.  She noticed a poster on the wall that said, “Respectfully Question Authority.”  It was one of several bromides “lining the hallway to communicate the firm’s values:  antihierarchy, antibureaucracy, and independent thinking.”  The interviewer subsequently explained, “We want our employees to be critical thinkers, not rule followers.”

In contrast, Neely’s later interviews with those who work at hedge funds found that the motivational posters didn’t fit with the environment.  People were “penalized for accepting the invitation to openness,” receiving “unwelcoming, even retaliatory, responses.”  That resulted in those involved — especially those perceived as outside the norm in some way — being “uncomfortable speaking up,” a natural response given the conditions, no matter what the posters say.  Independent thinking becomes less likely, not more.

Patrilineal propagation

Breakaway firms have long been a feature of the investment industry.  A person has success at one firm and decides to hang out their own shingle (or a group of people do so together).  As a result, some organizations have spawned impressive family trees over the years.

Most traditional organizations have not supported the breakaway process, not wanting to encourage their best people to leave.  That has also been the case with many hedge funds, but others have flipped the script:

Hedge fund founders provided valuable forms of mentorship, training, and seed funding to a select group of trustworthy, loyal protégés groomed to carry forward their investment tradition.

Neely calls these “cultivated” firms, with the Tiger Cubs being the most famous examples.  Who gets mentored and funded?  As with hiring, those choices “hinge on a sense of familiarity,” with predictable results in terms of race and sex.  In addition, it should be no surprise that there is portfolio herding and organizational replication within these extended tribes.  The networks are “based on trust, loyalty, and tradition,” whereby The Way gets passed down to the next generations of the clan.

Big conclusions

In the introduction to the book, Neely writes:

Elitism, whiteness, and masculinity largely determine who gets the W in this risky game, thought not always in predictable ways.  I close the book by arguing that, unchecked, this structurally unequal financial sector will accelerate inequality over time.  Systemic change is the only way to slow this concentration of money, status, and power into fewer and fewer hands, and to disrupt the economic dominance of elite white men that so forcefully forecloses upward mobility for everyone else.

This illustrates a question of scope regarding Neely’s work.  Her interviews with individuals paint a picture of hedge fund culture that is familiar to those who know the industry well.  But the broader conclusions often seem forced.

Do hedge funds cause societal problems such as inequality, reinforce them, or merely reflect them?  Are practices that prove to be exclusionary a sign of an intent to discriminate or evidence of shortsightedness and cultural inertia?  Those are complex questions.

Neely also delves into the “loopholes and legal exceptions” that provide advantages to hedge funds.  And comments that, like the large banks, “the hedge funds have very smart people who are paid to get around the rules,” putting the regulators in an unfair fight.

A decade ago, when The Wolf of Wall Street hit movie theaters, Neely wondered:

Why weren’t we looking at the perfectly legal, quotidian behaviors and banal job functions that create tremendous social problems, such as economic instability and socioeconomic inequality?

Her work offers insight into the quotidian behaviors.  However, the link to those important social problems is tenuous.

Practical perspectives

Among the important ideas prompted by Neely:

Social capital.  What comes through clearly is how important social capital is to the success of individuals wanting to make their way in the world of hedge funds, where that social capital seems particularly powerful (and narrowly drawn).  Those without social capital face huge obstacles to advancement.  Organizations should consider whether a constricted view of human capital — heavily judged based on social capital — is a tenable approach to long-term success.  There are certainly places to find diverse, equivalent talent should there be an interest in doing so.

Innovation.  Neely points out that Alfred Winslow Jones, “the hedge fund industry’s founding ‘father’ was a Marxist sociologist.”  (That part of the origin story isn’t usually highlighted.)  He used social theory to understand market behavior — “and then applied technical and mathematical methods to capitalize on social phenomena.”

What would Jones think about “hedge funds” today?  The term is now applied to an incredible range of strategies, many that don’t feature the hedging that Jones employed.  But despite the array of approaches and big changes in the universe of securities used, a remarkable sameness in culture is in evidence across many of the firms.  That fits a general pattern in the industry well beyond hedge funds:  “investment organizations” think a lot about investments and not much about what it takes to build a great organization.  Given his sensitivity to social phenomena, you’d think that would cause Jones to raise an eyebrow.

Questions for allocators.  Institutional investors who select asset managers — especially pension plans, foundations, and endowments — wrestle with how to balance investment beliefs and organizational beliefs.  If they invest using hedge funds and other alternative managers (which almost all of them now do), Neely’s book offers a reminder that some corners of the markets are very much out of sync with the diversity initiatives promoted by asset owners.

But even those who are solely focused on prospective investment results should ask:  What cultural attributes lead to success?  Putting paper-thin motivational posters on the wall is nice, but how can an organization be created that actually lives up to those principles?

