The telephone rings, and it's your stockbroker on the line with a tip about the next hot company.
You had best be careful - especially if that hot tip is based upon a "buy" recommendation from the brokerage's securities analyst.
A new study by Brigham Young University professor of accounting Steve Glover suggests that stock analysts are unconsciously influenced to distort their earnings forecasts based upon earlier recommendations to either "buy" or "sell" a company's shares.
"It is important for investors to be aware that forecasts issued by analysts often are biased in the direction of earlier recommendations," Glover said. "There is no indication analysts are doing it deliberately. There simply appears to be a bias in the system."
The stock market crash in 2000 and the uncovering of the Enron scandal brought to light the uncomfortable allegations that some stock analysts were issuing misleading earnings forecasts when the firms they worked for also were conducting investment-banking business with the companies they were covering.
Tighter federal regulations followed to address such potential conflicts of interest.
But BYU accounting professor Douglas Prawitt, who is familiar with Glover's study, said although such federal regulations might successfully reduce intentional bias by analysts, no amount of legislation can eliminate the problem of unintentional bias.
"Unintentional biases are just hard-wired into how we think and how we process information," Prawitt said.
Glover's study, co-written by Michael J. Eames of Santa Clara University and Jane Jollineau Kennedy of the University of Washington, was conducted using 150 students who were working to earn master of business administration degrees.
The students were provided identical information about the companies they were to analyze. They were told their only goal was to develop an accurate short-term earnings forecast.
"Although the students told us they didn't consider the previous forecasts relevant, the data suggested otherwise," Glover said. "We saw optimism in earnings forecasts when the previous recommendations was to buy and pessimism when there was an earlier 'sell' recommendation."
Still, many securities analysts will make it a point to study the research of their competitors, said Sterling Jenson, senior managing director at Wells Fargo Capital Management in Salt Lake City and past president of the Salt Lake City Society of Financial Analysts.
"Looking at the research of others may raise some issues that an analyst hadn't considered before and help enhance the accuracy of their own forecasts," Jenson said. "Most analysts are committed to doing their own research, but everyone likes to see what their competition is doing."
Prawitt, who teaches a class with Glover at BYU named effective management judgement and decision-making, argues nonetheless the possibility of an unintentional bias creeping into an analysts' reports still must be considered in the decision-making process.
"You can't eliminate it, but you can try to mitigate the effects by making people aware that such biases exist and let them know when they are most likely to show up," he said.
Although some academic researchers and securities regulators have accused securities analysts of issuing intentionally optimistic earnings forecasts to curry favor for the brokerage houses for which they work, Glover suggested such charges might be misplaced.
"When a company misses analysts' earnings expectations, the market typically reacts and punishes the company with a drop in stock price," Glover said. "That certainly isn't a way to curry favor with a company's management."
Karey Barker, a fund manager at Wasatch Advisors in Salt Lake City, said even beyond such potential biases investors need to understand why analyst research gets published in the first place.
"They [brokerages] are in the business of selling stocks. It is sort of like going to a car lot. The sales staff may want to point you in the direction of the car they want you to buy, but they're not very likely to bad-mouth any vehicle on the lot."
And she noted that analysts often reveal their biases just by the fact they've decided to issue research on particular companies. "Historically, if an analyst didn't like a company, they just didn't publish any research on it."