Monday, August 30, 2010

From CIA to BIA: Spotting execs who bend the truth

By Alistair Barr, MarketWatch
Company executives beware: Former interrogation analysts from the Central Intelligence Agency are listening in.

A Boston-based research firm called Business Intelligence Advisors Inc., founded by former CIA behavioral-science experts, is scouring thousands of conference calls and other corporate announcements for signs of potential exaggeration or dissembling by executives.

Such research has a following among hedge funds and other institutional investors looking for ways to generate higher returns or avoid big losses.

"An ever-expanding universe of very smart investors is trying to figure out how companies are working successfully or not, as the case may be," said John Scott, managing partner at investment and advisory firm Paratus Global Partners LLC. "Investors are increasingly exploiting nontraditional sources of information like BIA."

BIA started in 2001, when the hedge-fund industry began expanding quickly, increasing competition for profitable trading ideas.

Around the same time, new disclosure rules known as Regulation FD forced companies to release important information to all investors at the same time, undermining cozy relationships between big investors and management.

While investors can't legally get material corporate information before rivals anymore, BIA may help them interpret information more quickly or in a more profitable way.

"Everyone's looking for an edge," said Christopher Malloy, associate professor of finance at Harvard Business School. "Quarterly conference calls are a very important source of company-specific information. If you can interpret that information better than anyone else, you have an edge."

BIA's approach may be catching on elsewhere. In July, David Larcker and Anastasia Zakolyukina of Stanford University's business school published an analysis of transcripts from almost 30,000 conference calls, highlighting speech patterns of executives that suggested possible "deception."

The researchers focused on companies that later had to restate financial statements in a material way. Chief executives used fewer self-references, more third-person plural and more impersonal pronouns, the researchers found. These executives also used fewer extreme negative emotion words and more extreme positive emotion words, along with more "certainty" words and fewer hesitations.

"There are other people thinking about the conference-call space, but I haven't seen anyone doing what BIA does," Malloy said.

'Dissembling behavior'

BIA says on its Web site that the firm's analysts have picked through 50,000 question and answer sessions and more than 4,000 earnings conference calls by more than 1,500 companies in 30 countries.

The firm also trains clients during all-day seminars run by its behavioral-science specialists, according to Harvard's Malloy, who said he attended one of the sessions.

BIA paid Malloy to back-test the firm's research from 2003 to 2009 to see how investors may have done if they'd traded on the advice.

After BIA analysts study the conference calls, they produce a report that rates how concerned they are that executives may be lying. They also drill down into each answer in search of "dissembling behavior," Malloy elaborated.

Chief executives of companies that later restated financial statements used fewer self-references, more third-person plural and more impersonal pronouns, a Stanford study found.

The ratings come in four main categories, which were assigned a number in Malloy's study. A "low caution" rating, suggesting executives probably were telling the truth, was given the number 100. As BIA's caution increased, the numbers climbed to 300, then 400 and finally 500, indicating "extreme caution," he said.

Malloy built a theoretical investment portfolio, buying stocks in the 100 category and shorting shares in the 500 category. The positions were put on a few days after BIA's reports came out and then held for three to six months.

The portfolio strongly outperformed the stock market from 2003 to 2009, a period in which the S&P 500 Index soared and then plunged.

"The 500 portfolio in particular had extreme negative performance," Malloy reported.

The results were also "monotonic," he added. That's a wonky word for something that exhibits a clear pattern.

Stocks where BIA was the least worried about executives lying performed the best, according to Malloy. The next category of shares did a little worse, followed by the next one. The stocks where BIA was most concerned did the worst. "The pattern was exactly what you'd expect," he said.

Intelligent personnel

BIA was profiled in a recent book by Eamon Javers called "Broker, Trader, Lawyer, Spy: The Secret World of Corporate Espionage."

In a Politico.com article that was adapted from the book, Javers reported that active-duty CIA officers worked for BIA.

BIA called the book "inaccurate and misleading" in a statement at the time. Cheryl Cook, its president and co-founder, said the firm no longer employs active CIA staff but confirmed in the article that BIA used to do this.

