a great academic paper: “Playing Favorites: How Firms Prevent the Revelation of Bad News”

A sidebar next to the “Heard on the Street” column of yesterday’s Wall Street Journal highlighted a research study by Profs. Lauren Cohen and Christopher Malloy of Harvard and Prof. Dong Lou of the London School of Economics titled “Playing Favorites…”.  I found the study itself on Prof. Cohen’s web page (along with a lot of other neat stuff that I’ll be writing about soon).  It’s well worth reading at least the summary at the beginning.

information manipulation

Mssrs. Cohen, Lou and Malloy studied the way in which companies choreograph conference calls by selecting the analysts who are allowed to ask questions.  Their finding:  companies that routinely call only on the analysts who are the most favorably disposed toward them–as measured by how bullish their official buy/sell recommendations are–may have a temporary positive bounce right after the call.  But they end up being significant subsequent stock market underperformers.

how so?

The authors suggest three motivations for companies to engage in this type of information manipulation.  It may want only softball questions because (in my words, not necessarily theirs):

–a company may be trying to “smooth” earnings by making more or less arbitrary changes in its accruals for, say, inventories or tax rates, and doesen’t want these devices subjected to scrutiny, or

–a company may have made its earnings guidance only by the skin of its teeth–and maybe even then only by making dubious accounting choices, which they may not want exposed to the light of day, or

–a company may want to present a glowing, somewhat bookkeeping PED-assisted, quarter because it’s going to soon sell new equity and wants the most favorable price.

why do analysts play ball?

After all, it’s embarrassing to be seen as a sycophant.

CL&M point out that the analysts called on may get to fill the holes in their earnings forecast spreadsheets, and therefore improve their future profit forecasts.  Colleagues who can only listen to the call may have different holes but can’t get them filled, so their forecasts may gain nothing.  In any event, CL&M demonstrate the favored analysts do indeed have better numbers.

As far as “why,” my experience is that the brokers the favored analysts work for garner more investment banking business from the firm in question.  Management returns the follow-up calls of the favored analysts faster, so they have better answers for their money management clients.  And when the CEO or CFO visits institutional holders of the stock, the softball-tossing analysts most often get to arrange the itinerary.   All this means more money for the brokerage houses they work for–and because of this for the analysts themselves.

the best earnings estimates?

How do the CEO’s pets end up with the best earnings estimates?  It may be the way CL&M suggest.

I don’t believe it, though.  Personally, I think selective disclosure still happens, despite its prohibition by Regulation FD.  At the very least, more frequent contact with management gives the favored analyst a greater chance to understand and decipher body language, intonation and word choice–all of which can provide valuable hints about how business is going.

why do these firms subsequently crash and burn?

CL&M observe that the analyst selection behavior is designed to prevent bad news from reaching the market.  But there are limits to how long negative information can be suppressed.  Eventually the companies have to come clean–if for no other reason than the auditors have arrived.  This results in negative earnings revisions and stock underperformance.

Maybe so.  Personally, I have a simpler, though non-verifiable view.  I think the conference call manipulation stems from–and reveals–a character flaw in a firm’s CEO.  The boss doesn’t want to have his ideas questioned and never wants to hear bad news.  Because he always shoots the messenger, subordinates hide unpleasant realities until they’re so big they’ve done serious damage to the firm.

one complaint, sort of

The study has a lot of statistics but no names of offending companies.  They would be worth knowing.  A shrewd investor, however, would keep that information for himself.  He’d also thereby avoid a firestorm of protest from egomaniacal CEOs.

Morgan Keegan, fund directors and fair value pricing: and SEC action to keep tabs on

Morgan Keegan, now a part of Raymond James, was a regional brokerage firm with a strong fixed income emphasis.  It was severely wounded by large losses in fixed income mutual funds during the housing meltdown, and by subsequent SEC legal actions.  The regulator accused the firm of misrepresenting the risk character of some mutual fund offerings to potential clients and of systematically mispricing funds over extended periods of time.  As part of a settlement, the portfolio manager who ran a number of these funds agreed to a fine of $500,000 and a lifetime ban from the securities industry.

“So, what’s new?” you may ask.

What’s unusual about this case is that late last year the SEC sued the boards of directors of some of these funds for what it says was their failure to ensure that the funds were priced correctly.   Although directors are, legally speaking, the highest-ranking officials in any mutual fund and are therefore directly responsible for the conduct of the fund’s officers and staff, the SEC has until now only held the investment professionals and support staffs of wayward funds accountable for their actions–and left the directors alone.

my thoughts

1.  The returns cited by the Wall Street Journal  for one of these funds in reporting on this case are really ugly.  It lost 30% of its value in 2008 vs. a return of +6.8% by the fund’s performance benchmark.  In 2008, the fund was down by 73.2% vs. a benchmark return of +4.0%.

2.  Fair value pricing–meaning having third-party experts estimate a price for a security if there are no trades for it on a given day–is an important issue.  Typically a rogue manager or a rogue firm will want to assign securities a price that’s too high, to disguise a fund’s underperformance.

