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.
Rice University Professor Margarethe Wiersema’s research 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, Rice University Professor Margarethe 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 Rice’s 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.
For more information, contact Margarethe Wiersema at margarethe@rice.edu or Laura Hubbard of the Jesse H. Jones Graduate School of Management at lhubbard@rice.edu.
