by Cydney Posner
Here’s an interesting report from Bloomberg on a soon-to-be-published study that concludes that stock analysts are actually worse at predicting corporate earnings now, after a number of regulatory actions to increase transparency and prevent research analyst conflicts of interest, than they were prior to these actions. In the wake of the dot-com crash and the Enron scandal, Congress, regulators and SROs enacted laws and adopted rules designed to increase transparency, improve corporate disclosure and prevent analyst conflicts, e.g., SOX (2002) and various conflict-of-interest rules adopted by the exchanges. While the study found an improvement in forecasting in the early 2000s right after adoption of these rules, the improvement was short-lived. The study showed that forecast accuracy significantly declined over the longer term despite the reduction in analyst conflicts of interest.
The study, “Did Analyst Forecast Accuracy and Dispersion Improve Following the Increase in Regulation Post 2002?,” measured two values: forecast errors (the degree to which analyst projections differed from actual results) and dispersion (the degree to which analysts’ predictions differed from each other). The article reports that both values “worsened by more than 2 percentage points between 2000 and 2013, with the average estimate missing its target by 35 percent, compared with 33 percent, according to the authors.” These results are apparently consistent with past studies showing a brief improvement in accuracy that later faded, they said.
Although the authors of the study did not conduct any tests to determine the causes of the decline, the authors attributed the problem largely to the quality of companies’ financial reports and absence of the release of sufficient data. In addition, the authors speculated that another cause might be “the Hawthorne Effect.” No, that’s not a new novel by John Grisham. The Hawthorne Effect is the name of “a tendency for changes in work environments to produce productivity improvements that don’t last.“ This decline, the article reports, might just be an example of it as the spotlight on analysts faded: according to the authors of the study, the analysts “’knew they were being watched and expended ‘extra efforts’ on metrics on which they were being measured…. Over time, as the attention waned, the analysts may have reduced their extra efforts and their forecast properties could have suffered.’” The study authors also interpreted the wider dispersion to suggest another potential cause – “’higher uncertainty, or lower availability or reliability of information, reducing the value of forecasts….The continued problem with the information environment, therefore, seems to be largely due to the quality of financial reports.’” (Interestingly, although the study itself, when published, may discuss it, the article does not mention the possible impact of limitations on selective disclosure to individual analysts related to the adoption of Reg FD, which might just have also contributed to a decrease in the accuracy of earnings predictions.)