Recent corporate failures have raised serious questions about the quality and objectivity of investment analysts.
One of the issues raised amongst regulators in connection with the spate of recent high profile corporate failures worldwide is the adequacy of external monitoring. Specifically, the independence of investment analysts has been mentioned in this context. So far, I have not heard of any reaction from investment analysts on the subject, other than the attempts by some to brush it off as a not very important issue, particularly for large investment houses where there are strong "Chinese Walls".
Market stability and integrity depend, among other things, on adequate external checks and balances. Although this inadequacy, as reflected in recent corporate failures, was perhaps attributable primarily to a shortfall in the quality and timeliness of information provided, the unsatisfactory performance of the investment analysts may have also been a significant factor. Indeed, doubts have been expressed on the willingness or the ability of analysts, particularly those employed by securities dealers, to exert negative but correct judgements.
As pointed out by Alan Greenspan in a speech on corporate governance delivered in New York on 26 March 2002, investment analysts, at least those in the United States, have been persistently overly optimistic in their views on company performance and prospects. He illustrated this by referring to the degree with which the five-year earnings forecasts of the S&P 500 corporations between 1985 and 2001 provided by investment analysts have been wide of the mark. Their forecasts of earnings growth over the period averaged 12 per cent per annum, while the actual earnings growth averaged only about 7 per cent.
Alan Greenspan went further to attribute this to "the proclivity of firms that sell securities to retain and promote analysts with an optimistic inclination". In fact, according to Mr Greenspan, the optimistic bias of investment analysts "apparently has been especially large when the brokerage firm issuing the forecast also serves as an underwriter for the company's securities". This says a lot about the objectivity of the work of investment analysts.
It may be argued that this implied criticism is a little unfair. The quality of the analysis depends to a large extent on the quality of the information available. This is something out of the control of the investment analysts and is very much under the control of the Board of the company, in particular the chief executive officer. In most cases the CEO also has a strong influence over the choice of Board members, external auditors, membership of the audit committee and therefore the standards that measure the ongoing success or failure of his business strategies. And these choices are almost always unquestionably affirmed by shareholders, particularly those of companies with widely dispersed ownership. No CEO likes to admit, or present information that amounts to admitting, that the company he or she runs is in difficulty. The downside is of course that his or her mandate to run the company from the shareholders may be withdrawn. Put bluntly, this somewhat inevitable conflict of interest is not conducive to voluntary efforts on the part of the Board or the CEO to maintain high standards of corporate governance, let alone raise them.
But this is precisely why there is a need for objective external monitoring. The increasing complexity of the operations of the large companies has for some time made it very difficult for the average shareholders to do this. They simply do not have the research capability. This is a job for professionals who are capable of critically examining the numbers and trends, and assess objectively the prospects of the companies. Regrettably, however, there is no market for the free-lance, independent professionals in this field. It is ironic that the credibility of investment analysts has hitherto come from their association or employment with investment houses that are in the business of underwriting or selling securities. The possibility of conflict of interest is addressed or dismissed by claims that the independence of investment analysts is ensured by the presence of "Chinese Walls". But the historical evidence of the existence of a large optimistic bias in their views casts grave doubts on these claims.
Alan Greenspan expects that with greater transparency of the analysts' recommendations and of their ex post results, market discipline will lead to the optimistic bias of the investment analysts to diminish rather rapidly. I hope he is right. I fear, however, that this may not be so easy in smaller markets with less sophisticated investors, and where there is an oligopolistic presence of investment houses. In these circumstances, there is perhaps a need for special efforts to ensure even greater independence than that afforded by "Chinese Walls".
Joseph Yam
11 April 2002
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