An old saw attributed to Henry Kissinger states that if bad news is going come out sooner than later, then it’s best to get it out sooner than later.
That appears to be true when it comes to earnings calls, according to new paper from the National Bureau of Economic Research. Companies that choreograph or “cast” their calls and consistently call on analysts favorable to the firm tend to be hiding something. And while hiding it is beneficial to the company’s share price in the short-term, that “hidden something” usually pressures the price in the long term.
“Our key finding is that firms that manipulate their conference calls in this way appear to be hiding bad news, which ultimately leaks out in the future,” wrote Christopher Malloy and Lauren Cohen of the Harvard Business School and Dong Lou of the London School of Economics and Political Science, in Playing Favorites: How Firms Prevent the Revelation of Bad News. “Specifically, we show that casting firms experience higher contemporaneous returns on the (manipulated) call in question, but negative returns in the future.”
As one example, the authors used an earnings call from Sealed Air in 2007. On that call, company executives called on analysts who had previous positive coverage of the company. This is a choreographed call, the authors wrote, meant to avoid releasing possibly negative information. In the same call, the company apparently did not directly address one analyst’s concerns about emerging markets and the competition and margins in those markets. The following quarter, the company missed earnings expectations (presumably the emerging markets concerns proved valid; the paper doesn’t say), and had its first negative free cash-flow quarter – after 20 consecutive positive ones. Company shares dropped 7 percent on the announcement.
The paper found this was consistent with companies that have seen a quick drop in share price in a particular quarter (after the bad news has leaked out and/or after the company has stopped “casting” the calls, the authors wrote).
This is one “subtle, but economically important way in which firms shape their information environments, namely through their specific organization and choreographing of earnings conference calls.” And there are many explanations for doing so. One reason: secondary equity offerings. At the time of the call, companies may be interested in “keeping share price high to maximize proceeds, and so may prefer to call on friendly analysts. Two other reasons are that the companies are firms with higher discretionary accruals (future liabilities, say) and or “barely meet/exceed earnings expectations.”