The problem:  shareholders who sense the problem early and cash in their shares get more than their share of the fund assets, leaving loyal/trusting shareholders with a large hole in their fund NAV once the fraud is uncovered.

3.  Fair value pricing isn’t a new issue.  It was a big problem during the collapse of the junk bond market in the late 1980s.  It was also the centerpiece of Eliot Spitzer’s expose of shady practices by international funds in the mid-1990s.  Apparently the SEC again called mutual fund boards’ attention to possible fair value pricing issues with funds holding mortgage-backed bonds in 2007.

4.  The SEC must think that its warnings were being ignored by mutual fund boards and that it had to make an example of someone.

5.  If so, the agency appears to have chosen its target well.  Morgan Keegan isn’t a large, deep-pocketed, politically powerful investment banker like Goldman Sachs or Morgan Stanley.  The Morgan Keegan name no longer exists.  The firm has recently been sold to Raymond James, whose executives presumably have no personal ties with the accused directors and no interest in prolonged or expensive litigation which would only keep any past Morgan Keegan misdeeds in the public eye.

Yes, the directors doubtless have liability insurance against possible lawsuit.  But my guess is that the insurer in question may assert that coverage doesn’t extend to instances like this.

This case has the potential to change the way mutual fund directors are selected, what qualifications they should have, how they carry out their duties and how much they’re paid.  It’s worth keeping an eye on.

T. Boone Pickens loses in federal court

I’ve been watching the career of oilman T. Boone Pickens since I picked up coverage of his Amarillo, Texas-based Mesa Petroleum as a rookie analyst in 1979.

Always a showman, Mr. Pickens was, in my view, at best a middling oilman, but he was a brilliant user of financial engineering.  For example, when Mesa had bought a large swath of Gulf Coast drilling rights that turned out not to contain much oil and gas–only enough to recover costs–Pickens borrowed an idea from nineteenth-century steel companies and spun the dud properties off to shareholders in a royalty trust.

Placing them in the hands of income-oriented investors gave them a value they would never have otherwise had.  The action spruced up the financial metrics of the slimmed-down Mesa, to boot.  And Pickens successfully cast the move as the caring response of a powerful oil company to shareholder needs–which, in a sense, it was.

His latest foray into fund-raising for athletics at his alma mater, Oklahoma State University, however, is a little weird.  According to the Wall Street JournalPickens and OSU decided to insure the lives of 27 elderly alumni for $10 million each, in a program named “Gift of a Lifetime.”  OSU would pay the premiums and be the beneficiary.  The idea was apparently that if the participants died faster than the insurance company actuaries figured, OSU athletics could gain up to a quarter-billion dollars.

A fly in the ointment   …those old Cowboys refused to die.  (Actually, if the WSJ figures are correct, the entire group would have had to pass away within two years for the fundraising effort to have a $250 million “profit.”)

After two years and $33 million in premiums paid, the program ran out of money and allowed the policies to lapse.  Then Pickens and OSU sued the insurer, Lincoln National Life, claiming fraud and demanding its premiums back.

The whole odd story came to light when a Federal Appeals court last week upheld the verdict of a lower court in favor of Lincoln.

Strange   … and how the mighty have fallen.

the Cyprus bank crisis solution

the bailout

Over the weekend the EU and IMF came to agreement with the government of Cyprus on the shape that the rescue of Cyprus’ failing banks will take (I wrote about the overall situation late lase week).  The banks themselves remain closed, as they have been for ten days.

The highlights, if that’s the right word to use:

–the smaller of the two main Cyprus banks, Bank Laiki, will closed down.  It will be separated into a “good” bank, which will contain all insured deposits (those of €100,000 or less), and a “bad” bank, which will contain everything else.  Deposits in the former are safe.  Deposit and bond holders in the latter will get whatever’s left after the bank’s dud loans are settled.  That could well be close to zero–and, in any event, large depositors will have lost access to their funds for a considerable period of time.

–the Bank of Cyprus, the bigger bank, will remain open.  This is a face-saving concession insisted upon by the Cyprus government.  Uninsured deposits will be used to cover the losses on the bank’s loan book, with uninsired depositors losing as much as 40% of their money.

it’s Cyprus’ best alternative

The country’s recent prosperity is due mostly to the access it allows to the rest of the EU, and its less than diligent attention it pays to the provenance of the bank deposits it accepts.

The rescue injects €10 billion of EU/IMF money into the Cyprus banking system.  Cyprus also gets to remain in the EU.  Otherwise, it would still have the same large bank loan losses, but be €10 billion poorer and out in the cold.

Some commentators are saying that the losses that uninsured deposits in Cyprus will suffer will undermine confidence in the banks in other EU countries, like Italy or Spain.  I don’t think so.  The Cyprus story–crazy bank lending, deposits of dubious origin, tax haven–is well-known throughout the EU.  If anything, the union was hamstrung in its efforts to bail Cyprus out by how well-known the story is–and, in consequence, how politically unacceptable an outcome where Cyprus escaped very significant hardship would be.

The main result of the Cyprus episode, I think, will be to give the EU a significant push toward unified EU bank regulation.