Montieth Illingworth, a spokesman for the firm, wouldn't comment this week and declined to make BIA executives available for interviews. "The company operates with integrity in accordance with a strict culture of compliance and confidentiality," BIA said in its statement responding to Javers' book. "Our clients in the financial-services industry rely on us to systematically analyze the quality of information in corporate disclosure."

Richard Leggett, a former managing director in Goldman Sachs Group Inc., has been chairman and chief executive of BIA since October 2008. Before that, he ran ISS -- the corporate-governance giant owned by RiskMetrics Group. RiskMetrics agreed to be acquired by MSCI Inc. this year.

Leggett also ran the Center for Financial Research and Analysis, an independent-research firm specializing in forensic accounting that was bought by RiskMetrics in 2007.

BIA is backed by .406 Ventures, a venture-capital firm, and Frontier Capital, a private-equity firm. Liam Donohue, general partner of .406, and Joel Lanik, a principal at Frontier, are directors at BIA.

'Tells'

The basic idea behind BIA's research comes from years of analyzing CIA interviews and interrogations. When people are lying or covering something up, they generally feel uncomfortable and this shows in the way they talk and move.

"Their theory is that people exhibit certain behavior, and if you understand this behavior and keep track of it all, you can tell if people are lying or not," Malloy said.

Scott of Paratus Global Partners puts it in poker terms. During the card game, players look for physical reactions, known as "tells," that may give away what cards an opponent is holding or the tactics they may be planning to use. This includes things like winces, fast or slow movements and long pauses to think.

BIA tries to spot verbal and nonverbal versions of this. One warning sign is when executives make positive statements with no facts to support what they're saying. Warning flags are also raised when management takes a long time to answer a question.

Another indicator BIA monitors is when executives avoid answering a question by talking about something else, often a subject they've been prepared to emphasize. This is known as a "detour statement," according to Scott. "BIA looks at what they're saying, how they're saying it and what they're not saying," he added.


WaMu

Scott has seen BIA research on quarterly conference calls held a few years ago by the now-bankrupt thrift Washington Mutual.

One warning sign is when executives make positive statements with no facts to support what they're saying.

"Their analysts were able to pick up on nonverbal indicators and statements that led them to conclude, without knowing much about WaMu's business model or financial statements, that management was not being forthcoming and instead were being evasive and even dissembling," Scott said. "In future quarters, management had to admit to problems. This was nine months or so prior to the collapse of WaMu."

WaMu failed in 2008. It was seized by federal regulators and sold at a fire-sale price to J.P. Morgan Chase & Co.

Palm

In April, newsletter Value Investor Insight asked BIA to analyze conference calls held by handset maker Palm Inc.

In a June 2009 conference call, analysts were keen to find out how early sales of the company's recently launched Pre were going.

Palm Chief Executive Jon Rubenstein and Chief Financial Officer Doug Jeffries said positive things about sales, but didn't provide specific numbers to support their assertions. "You know, I think we're just cranking along," Rubenstein said at one point, according to a transcript of the call.

BIA became cautious "as the number of substance-free but positive-sounding statements about Pre sales" multiplied.

During a conference call later in 2009, Palm executives avoided analyst questions about carrier demand for the company's products. Instead, they relied on "protest" and "qualifying" language, signalling uncertainty or lack of comfort with the subject, according to BIA.

In a December conference call, analysts asked about pricing. Jeffries, the finance chief, said there were "no big surprises," on that front. BIA described that as a "significant qualification."

"By saying there were 'no big surprises,' they have essentially confirmed there were some surprises, which were probably more significant than management wanted to admit," BIA said in its analysis for Value Investor Insight.

By March 2010, Palm had reported disappointing results from what it called "unforeseen challenges from intense competitive marketing efforts, to our own executive missteps," Value Investor Insight wrote.

After climbing above $18 in 2009, Palm shares slumped below $4 in late March 2010. The company agreed to be acquired by Hewlett-Packard Co. for $5.70 a share in late April.

(From MarketWatch, August 30, 2010)

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