SECURITIES ANALYSTS AS FRAME-MAKERS

Abstract

In this paper we explore the mechanisms that allow securities analysts to value companies in contexts of Knightian uncertainty, that is, in the face of information that is unclear, subject to unforeseeable contingencies or to multiple interpretations. We address this question with a grounded-theory analysis of the reports written on Amazon.com by securities analyst Henry Blodget and rival analysts during the years 1998-2000. Our core finding is that analysts’ reports are structured by internally consistent associations that include categorizations, key metrics and analogies. We refer to these representations as calculative frames, and propose that analysts function as frame-makers – that is, as specialized intermediaries that help investors value uncertain stocks. We conclude by considering the implications of frame-making for the rise of new industry categories, analysts’ accuracy, and the regulatory debate on analysts’ independence.

Despite the extensive academic attention bestowed upon analysts, existing treatments provide a limited account of their intermediary role. Extant work is best understood as three broad streams. One approach, rooted in the finance and accounting literatures, views analysts as information processors and stresses their activities of search, assembly and communication of information. Another approach, based on neo-institutional sociology and behavioral finance, documents the tendency of analysts to mimic each other. We refer to it as the imitation perspective. Finally, a more recent sociological approach has started to outline the role of analysts as critics.

Analysts as information processors. The information processing literature on analysts rests on a remarkable finding: securities analysts, long regarded as valuation experts, are unable to provide accurate forecasts of stock prices. Beginning with Cowles’ (1933) seminal piece, titled “Can Stock Market Forecasters Forecast?” numerous finance and accounting theorists have documented the failure of analysts’ recommendations to produce abnormal returns and accurate forecasts of earnings and price targets (Lin and McNichols, 1998, Hong and Kubick, 2002, Michaely and Womack, 1999, Lim, 2001, Boni and Womack, 2002, Schack, 2001). ¹

Two complementary explanations have been put forward to account for this failure. One view, based on the efficient market hypothesis (EMH), argues that accurate financial forecasting is simply impossible in an efficient capital market (Samuelson, 1965; Malkiel, 1973). According to the EMH, stock prices in a competitive capital market capture all relevant information about the value of a security, following a random walk. There are no mispricings, no possibility for any actor to find extraordinary profit opportunities and indeed, no scope for financial intermediaries to help their clients do so (Fama, 1965, 1991; Samuelson 1967; Jensen, 1968, 1970; Malkiel, 1973). The bleak implication for analysts is that accurate forecasting and lucrative advice are impossible.

An additional explanation for analysts’ inaccuracies, based on agency theory, is that the fiduciary relationship between analyst and investor is distorted by a variety of conflicts of interest, producing dysfunctional biases in analyst’s forecasts and recommendations. These distortions include investment banking ties (Lin and McNichols, 1998, Hong and Kubick, 2002; Michaely and Womack, 1999), access to company information (Lim, 2001), brokerage interests of the bank employing the analyst (Boni and Womack, 2002), investment interests of the clients of the bank (Sargent, 2000), or the investment interests of the analysts themselves (Schack, 2001). Analysts, in short, come across from this literature as conflict-ridden intermediaries.

The aforementioned conflicts have become particularly prominent following the Wall Street scandals of 2000-2001. During these years, top-ranked Internet analysts (including Henry Blodget) resisted downgrading their recommendations even as prices fell from record highs to zero (Boni and Womack, 2002). Other analysts were recorded privately criticizing companies they publicly recommended (Gasparino, 2005). Such was the public uproar against analysts that the Securities and Exchange Commission even issued explicit guidelines for retail investors to use analyst reports with caution (Securities and Exchange Commission, 2002).

Whether in the form of market efficiency or conflicts of interest, the approaches to analysts presented so far share a common premise: both assume that the core intermediary function performed by security analysts is to forecast the future and provide recommendations. Analysts are accordingly presented as engaged in search, assembly and diffusion of information. To highlight this common focus on information, we refer to this literature as the information processing approach.

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