Sell-side analysts have been the subject of much academic and practitioner research over the years.  Certain parts of their work — earnings estimates, target prices, and recommendations — are easy to track, leading to conclusions about whether individual analysts, groups of them, or analysts overall add value by means of those outputs.

Left out of such reviews are the other aspects of an analyst’s job, which surveys show are more highly valued by institutional investors — and the social forces that affect their actions.

The last posting in this series reviewed a paper by Millo, Spence, and Valentine about beliefs in active management during an era defined by the rise of passive management.  Another paper from the authors, “The Field of Investment Advice: The Social Forces that Govern Equity Analysts,” is the topic now at hand.

The same set of interviews was used as the basis for this paper as for the previous one.  Of note is that James Valentine, one of the authors,

had spent a considerable amount of time in the field as a practitioner and continued to pursue commercial interests in that space while simultaneously holding an academic position.  This represented both an opportunity and a challenge for the data analysis.

Valentine (the author of Best Practices for Equity Research Analysts, reviewed here) was able to help with “the jargon and tone of respondents,” but his experience presented a challenge in that the goal of such studies is to glean ideas from the research subjects, not from a member of the research team.  Often academic research misses important considerations in interpreting results because of a lack of direct knowledge of how things work.  Having a practitioner involved can minimize that risk, but the potential pitfalls of doing so must be mitigated.

This paper is representative of the other social science research examples that have been used in this ongoing series of postings.  Each of the studies has gotten to the heart of the particular investment subculture being studied, in the process revealing implications that go beyond the narrow confines of those subcultures, since “the way things are done” within them affects investment discourse and practice in general.

A conundrum

The abstract for the paper indicates that sell-side analysts present “a conundrum,” in that they “are seen as influential market participants, yet researchers widely criticize them for their bias and inaccuracy.”  Studies that focus on easy-to-track estimates and ratings not only leave out the other activities that investors prize but ignore the social forces that shape analysts’ work.

“Webs of relationships” characterize the environments within which analysts operate, including those with the companies that they analyze, the buy-side investors who tap them for information (and “concierge services”), others in the firms at which they work, and their analyst counterparts at other firms, with whom they compete.  The dynamics of those relationships are overlooked in most evaluations of analysts, which thereby “underappreciate the social sensitivities and social pressures that analysts have to navigate on a recurring basis.”

Among the “other” responsibilities of analysts (in addition to writing reports that contain their predictions):  keeping the lines of communication open with the company managements that they follow; arranging for access to those managements by buy-side investors (at conferences and smaller private meetings); serving as a go-to source of information about the companies and industries they follow; developing and maintaining relationships with buy-side analysts and portfolio managers; and supporting their firm’s corporate finance and trading businesses (in more of a wink-and-nod way than used to be the case).  Plus, the work product of an analyst is “often used ceremoniously” by companies and the analyst’s own firm for promotional reasons.  In short, the assessments of covered companies are affected by social considerations as well as by financial analysis.

Field theory

The authors use field theory in their diagnosis, which “expands the motivations relevant to actors’ behaviour beyond those associated directly with economic utility maximization.”  The theory also recognizes the need for actors “to maintain and strengthen the social order,” even though they are in competition with others within the field.  Everyone involved is aware of the “rules of the game.”

Patterns of behavior are not just economic, but take into account “the whole structure and history of the surrounding field,” resulting in two important insights related to the work of analysts:

First, [field theory] expands the repertoire of relevant social skills in the field of investment advice and implies that sell-side analysts, as actors in a social field, aim to improve their situation using all resources they perceive they have at their disposal; economic resources as well as social (e.g. connections) and cultural (e.g. skills, expertise, professional authority) resources.  Second, the “rules of the game” that prevail in a given field are shaped and learned gradually through recurring interactions and are the product of experience, habit, and routine which, to some extent, evade conscious consideration as they become part of the taken-for-granted worldviews of these actors.  This habituation to the implied rules of the game is also expressed in the belief that the established social order in the field represents an objective and natural truth; that the way things are is the way they should be.

The notion that “the way things are is the way they should be” is not limited to the world of sell-side analysts, although they serve as a good example of a broader principle.  “The interdependencies and relationships that have built up over time between sell-side analysts and buy-side actors that may have become habitual, taken-for-granted features of investment decision making” have close cousins in other parts of the ecosystem.  (What are the taken-for-granted features in your realm?)

The rules of the game

The environment in which sell-side analysts operate is characterized by social inertia, a product of the “inter-personal and inter-organizational interdependencies that maintain the structure of the field, despite regulatory and economic changes aimed at disrupting these.”  The social order is protected in a variety of ways:

~ Relationships are valuable and analysts “hone their trade through the cementing of social ties over time.”  Therefore,

maintaining the social order may be so important for actors that they would protect their social ties even if this would imply rejecting potentially innovative ideas or new opinions, as the actors’ worldviews are embedded into the existing social structure of the field.

