Quis custodiet ipsos custodes? A timely discussion on the independence, professional standards and competence of analysts covering companies on the Nigerian Stock Exchange.
As the Nigerian stock market convulsed in the past year analysts have come to be regarded as shamans with the powers to conjure or calm the animal spirits at will. One day reassuring investors that the patient is making a full recovery and the next minute pouring the oil for Extreme Unction. Under circumstances of fear and loathing that have characterized investor sentiment over severe losses suffered, the pronouncements and prescriptions of analysts can and do have significant effects on the share price of companies. In some cases, the very sustainability of the firm has been called into question. With this kind of power one only wonders how soon it will be before abuses start to appear. As history teaches with countless examples, power corrupts and absolute power corrupts even the best of men absolutely. Those responsible for good order in the market need not wait till then. In this post we discuss the vital role that analysts play in the market and why such influence as they have so clearly enjoyed in recent times is critical to their investment filtering function as well as the efficiency of markets. Next we discuss with a number of marquee examples, cases where such powers have been applied to perverted ends. Recent allegations of purported analyst research used as a cover to de-market sector competitors accentuates the relevance of the subject. Finally, we examine ways to ensure that such power is not misused for ends contrary to those for which they were originally intended.
Speaking in an November 2007 interview with the Times of London just a few days after downgrading Citigroup from Strongly Perform (SP) to Strongly Underperform (SU), Meredith Whitney, former executive director of equity research at CIBC World Markets, stated without mincing words: ‘People are scared to be negative, especially when a company has such a wide holding. Clients are not pleased with my call and I have had several death threats. But it was the most straightforward call I’ve made in my career and I am surprised my peer analysts have been resistant. It’s so straightforward, it’s indisputable.’
In her note, Whitney raised grave concerns that Citi would have to cut its dividend and raise as much as $30 billion. Before the end of the trading day, Citi’s shares had dropped 7%, the Dow Jones Industrial average had given up 362 points and the S&P 500 had shed 2.6%. To put it in context, Citi’s market cap dropped about $15 billion and the US stock market lost $369 billion on that day. Little wonder that CIBC’s chief analyst received death threats. When things go wrong on the market at such a dizzying pace, the search for a scape goat intensifies. So much for being the canary in the mine.
In the following videos, David Einhorn and William Ackman, founders of Greenlight Capital and Pershing Square Capital respectively stress the importance of the analyst’s role to the efficiency of markets and the long-term welfare of shareholders.
No one is going to listen to David Einhorn because I am David Einhorn. They [will] only listen to David Einhorn if I say something that is sensible. Otherwise, they will do the opposite. – David Einhorn.
Now, all of this is cold comfort for those who believe that the bringer of messenger is the cause of the bad news. Yet, it serves as the substance of what lies at the heart of the investment research: painstaking research, a specific investment recommendation on the security (Summary Rating) based on the research with a clear description of analysis procedure and valuation methods used as well as any mitigating factors, and, finally, the conviction to back the actionable recommendations with one’s reputation.
In an era when investors have access to published information from innumerable sources via the web, print and electronic media, it should come as no surprise that the quantity of information exceeds the quality. Ironically, more information does not mean better information. Since both good and bad quality information can motivate investors to act, with potentially deleterious consequences in the latter case, it is important to distinguish between what constitutes good information, in this case, good investment research and bad information, i.e., bad research. This is not simply a matter of value judgment for its sake. It goes right to the heart of the integrity of markets. If investors doubt the qualifications and motives of those providing the information on which they make their investment decisions on, the tendency is that they would misprice the risks on securities and consequently, mal-allocate resources, leading to inefficient markets.
In this regard, analysts serve the following vital functions in the market:
Provision of coverage: By doing so, the analyst signals to the market that he will handle the information sieving function (from the issuer, customers, clients, suppliers, competitors, etc) thus reducing the costs of private information gathering and processing which allows investors to pass on those resources -that would have been spent on the trawling and picking effort - to firms that require that capital.
Publication and distribution of research: Essentially, by releasing the valuable information they uncover, analysts either affirm the narrative of management or counter it, providing a commentary on either management’s full appreciation of the company’s position and prospects, which in itself is a revelation on either their credibility and/or competence. Hence, analysts play a crucial role in monitoring the alignment of agent actions with principals’ interests and expectations.
Issuance of trading recommendations: Finally, by making an explicit statement on what action to take based on the processed information, the analyst is provides actionable guidance to be taken immediately on the security.
Since risk assessment and management practices at financial institutions have been the main sources of stress that led to the global economic turmoil that started in 2007, analysts covering the sector have received a lot of the headline interest.
As early as May 2008, Andrew Cuffe of JP Morgan’s published a report on the banking sector in which he pointed out that bank share prices have run well ahead of fundamentals and do not incorporate the numerous risks facing Nigerian banks both from an operational and macro perspective.
