Yesterday’s delightful insider trading settlement with Richard Moore, the CIBC banker who deduced the identity of a buyout target through sheer clingyness, is a good reminder that insider trading is weird. Nobody told Moore any material nonpublic information, but he got in trouble anyway.
It’s also a good reminder of this new-ish (March 2013) paper that I came across the other day, in which some academics went and interviewed sell-side research analysts about how they do their jobs. They don’t say anything all that surprising, though I guess if you’ve never met a sell-side analyst it’s sociologically interesting. But it’s a nice counterpoint Richard Moore: reading smoke signals and figuring out an acquisition is illegal insider trading, but having the company tell you stuff and then using it to make trading decisions isn’t. If you do it right.
Why would you talk to management? There are a bunch of reasons but one is surely that they might tell you stuff.1 And they will, though the phrasing is careful:
[O]ur interviewees reported that they have private phone calls with senior management—most often the CFO—at least quarterly on average. … One analyst stated, “There are three things that can happen when you ask a question on an earnings call: one, you sound like a complete idiot; two, they give you no information at all; and three, you get a really insightful answer except you’ve just shared it with all your competition. So I don’t ask questions on calls.”
While the analysts maintained that management does not provide “actionable” information on these private calls, they said they get “color” and “granularity” from the calls. One analyst remarked that management tends to be more “candid” on these calls than they are on the public earnings calls.
The Zagat-quoted words in that last paragraph are pretty good. Obviously everyone basically understands that it’s bad – like, illegally bad – for management to privately tell an analyst “material nonpublic information,” and “actionable” is sort of a shorthand for that. “Color” and “granularity,” on the other hand,2 do sound like something other than “actionable.” They’re just filling in details to improve the literary quality of the analyst’s reports, they’re not actually giving them useful information. “Candid” is a bit rough though; the sense is “oh sure CEOs will lie on public earnings calls but they’re always honest with me.”
Or not, it doesn’t matter – another reason to talk to management is to use your spy skills to figure out if they’re being dishonest:
One analyst provided an interesting anecdote about the extent to which some brokerage houses will go in order to understand how to read cues from management in the post-Reg FD environment: “We had an FBI profiler come in, and all the analysts and portfolio managers spent four hours with this profiler trying to understand how to read management teams, to tell when they’re lying, to tell when they were uncomfortable with a question. That’s how serious this whole issue has become.”
A third reason, my favorite, is what I guess you’d classify as the agency cost model:
One analyst reports that buy-side clients value sell-side analysts’ views more when analysts have direct contact with management: “Regardless of Reg FD, investors value analysts’ direct contacts with management more than anything. As an analyst, if I call up a money manager, a hedge fund, whoever, and I’ve got a call to make on a stock, and I’m able to say, ‘Hey, by the way, we were able to spend 20-30 minutes talking to senior management,’ boom! Their ears are just straight up.”
Your job is not exclusively to be right, so a call with management has value beyond maybe improving your investing thesis. If it makes you look cool to your clients, there’s value in that. One can imagine something similar on the buyside; getting a stock call wrong seems less likely to get you fired if you’ve talked exhaustively with management than if you were just throwing darts, whether or not one approach is better than the other.3
This isn’t limited to sell-side analysts. We’ve talked in the past about how large investors who meet with managements a lot do better than those who don’t, which certainly suggests that they’re getting information – even if it’s only conveyed in the form of body language – that other investors don’t get, and that a reasonable investor might consider to have “significantly altered the total mix of information made available.” I mean, they make money on it. Remember, too, that there were approximately a bazillion phone calls between SAC Capital and Elan insiders, of which a few constituted illegal insider trading and the rest were just fine. Was SAC just wasting its time with the rest of them? Or did it get something out of them?
There are I guess two things that go towards explaining this. One is that the “material nonpublic information” of insider trading is all about simple binaries: though the law talks about “significantly altering the total mix” or whatever, what it actually means is that you can’t trade on inside information about an upcoming earnings beat, a merger, a drug approval, or some other specific obviously relevant event. That makes sense as a practical matter – like, what, you’re gonna convince a jury to send someone to jail for getting “granular” “color” on inventory turnover or whatever? But it has some efficient-markets weirdness: if you made money on it, then it was material, no? Consider the SEC’s effort to crack down on hedge funds who outperform the market: you’ve got outperformance, you’ve got lots of management meetings … what more do you need?
The other explanation is that if something is traditional enough, it’s okay. Regulation FD went into effect in 2000 to change the way companies communicate with the market: instead of selectively disclosing information to analysts and favored shareholders, as they historically had, now they have to disclose information to all investors at the same time through public means. Here’s something an analyst said in 2013:
In private conversations with management, you get details that they’re not necessarily going to go into on a public call with investors. They might be more willing to share that with us because then we can then go to clients and say, “This is our understanding of the situation. This is what the company says; this is what we think.” It’s a way for them to broadcast. We’re sort of like a megaphone for them.
See? You don’t get information out to investors by disclosing it publicly. You get it out by telling it selectively to analysts. They’re the megaphone. That’s still more or less what everyone thinks. The fact that the law says otherwise is beside the point.
Inside the ‘Black Box’ of Sell-Side Financial Analysts [SSRN via Corporate Counsel]
1. Related but distinct is that they might correct you when you’re thinking dumb stuff:
We learned that private calls with management are useful because they allow the analyst to check his/her logic with management, and some analysts responded that they save their detailed questions for the private call-backs. … One analyst said that the private call-backs from management were “principally to go over modeling questions and make sure your assumptions are in the ballpark, so to speak. And it’s just to go over any other types of questions about the quarter.”
2. And “insightful” I guess: I like the guy who doesn’t want to share management answers with his competition. Because they’re competitively valuable information I guess?
3. Also: what are the sell-side analysts getting paid for? Here’s another analyst answering the question whether he puffs up his recommendations to keep in managements’ good graces:
I’ve heard horror stories from other analysts who get cut off from management, and they just have to deal with it. . . It’s a fine line. It’s a needle you have to thread sometimes, between being intellectually honest yet not offensive. It’s always in the back of your mind, because one of the biggest things the buy-side compensates sell-side research firms for is corporate access: road shows, meetings, access to management teams. So you obviously want to keep an amicable relationship with the companies that you follow.
You could have a model where the best thing that a research analyst could do for his investing clients is put a “buy” on every stock he covers, so as to get lots of management access and let his clients decide for themselves. This works better for big clients than retail ones of course.