~ “The buy-side is slow to move from an existing sell-side relationship and there is not enough bandwidth to constantly cultivate new relationships.”

~ “The continued existence of social ties between different financial intermediaries was evoked as a reason to explain the persistence of underperforming sell-side analysts in the marketplace.”

~ “Members of buy-side firms reinforced the view that buy-side/sell-side relationships outlive their useful economic lives and that payments for sell-side services do not rely solely on the quality of their analysts’ output.”  (At some buy-side firms, people weren’t even sure how the payments to firms were calculated or how their assessments of analysts factored in.)

~ Buy-side interviewees mentioned the need to have good relationships with analysts at firms that can provide deal flow; the effect of “reciprocity generated by gifts and entertainment;” the “cultural matching” power of friendships that develop; and even sympathy for someone who is a “nice guy” or has a family to support.  None of these would be a part of an objective assessment of an analyst’s forecasting ability.

~ Another factor:  bigger firms need to field a large analyst staff that covers a broad universe, at times “privileging coverage over quality.”

Consensus estimates

The paper uses earnings estimates as a way to illustrate the competitive relationships among analysts.  The dynamic among them is similar to that found in other fields, described in this way by a sociology book cited by the authors:

Actors make moves and other actors have to interpret them, consider their options, and act in response.

Because data platforms publish “consensus” earnings estimates, which average the views of all of the analysts covering a company, individual analysts can “position themselves vis-à-vis an aggregated version of views in the wider field.”  That leads to patterns of convergence and divergence:

Consensus numbers and the positioning practices that surround them are thus indicative of a social and informational infrastructure that may help provide a richer explanation for phenomena such as herding, or conversely of boldness whereby some analysts try to diverge from the herd in abrupt ways.

Consensus estimates serve as a benchmark, framing “how actors perceive the field and how they differentiate between different categories of actors.”  The attention paid to the consensus “has the unintended consequence of amplifying the impact of the average consensus number and the opinions associated with it.”  In practice, “the consensus number serves as an infrastructure for developing opinions rather than a visible building block in the discourse,” embedded and weighty in the investment processes of most practitioners.

The consensus also allows those willing to stray from the crowd to be easily identified, while everyone else blends in.  The authors describe the stay-safe career calculus that causes a clustering around the consensus as fulfilling “the normative demand from analysts to avoid erroneous predictions,” since being wrong when you’re with the consensus is not the same as being wrong when you are away from it.

While clinging to consensus is the norm, “in a social field that rewards alpha generation and distinctiveness, heterogeneity was extolled as a virtue by actors who saw diverging from consensus numbers as beneficial.”  This disparity in motivations and actions among analysts — the desire for most to converge to consensus and a few to diverge from it — is missed in analyses that ignore the social element and gameplaying inherent in analysts’ roles.  (A similar dynamic exists among those on the buy-side; see the “Real active or faux active?” section in the previous posting.)

According to the authors:

The diverging patterns of reactions to consensus numbers may be understood as different interpretations of the rules of the game in the field.  The differentiating factor is the type of resources the followers and challengers assume they have.  In other words, actors work within the realm of what they perceive as possible, having internalized the structures of the surrounding field.  Our research adds a deeper understanding to existing findings in the analyst literature that indicate sell-side analysts who have a higher status or are more courageous and want to improve their situation by gaining more attention are more likely to challenge the consensus.  In contrast, others who see the best course of action as not attracting attention, tend to comply with these numbers.

(Another aspect of the estimate game is summarized in a Bloomberg article about the “overly conservative guidance” companies provide regarding earnings, so that they can be credited with “beating” consensus.  “That is how the game is played,” said the researcher who authored the study the article was based on.)

Broader implications

Sell-side analysts are key players in the investment chain.  Despite perceptions that they are biased and that their predictions are inaccurate, their influence is undeniable and multifaceted.

Consider just the earnings estimates that those analysts produce.  The aggregated consensus estimates are the core feature of much investment discourse.  Buy-side analysts and portfolio managers are constantly forming their own estimates and judging the work of others based upon the consensus and the array of estimates around it.  (As the paper indicates, generalist analysts are prone to relying on the consensus more than specialists.)  In addition, all kinds of quantitative strategies work off of the spread of estimates versus consensus, the migration of the consensus over time, earnings surprises away from consensus, the patterns of individual analyst predictions versus the group, etc.

The estimates are products of a complex social environment.  Despite the inherent competition in their world, sell-side analysts and those who interact with them generally “resist change and stick to existing practices,” those rules of the game ingrained in that web of relationships.  What seems to outsiders to be a rational economic endeavor is something much more.