Analyst ratings, coverage of a firm trump CEO

Analyst ratings, coverage of a firm trump CEO’s performance

FROM RICE NEWS STAFF REPORTS

Downgrades in a firm’s analyst ratings or a drop in analyst coverage are likely to contribute to the dismissal of a firm’s CEO. In fact, these two factors are more significant than performance alone in explaining CEO dismissal. Research by Rice University Professor Margarethe Wiersema clearly indicates that the analyst community has a profound influence on a corporate board’s decision to retain or fire the CEO.

If investment analysts downgrade a company’s rating from buy to hold, or if they no longer provide coverage about the firm, chances are the CEO should start looking for packing boxes — and soon. While prior research has indicated poor firm performance to be a predictor of CEO dismissal, Wiersema’s findings show that stock analysts have an independent impact above and beyond firm performance.

Analysts’ assessments of a company’s future prospects are reflected in their ratings of the company’s stock and in their decision to provide coverage that influences investor decisions. ”As a result, corporate boards are very sensitive to how analysts perceive the company,” said Wiersema, the Fayez Sarofim Vanguard Professor in Management at the Jesse H. Jones Graduate School of Management. ”And they will respond to analyst recommendations in their decision to retain or fire the CEO.”

Since the mid-1990s, the analyst community’s influence and visibility have grown considerably as analysts began making a real impact on stock prices. Wiersema sees their shifting and expanding influence as particularly significant now that regulatory changes have dramatically altered the composition of corporate boards. All directors must be independent outsiders with no ties to the firm; no company bankers, lawyers, suppliers or customers can be on the board.

”Since directors no longer have a connection to the CEO or company, there’s no insulation and they are much more sensitive to external demands,” Wiersema said. ”No one is trying to protect management; that kind of board doesn’t exist anymore.”

But board members do want to protect themselves. So corporate boards are more willing to scrutinize and take action stemming from analyst recommendations because of the very real threat of lawsuits. Directors can be sued for fraud and misrepresentation and pay big penalties if the courts find they haven’t served the best interests of the shareholders. ”Boards used to be immune from financial and legal obligations,” Wiersema explained, ”but that got turned around with WorldCom, where each of the directors was held personally liable.”

Though the analyst community has a strong voice and an attentive audience in corporate boards, that doesn’t mean their analysis is correct. Wiersema can point to numerous examples where analysts have gotten it wrong on both sides, sometimes wearing rose-colored glasses about a CEO who is not adding value to the company, or in other instances serving as a catalyst for the dismissal of a CEO who should have stayed.

Wiersema adds that adverse ratings from analysts tend to move corporate boards to action because downgrades and sell ratings are so rare. In fact, seven out of 10 analyst ratings are positive. ”Analysts actually tend to be overly optimistic in their outlook,” Wiersema said. ”If half the ratings were negative, they probably would not have the same effect.”

CEOs should be able to recognize when their job is in jeopardy. Wrong or right, analyst ratings are monitored closely, and companies know when the ratings have gone down, or are about to. Wiersema said that for years, CEOs have tried to keep analysts as their fans rather than critics because they know that a downgrade has adverse consequences for their stock price. But now it’s clear that the stakes are even higher, and they could be out of a job too.