Over the last few days lots of people have asked me questions about the timing of certain negative analyst research notes on BlackBerry. Tero Kuittinen, over at BGR wrote a pretty solid piece describing some of the most recent action, including Pacific Crest’s recent report suggesting that BlackBerry is manufacturing significantly more product than it is selling.

Kuittinen, who has an equity research background, offers the following explanation:

One major factor motivating hysterical research notes and wild estimate swings is simply a raw need for attention. There are too many small and mid-sized brokerages out there. Most clients have slashed the funds they use to pay for research over the past decade, and many hedge funds have the habit of calling analysts with the highest and lowest estimates on the Street and ignoring the middle.

I thought I’d take the time to expand on this because the vast majority of readers probably don’t have much of an idea how the world of equity (stock) research works. 

Research analysts (like I was for over a decade) are paid to cover stocks by doing research, writing reports, and “selling” that research to clients. The clients are people who manage mutual funds, hedge funds and pension funds. In other words, the clients are professional money managers (not us regular Joe retail investors who trade at a discount broker).

Although we say analysts are in the business of selling reports, there is no financial transaction that happens. Nobody actually buys the report. Instead, clients pay for an analyst’s work by directing some trading business (buying and selling stocks) to the firm’s sales desk. This way the analyst’s firm gets some trading commission which helps to pay for those annual bonuses.

Analysts don’t actually get paid for accurate stock calls. At least not directly. Instead their pay is much more correlated to what clients think of them. If clients love you, generally speaking, your bonus is going to be higher. In a perfect world the clients love the analysts who do great research, publish great reports, and share excellent insight into their areas of coverage (such as the mobile tech industry).

Analysts don’t actually get paid for accurate stock calls

But the world isn’t perfect, and every analysts is human. Different people have different ways of behaving. And analysts respond to their environment just like any other person would. 

The environment is like this: Very large investment banks (with very large research departments) automatically get a large cut of the trading business. They are expected to hire top quality analysts and these analysts are under less pressure to make insanely out-of-left-field comments on stocks. Analysts at large firms have an automatically huge audience. They don’t need to noise to get attention. They just need to focus on doing good work. But they can also get lazy and complacent.

It’s also important to understand that large firms have a much better chance at getting paid to do investment banking deals with large public companies. If BlackBerry were to do a stock issue, sell a part of their business or make a major acquisition they would hire an investment bank (or syndicate of banks) to work for them. This generates fees. Guess who’s not going to be in the syndicate? The small guys. 

So these smaller boutique research firms are not going to earn fees by covering very large public company stocks. At least not often. And investment banking fees help pad the bonus pool which gets distributed, in part, to the analysts. 

This leads us to all kinds of potential conflicts of interest.  How can an analyst at a small firm make sure that his firm gets paid for his work?

  • He can find himself finding ways to report on a stock in a way that supports a big client’s position on a stock. A hedge fund client who is short BlackBerry may develop a friendly relationship with the analyst. The analyst gets influenced into adopting a bearish stance on a stock because the client is doing a lot of business with the analyst’s firm. This all happens tacitly (unspoken).
  • The analyst could have a relationship with a smaller company that may lead to financing business for the analyst’s firm. Let me make up an example. Say an analyst’s firm is courting a smaller firm that makes a product to compete with BlackBerry’s enterprise division. If the analyst was to write negative things about BlackBerry this would help him build rapport with the BlackBerry competitor, increasing the chance that his firm can do business with them on an IPO, M&A deal, or whatever.
  • Or the analyst can simply realize that the squeaky wheel gets the grease. So he’ll yip and yap about anything that is outside of the current focus in order to draw attention to himself. I’ve seen this happen plenty of times in my career.

Also, understand that this isn’t necessarily the norm. I’m not saying all analysts at small shops behave this way. I’m not saying most of them behave this way either. But some of them do.

You have to either accept it at face value and admit you were wrong

Other analysts simply get caught up in what Dr. Robert Cialdini calls “The rule of commitment and consistency”. I highly recommend his book “Influence: The Psychology of Persuasion”. In short, people who make public statements on something tend to get very married to their views. The more public your commentary the more difficult it is to later separate yourself from it and change your view. This is pretty much a universal rule dictating human behavior. 

Put yourself in an analyst’s shoes. You’ve make very public statements about your views on a stock. If something happens that goes against what you’ve consistently said, you have to either accept it at face value and admit you were wrong, or you can dismiss the data and find new data that supports your view.

Most analysts do the latter. And that doesn’t make them evil or stupid. It just makes them human. My bet is that most analysts actually believe what they publish. If you gave them a polygraph test asking them questions about the integrity of their work, they’d pass.  Sometimes an analyst’s opinion comes purely from high quality research. This is the ideal situation. But other times analysts form opinions that are unconsciously shaped by what they know is going to get them  paid. And that’s why we see some of the garbage that we see.