Finance is a big tent—I mean a really, really big tent. With the financial industry rising to be worth about 7.5% of GDP, there’s now $1.5 trillion in the industry up for grabs. It’s no surprise you have millions of people eager to get in the game.
But not all financial games are different, and often some games remain shrouded in mystery and controversy. The relationship between analysts and investor relations is perhaps one of the most mysterious.
That might sound over dramatic, until you contemplate the financial scandals of the past. For an investor, there is one grave sin that cannot ever be done—lest you want to risk bankruptcy and prison. Namely, insider trading.
What insider trading is and what it is not is a very complex topic, and a moving target—not all countries will define it the same, and it’s not the same for different asset classes! But at its core, the idea is enshrined in Regulation FD, which explicitly states that analysts cannot use “material nonpublic information”. That is a crime, and it is a very risky one to indulge in.
What that means is that analysts by law cannot have an informational edge over anyone else. Analysts can legally use nonpublic information if it is not material (but if it isn’t material, it has no economic value and shouldn’t be used by analysts anyway), and they can use material information if it is public (past earnings reports are okay, but this quarter’s earnings report is forbidden until officially released to the public).
There are ways around this. For instance, high-frequency trading firms will use AI and machine learning to go through releases and reprice assets immediately. Since this lacks human intervention and a lack of human judgment, this can backfire. If you’ve ever seen a stock initially shoot up after an earnings release and then fall far—that’s an HFT firm making a mistake.
But the point is to act faster than any human can on public information, essentially getting an edge through technology. All legal and not technically front running.
And while it sounds unfair, HFT firms are a small part of capital markets and their growth plateaued long ago. For the more human side of finance, the speed necessary to respond to information as it becomes available is impossible, so careful analysis by putting together as much material public information as possible is where these analysts get their advantage.
Some firms have gotten very good at this, and they have the past performance to show it. And one of the most important techniques for getting all of that information is shockingly banal: the telephone.
Let’s say a young analyst is analyzing a stock and notices COGS has been rising at a higher rate (say 5% CAGR over 5 years) than revenue (say 4.5%). A good analyst will simply pick up the phone, call IR, point out the observation and ask the company for comment. Companies will typically respond, with smaller companies responding faster and with more information than larger ones, typically.
Obviously, one can jumpstart this information conduit by maintaining a relationship with the investor relations department of a firm you cover. And if you work for a very big company, you’ll likely be at the earnings calls every quarter, at the firm’s headquarters talking to IR every once in a while and touring the company’s facilities.
None of this is against Regulation FD, and none of it guarantees superior performance. Remember that IR departments can be selective about what they say and how they say it, and since IRs typically want their stock price to go up, there is a strong incentive to distort the image of a company towards a more bullish view. A good analyst recognizes this incentive and will incorporate it into her analysis.
And thus the dance between IR and analysts begins, and continues, with the former always trying to paint the company in as positive of a light as possible and the analyst trying to get as close to insider information as one legally can without going across the line.
If you think the analyst’s attempts to get more detailed information are unfair, you can easily call up the company to try to get the same exact information yourself. And in the vast majority of cases, the chances of you getting information of equal quality and value are quite high—yet retail investors rarely go that extra step, which is just one of many ways in which analysts can provide significant value. But only if they dance with IR and know what moves to make.