The report was the first major break from the general chorus-and-applause on the stability and prosperity of Nigerian banks. In spite of assurances by regulators and bank CEOs that all was well, investors took note. With JP Morgan’s global institutional client network, the report must have been widely read in London and New York among frontier market fund managers. In only a few months the banking sector would slide from being the darling of the Nigerian stock market with steep valuations to the unwanted orphan sold in slavery. Very quickly, initial concern turned to simmering panic, which finally turned to a desperate rout.
In April 2009, Bloomberg described Nigerian bank share price losses as the worst in the world. In the report, Christopher Hartland-Peel, an equity analyst at Exotix, the frontier market investment banking boutique, stated that without meaningful disclosure investors will be hesitant to come back especially in the [Nigerian] financials. No one really knows how the companies are faring.
The signal event that raised awareness about the powerful role of analysts as examiners of institutional health was demonstrated when Kato Mukuru of Renaissance Capital, the emerging markets investment bank, issued a note on Intercontinental Bank, which had been the subject of an aggressive de-marketing campaign, stating with the confidence of a witch-doctor that:
In this note we address questions on the state of ICB’s balance sheet. By publishing ICB’s asset risks and stress-testing them, we hope to close the chapter on the de-marketing of this name and provide investors with the means to assess these risks.
Although, the Central Bank had issued a press release assuring the public on the health of the bank, it required the assurance of an analyst to lay the subject of investor anxiety to rest.
Ostensibly, when all else had been tried and failed, only the analyst as witch doctor could calm the storm. The RenCap report had laid issues to rest with a finality that even the Central Bank could not. Investor confidence in the stock returned.
While this new power seems to have been surreptitiously amassed by analysts, its evidence is public for all to see. Yet few have paused to think about its consequences. In fact, beyond disagreements on the conclusions of some reports, the bigger issues that touch on the independence, compensation and qualifications of analysts covering companies on the Nigerian Stock Exchange have been ignored. Without making an assumption that abuse of investor trust must necessarily occur when analysts are influential, the risk that it can, and with ruinous consequences for the integrity of the market as experience in other markets shows, requires that adequate safeguards be put in place to ensure that they do not. If standards of objectivity are compromised, then it is a slippery slope from then on.
The United States provides a good example of what can go wrong when the power of analysts goes unchecked. It also provides a beacon for regulatory and policy responses to mitigate brazen excesses. During the nineties, analysts covering companies issued what Professor Jill E. Fisch describes as ‘overly optimistic and baseless recommendations about scores of companies.’ These recommendations drove the fin-de-siecle over-valuation fever that saw internet companies with no income streams trading at multiples of those with seasoned business models and proven income streams.
After conducting a three-year independent examination of biases in analyst recommendations, in April 2002, the US Securities and Exchange Commission in co-operation with the Office of the New York Attorney-General, National Association of Securities Dealers, New York Stock Exchange, North American Securities Administrators Association and states launched a formal investigation into the analyst research production practices at leading Wall Street firms. The probe found that analyst research was mired in conflicts of interest between its supposed objectivity when making summary recommendations for client action and their dependence on the investment banking parts of the firm to cover its expenses. Analysts, as it became glaringly clear, are not independent.
The Commission staff was concerned that analysts, who had became veritable media stars, appearing ubiquitously on television financial programs, did not disclose their own conflicts of interest so that investors could evaluate their recommendations against their possible biases.
In our opinion, lack of independence does not necessarily have to translate to lack of objectivity in recommendations. Put differently, because a symbiosis exists between analysts and bankers in a firm does not foretell that research will be misleading. Likewise, because analyst research is disinterested or supposedly independent does not mean that it will be objective or high quality. Moreover, a betrayal of trust does not and should not presume the existence of a prior fiduciary duty. A betrayal of trust may just be that: a betrayal of trust and no more and should be punished as fraud.
The firms were charged with issuing research reports that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims about the covered companies, and/or contained opinions for which there were no reasonable bases.
Be that as it may, the US SEC had elevated what was intended, at its origin, to be a service of client convenience and marketing for the fee-earning parts of the firm to a fiduciary duty of selfless commitment. An elementary understanding of the origins of research would have shown that independence as a quality of analyst production was incidental. Objectivity, yes, independence, not quite. In the beginning, because of fixed trading commissions in the United States which limited a firm’s ability to compete on price, one way to win client trading business was to present itself as knowledgeable about the security. This also explains the preference for BUY recommendations, since in most cases, the firm was responsible for the initial BUY signal, and as such would be reluctant to change it and lose clients money when they sold in a down market. To complicate matters further, most firms also offered investment banking services to the firms they covered, further reducing their motivation to downgrade its stock even when good reasons exist to do so.
In any case since the US SEC’s interpretation has become the universally accepted one this discussion will be based on those mandated obligations. But its acceptance must be placed in the historical context of revelations of executive malfeasance at Enron, Tyco, WorldCom, Adelphia Communications and other high profile public companies at the time and a political need to ‘fix Wall Street’ not on the sole purpose of punishing errant analysts, grievous as their actions were.
