Sell-Side Analysts and Option Expenses: Is There Anybody Out There?

I’ve commented quite a bit lately on the topic of sell-side research, its plight and its problems. Unfortunately, many of the problems it faces it brings upon itself, as highlighted in Herb Greenberg’s interesting piece in Saturday’s Wall Street Journal titled “How Expensing for Options Throws Analysts Off Course.” Before I dig right in, I’d like to tell you what I’d expect from sell-side analysts (or analysts of any stripe, to be truthful):

1. Honesty;



2. Intellect;



3. Analytical rigor;



4. Critical, independent thinking; and



5. A digestable, informative work product; that gives me



6. A reason for me to read their stuff

I mean come on, is this really too much to ask? I’ve known and worked with many sell-side analysts in my career, almost all of whom have been good, caring people. But the problem is that many missed several key items on the list above, with numbers 3 and 4 the most frequently omitted. Analytical rigor and critical thinking? Shouldn’t these be the two bedrocks of investment research, regardless of whether or not one is talking buy- or sell-side, retail- or institutional-oriented, etc.? Am I missing something here? I think not. And there are structural issues for why these problems have become embedded in the [sometimes] dysfunctional Wall Street architecture, i.e., analysts covering too many companies, being forced to release work product too frequently, pressure from clients and bankers to emphasize the positive and downplay the negative, etc. But the bottom line is that research is and should be treated as a profession with the same degree of standards expected from other professions, i.e., law, accounting, medicine, etc. And in the absence of this recognition of research as a profession, it will be frought with inconsistency, conflict and bias.

Anyway, so what of Herb Greenberg’s article? The bottom line is that earnings estimates reported to the biggest aggregrators and distributors of such things are not prepared in a similar manner, because not all analysts taken option expenses into account in their estimates.

One tried and true way to analyze a company is to
compare its value with its peers. When it comes to tech and biotech,
more than any other industry groups, you’re on your own — especially
if you’re relying on the most widely used consensus earnings forecasts.

Earnings per share estimates for many companies simply
aren’t created equal, largely because of the uneven treatment of
options expensing by analysts. While it has been a full year since new
accounting rules required companies to include options expenses in
earnings, there is no such standard for analysts or companies that
compile estimates.

That can lead to confusion and even misleading
valuations, especially for investors who don’t pay attention to the
details or, worse yet, who use computers to pick stocks based
exclusively on the numbers. “Consensus EPS estimates do not provide an
apples-to-apples comparison among large-cap technology stocks,” writes
Sanford C. Bernstein analyst A.M. Sacconaghi Jr., in a recent report.

********************

The trouble comes when analysts, for whatever reason, don’t include
options expenses in their primary earnings estimate. Their numbers are
then compiled — and consensus is created — by three companies: Thomson Corp.’s Thomson Financial, Reuters Group
PLC’s Reuters Estimates and Zacks Investment Research. Zacks, which
claims to have created the industry nearly three decades ago, is the
only one whose consensus always includes options expenses, even if it
means manually figuring it out; as of the third quarter, it had to do
that for 300 of the 4,500 companies in its database. Reuters Estimates
and Thomson Financial base their consensus on majority rule. “We need
to conform to market standard,” says Ashwani Kaul, senior research
analyst for Reuters Estimates.

********************

And that’s where this story gets weird. Only a handful of brokerage firms, including Bear Stearns; Bank of America Corp.; Goldman Sachs Group Inc.; and Sanford C. Bernstein, a unit of AllianceBernstein LP, require analysts to include options expenses in estimates that are picked up by Thomson Financial, Reuters and Zacks.

Why don’t all of them? Good question — and viewing
earnings any other way is puzzling even to the CFA Institute, which
charters analysts. “Our view is that options are a form of
compensation,” says Rebecca McEnally, a spokeswoman for the institute’s
Centre for Financial Market Integrity. “And the fair value of options
expense should be treated as any expense in the forecast. To fail to do
so is to underreport expenses and overreport the earnings.” If that’s
the case, then why are we having this discussion?

I’ve got to say that Ms. McEnally’s sentiments perfectly reflect my own. As a person who was a derivatives transactor and ran derivatives teams, and spent a tremendous amount of time working with large corporations on strategies for managing their option costs, the avoidance of these costs when modeling earnings estimates borders on malpractice. If the companies themselves acknowledge that options represent a real cost to shareholders, and any credible academic in the fields of financial engineering or corporate finance echo the same, then what exactly is the analyst community doing? What are they thinking? Is it laziness? Is it unwillingness to adjust complicated historical models to take into account such valuation effects? Is it the uncertainty of the assumptions underlying option valuation? It could be any or all of these reasons, but frankly I don’t care. It is the analyst’s job to make assumptions, state them clearly, argue their position and make a recommendation. And sticking one’s head in the sand or simply ignoring a complicated, hard-to-quantify issue is not part of the job description.

This is a serious issue. If sell-side analysts want to prove their worth and solidify their role as a key part of the buy-side investment process, they’ve got to up their game, up their rigor, up their critical thinking and internalize their position as a professional. Otherwise, the marginalization of their historic role will continue unabated.