Friday, 13 June 2008

Analysts rule the waves (whether we like it or not)

In the 1960s we saw a wave of “diversification” among corporations, resulting in the emergence of many so-called conglomerates. They operated in all sorts of businesses that often didn’t have much to do with each other. For example, a famous conglomerate in the UK was Hanson Plc, whose divisions operated in activities ranging from chemical factories to electrical suppliers, gold mines, cigarettes, batteries, airport duty free stores, clothing shops and department stores. Diversification was popular and conglomerates flourished.

In the 1990s though, the trend reversed, and we witnessed a wave of de-diversification. Firms started to focus on their “core activities”, companies were split up, conglomerates were dismantled, and diversification was generally regarded as unfashionable, evil and simply not-done.

What led the trend to reverse? Economists have argued that it was shareholders fighting back. Shareholders can diversify their stock portfolios; they don’t need companies to do that for them. Managers only do so to serve their own needs, and feed their desire for empire building, size and security. In the 1990s, shareholders said “basta” and forced self-serving managers to de-diversify – or so they claim.

A slightly kinder view is offered by sociologists, who argue that in the 1960s it was considered good practice to spread risk and diversify and hence a “legitimate thing to do”. Managers weren’t selfish and evil; they simply did what was expected of them. When shareholders said, “we don’t want you to do this anymore” (perhaps because the market became more transparent and efficient), they diligently responded and applied more focus to their companies.

Yet, more recently, researchers have started to focus on the role that analysts played and still play in discouraging companies to spread their activities across different industries. After all, sometimes diversification might make sense! For example, a company like Monsanto sort of had to operate in pharmaceuticals, agricultural chemicals and agricultural biotechnology because their expertise bridged these different areas and therefore it was advantageous to operate in all of them. But that something makes sense from a strategy perspective doesn’t mean it makes sense in light of an analyst’s lunch break.

What…?! What do analysts’ lunch breaks have to do with any of this?!

Well… it is very important for listed firms to be covered by analysts. We know from ample research that firms who receive less coverage usually trade at a significantly lower share price. Consider this quote, from an analyst report by PaineWebber in 1999:

“The life sciences experiment is not working with respect to our analysis or in reality. Proper analysis of Monsanto requires expertise in three industries: pharmaceutical, agricultural chemicals and agricultural biotechnology. Unfortunately, on Wall Street, these separate industries are analyzed individually because of the complexity of each. At PaineWebber, collaboration among analysts brings together expertise in each area. We can attest to the challenges of making this effort pay off: just coordinating a simple thing like work schedules requires lots of effort. While we are wiling to pay the price that will make the process work, it is a process not likely to be adopted by Wall Street on a widespread basis. Therefore, Monsanto will probably have to change its structure to be more properly analyzed and valued”.*

Wait a second, did they just suggest that Monsanto should split up because it requires three (industry-specific) analysts to cover them and these three buggers can’t find a mutually convenient time to meet?! Yes, I am afraid they did.

Along similar lines, in a large research project, Ezra Zuckerman, professor at MIT, found that firms divested businesses, split up or demerged in order to make themselves easier to understand for analysts. Those firms who, for one reason or another, comprised an unusual combination of businesses in their corporation and therefore were “more difficult to understand” for the poor analysts traded at a significantly lower price. They could try to explain their strategy at length but after a while the only thing left for them to do was to split it. Arthur Stromberg, then CEO of URS Corporation, who initiated its spin-off, declared:

“I realized that analysts are like the rest of us. Give them something easy to understand, and they will go with it. [Before the spin-off,] we had made it tough for them to figure us out”.

Security analysts usually specialise in one or a specific combination of industries. If a firm does not conform to that division of analyst labour, they are more difficult to understand and analyse, which is why they will trade at a lower price. It then makes sense to give in to the analysts’ whims, and focus and simplify, even if that would make you weaker in a strictly business sense. Hence, analysts rule the (diversification) waves. And their lunch break will determine your stock price.

* Adopted from Tod Zenger, Professor of Strategy at Washington University.


Christian Bieck said...

Hm, this once again confirms my suspicion that most of what is attributed to (the ideology of?) shareholder value is in facts pretty bogus...

Xian said...

I second this observation of analysts/shareholder "value" split. Just look at business papers like FT today, it wouldn't take any reader long to find "unlocking value" by the suggestion of large (activist) shareholder as the sole reason for demerging, split, to be sold off (selling off parts), etc.

I recall a session from one management consultant (15 yrs exp on IT; he explained that the industry is generally consists of 4 groups: buyer, supplier, intermediaries (value-added ltd/plc) and analysts. While analysts are still a very small part, they can be influential, as much as being the trend-setter. I feel very much this is the same case.

Sildenafil said...

well analysts can rule the waves if they want or not that I do not really care what they have to say or show off, but thank you for the post!