Fortune's thinks that Wall Street analysts are congenitally wired to be optimistic about earnings. (Fortune shares a parent, Time Warner Inc. (NYSE: TWX) with BloggingStocks). He thinks analysts are optimistic because they think the companies they cover are special. I disagree. In my view, analysts are optimistic about 2008 because they have to help sell stocks and banking business to keep their jobs. And selling stocks and closing banking business depends on forecasting higher earnings.
I have worked with Colvin on a few occasions -- for example, he interviewed me on Wall $treet Week with Fortune in 2004 -- and I find him smart and disciplined. But in my view, he misses the boat in his explanation of why analysts, such as those at Merrill Lynch & Co. (NYSE: MER). expect S&P 500 profit growth of 14% for 2008. The fact is that nobody knows the future so analysts are free to predict a future which happens to help them remain employed.
In my view, the place to look is how analysts get paid. What Colvin does not examine is that analysts are part of an investment bank's overhead. They don't charge clients for their research reports. Instead, brokers and investment bankers give the reports to clients to get them to transact business with the bank. If the reports help close a deal, part of the resulting fees are used to pay the analysts' share of overhead.
If an analyst writes a report saying that a company will earn less money in 2008 than it did in 2007, then it is harder for a broker to convince a client to invest in that company's stock. And if an investment banker is trying to curry favor with that company's CEO, such a research report will not be helpful in closing the sale. If an analyst's report impedes a money-making transaction, that analyst will have a hard time justifying continued employment.
Since Colvin does not examine how financial incentives shape analysts' work, he comes up with a less than satisfying explanation for why they think 2008 earnings will rise. He seems to be under the impression that analysts work for the investing public.
But those investors pay nothing to get access to their forecasts -- anyone with Internet access could see Colvin's 14% earnings growth forecast. And that freeloading public gets what it pays for. The miracle is that anybody actually expects objective analysis from "analysts" that are really an overhead cost for the banking industry's sales force.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Merrill Lynch or Time Warner.
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