In the end, US regulators enacted extensive rules on the relations between analysts and investment bankers. The primary emphasis of the rules was on disclosure. Among the terms of settlement reached between the regulator and the firms, three are of prime relevance to the evolving situation in the Nigerian stock market namely:
The implementation of structural reforms in the relationship between analysts and bankers within the firm
Enhance disclosures of potential conflicts by giving prominence to a statement in this regard on the first page of every report
Voluntary restraint in issuing research during transactions in which the form forms part of the syndicate, primarily initial public offerings.
Ironically, the influence of the analyst in Nigeria did not assume its current position during the years of the stock market boom. In that period, valuations were driven by media publicity and optimistic forecasts by management rather than by analysts.
In the past, analysts could hardly command an investor audience. As we have shown, this is no longer the case. Today, they speak authoritatively, fully confident that investors will cling to their words.
To avoid the most blatant and egregious excesses witnessed in the United States, it is incumbent on regulators, issuing houses and stockbroking firms, as well as issuers to settle on the rules of engagement for the production and publication of research.
We list below a set of preliminary proposals for each group.
Regulators (Securities and Exchange Commission and the Nigerian Stock Exchange)
Examination of the relationship between sell-side analysts and bankers/brokers/fund managers in firms distributing research to ascertain the level of influence of the later on the former including the determination of firms to cover, the role of analysts in transaction support (for example, appearances at issuing house client road shows), compensation determination, regularity and timing of publications to coincide with material events at issuers. The purpose of the examination will be to decide if and to what extent existing relations impede the objectivity and quality of research produced and what safeguards firms have in place to address these.
Requirement that all relationships, holding, obligations or transactions that have the potential to cause a conflict of interest or be perceived as doing so be disclosed in reports and filed with the SEC at the end of every quarter
Requirement that at the end of every quarter, the firm distribute to all its clients, including non-clients on its mailing list, a full breakdown of each analyst’s performance, ratings, price targets, forecasts (over the past 3, 6, 9 and 12 months) as well as an explanation of its recommendation system.
Requirement that all firms providing research that is not explicitly paid for but is distributed to clients and non-clients provide all such reports and archives in full on their websites. In addition, the sites should contain a list of all companies they cover, date of commencement of coverage (including those they have dropped coverage of), and ratings dispersion. Graphical representations should be used as much as possible. For reports that are sold, the summary recommendations and a single page summary should be made available.
Issuers should have clear guidelines on access to management. They should be strongly discouraged from providing privileged access to any particular analysts, and when they do so, if any material information is inadvertently disclosed, it should be immediately released – at the latest, before the close of the business day- to other firms covering it. Issuers should be warned against discrimination in disclosure. To this end, the SEC should work for a Nigerian code of fair disclosure.
The establishment of an arbitration panel for analyst-issuer disputes.
The submission of trading records of the firm in an issuers’ securities up to five business days before the release of a report and fifteen business days after.
Restriction of firms involved in a transaction from issuing research reports on the firm.
Unambiguous penalties should be stipulated for non-observance of the above rules.
Issuing houses and Stock broking firms
Implementation of the recommendations listed above as the affect the firms.
Establishment of processes to ensure that research production is not misleading or biased.
Full disclosure of the basis of commencement of coverage, and at termination, the reasons why.
Support for the establishment of a professional body that will set and oversee ethical standards in the production of research, e.g., Association of Financial Analysts of Nigeria or Nigerian Institute of Financial Analysts.
Adherence to a best practices diet in analyst-client and analyst-issuer relations.
Full disclosure of all potential sources of bias and conflict of interest.
Commitment to educating clients on the context of analysis and basis of recommendations.
Securities issuers
Implementation of SEC and NSE proposals listed above as they affect public companies.
Clear guidelines on analyst-issuer relations.
Robust investor relations programs.
Commitment to openness and prompt disclosure of all material information [as soon as practicable].
Provision of earnings guidance.
No doubt, these suggestions only scratch the surface. They are only a starting point. What is needed is a comprehensive overhaul of analyst-issuer relations in Nigeria. One caveat though: integrity cannot be legislated. Regulators, issuers and firms need to put all hands on deck to ensure that investors do not lose faith in the market’s price discovery process, whether led by analysts or public company management. At the moment, analysts wield tremendous influence and with great power should come great responsibility. So as these seers go about making pronouncements on the fate of companies and statements that can add or wipe off several millions in their value, they should not forget that when the eye of scrutiny turns in their direction, they had better not be found wanting. If they are, the consequences will be dire.
One cannot help noticing how Niyi Meka Olowola, Oando's Head of Corp Comms, is nodding in approval. Maybe Goldman Sachs can learn lessons.04:47:49 PM January 25, 2012from HootSuite
It's at times like these companies praise heaven for media-savvy CEOs.Among Nigerian business leaders,Wale Tinubu, is easily among the best.04:46:01 PM January 25, 2012from HootSuite
Twitter: CustomsStreet
