Analysts Want You to Innovate, Except When They Don’t

October 10, 2013 Editor 0

Investment analysts love innovation. They greatly admire companies that come up with breakthrough ideas and talk about them in glowing terms, boosting their market valuation.

So in theory, at least, they want your company to innovate. In fact, they want you to innovate. The more innovations your team generates, the more the analysts will like your company and the higher its stock will climb.

But there’s a perverse twist: Simply by covering your company, analysts hinder its innovation. Research by Jie (Jack) He of the University of Georgia and Xuan Tian of Indiana University, published this year in the Journal of Financial Economics, shows that firms covered by larger numbers of analysts generate fewer patents. In fact, when analyst coverage declined (for reasons such as mergers or closures of brokerages) innovation increased.

And it’s not just quantity. It’s quality too. The patents coming out of heavily covered companies had lower impact and significance than those from other companies (the researchers measured the number of times each patent was cited in subsequent years).

The researchers say the evidence is consistent with the hypothesis that under intense analyst scrutiny, managers feel pressure to meet short-term goals and therefore invest less in long-term innovation projects.

That’s sad, because financial analysts are in a perfect position to help companies invest more in innovation. Their role, after all, is to explain to investors what companies are really up to. They should be banging the drum for companies that make bold long-term investments, increasing their market value and spurring them on.

Instead, analysts are yet another impediment to innovation. They’re part of the chorus in your head that’s shouting about what Michael E. Raynor and Mumtaz Ahmed call the “dreaded ratios.” Return on assets. Cash flow return on investment. Economic value added. These are the ratios that rule lives. Managers try very hard to keep these ratios from declining. The shortcut to doing that is to reduce the denominator by abandoning difficult markets, shedding assets, or cutting costs. And a lot of managers go for the shortcut.

That’s not good for companies’ long-term prospects. As Raynor and Mumtaz show in “Three Rules for Making a Company Truly Great,” companies don’t become great by reducing costs or assets. So in a sense, analysts have inadvertently created their own version of the tragedy of the commons. By demanding short-term performance, they make it harder for companies to achieve the long-term excellence that all investors are looking for.

The only way to counter the power of the analysts and the dreaded ratios is to create a companywide understanding that companies have to earn their way to greatness. Yes, the ratios are important, but what’s more important is what you do to make them rise. The best companies increase them the hard way, by increasing revenue. That usually means tolerating the higher costs that are necessary for the creation of innovative products, processes, or services.

So go ahead, flout the analysts. That may be the only way to make them truly love you.

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Categories: HBR, Insights

Tags: Financial analyst, Innovation, Science and technology studies