Making a stable investment object.
The importance of having good connections in the stock market.
Peter B Hägglund
Centre for Advanced Studies of Leadership
Stockholm School of Economics
Box 6501, S-113 83 Stockholm
Sweden
peter.hagglund@hhs.se
office: +46-8-736 97 43
mobile: +46-70-860 28 88
For presentation at the New York Conference on Social Studies of Finance.
Columbia University May 3-4 2002
Work in progress. Please do not quote without contacting the author.
Abstract
How come the investment objects created at the financial markets are stable? How is stability
achieved in this construction?
Twenty-three pulp and paper analysts and investors were interviewed on how they
communicate with each other, describing how they discussed the listed company. The study
suggests that the investment object is constructed through detailed connections to other
objects, and both the choice of external object (of which there are numerous) and the
properties of the connection are at the center of their discussions.
Both investors and analysts have an interest in continuous reconstruction of this object, and
this interest adds energy to the investment object and ensures its survival. The mechanisms of
stability are thus described as two: First, a stabilizing technology in the form of valuation
models and a dense net of connections. Second, an inflow of energy, which make possible
recurrent discussions on the properties of the investment object.
Paradoxically, stability is therefore achieved through continuous disintegration and
reintegration rather than durability.
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Making a stable investment object.
The importance of having good connections in the stock market.
INTRODUCTION
When analysts and investors discuss the listed companies, their object of discussion is the
company as an investment opportunity – they are forming an investment object from what they
know about the company’s operations. This investment object is then used as a base for
calculations on profitability and stock value estimates. The construction process is therefore
important and of particular interest is how it contributes to the stability of the investment object.
Stability in an investment object should not be assumed, but must be explained. The most basic
reason for this is that investment objects are constructed – they are an example of something that
is ontologically subjective, that is, they would not exist if there was no stock markets, no
enlistment rules, no rules of trade, no theories of investment etc (Hacking 1999:29f). Their
stability rests on the manner in which they are constructed rather than on an existence
independent from analysts, investors and other financial institutions. We should, therefore,
search for external explanations (Hacking 1999) to the stability of the investment object rather
than anticipate explanations based on, for example, how the content of the investment objects
mirrors the actual operations in the analyzed company.
A well-constructed investment object is itself an important constructor of its surroundings in the
financial markets. This performative function of analysts work has been shown to exist in other
parts of the financial markets. Mackenzie (2001) suggests that the theory for pricing options is
performative and, through forming the work on the financial markets, validate itself. The option
pricing theory and model has been in wide usage for several decades, and since they propose
specific behavior for the actors it strengthens the normative financial theory. In the area of
currency trading, research within the social studies of finance suggests that traders conceive the
market as a complicated being outside themselves, even though they at the same time take part
and form the market (Knorr Cetina & Brügger 2000). Both studies show that the creation of
context does not imply an existence independent of that context.
One inevitable question is if these investment objects indeed are stable. Research on the stock
price volatility has demonstrated an increase in volatility during the last decades (Bulkely & Harris
1997; So 1997). And volatility in the prices is a prerequisite for speculation, which we know exist
in the stock market. The markets are also structured in clusters of actors, who make up micro
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networks within the larger market in a way that further induces price volatility (Baker 1984). In
this, however, we have to differentiate between the investment object, which is reached through
thorough analysis, and the stock price, which is reached as sellers and buyers speculate in future
price changes. In the study of option pricing theory mentioned above, Mackenzie shows that
while the use of the theory does not ensure stability in the market (as is shown with an example
of the Long-Term Capital Management hedge fund), it nevertheless validates and stabilizes the
financial markets on a more basic level (Mackenzie 2001).
Setting the fluctuations of stock prices aside, studies do indicate that analysts are reluctant to
change their estimates and their opinions on the company (Chopra 1998). One might say that
analysts’ reports are less prone to change than the company they are analyzing. In the market
there exists a belief that many companies have lasted a long time as investment objects, and
researchers compare company analysis between different decades (e.g. Brown 1997). An
investment object is discussed as stable. For our purposes it is enough to conclude that
investment objects could be seen as approximations that are valid in a limited context. In this
regard, stability is a question about “if this object is here to stay” (Hacking 1999:33).
This paper will explain stability as emerging from two sources in the process of construction, two
different mechanisms with complementary functions on the stabilized object. The first holds that
different technologies can explain the durability of the constructed object (Latour 1992). This
technology could be something tangible, like a computer system or a miniaturized threedimensional replica of the company with very small tin-executives placed inside the carefully
crafted windows. That creation would be stable, but it would probably not be a useful investment
object. Technology could also be a non-tangible, like rules and regulations, organizational norms
or step-by-step procedures that would make it difficult to change the investment object once it
was created.
The other approach to stability is to add energy to the object. This approach emphasizes that
nothing is stable in itself, but that everything needs other actors to energize it with interested
actions. Something that does not evoke such an interest passes away (Latour 1996). Both the
Stability
Technology
Energy
source and the rational for that energy becomes interesting – who adds energy, why do they do it
and what does it cost the constructed object. So one mechanism intends to force events in a
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preferred direction to hold the stabilized object constant through time, while the other battles
inertia with added energy.
If stability is seen as a function of the construction process, the question is: What in the analyzing
process promotes stability of the investment object? To explore this notion, we must study the
practice of constructing an investment object where it is actually done – at the stock market –
and see what resources the actors there have and how they call on them. Consequently, this
approach will direct attention the formation of the investment object, rather than the calculations
that is necessary to put a price on this object. This paper will focus on how the investment object
is stabilized in the construction process, and will suggest answers to two related questions. What
kind of stability is achieved in the investment objects, and how is this potential stability achieved?
FIELD MATERIAL
Method
This study follows how the investment object is created in the discussions between investors and
security analysts. The general idea behind the method was to focus on the instances when the
‘company’ surfaced in the discussions between these two main actors in the stock market. 1
Ideally, this would include observation of both investors and security analysts in action.
Observing them in their personal work and thereby being present whenever they contacted each
other, following that contact and analyzing it in its context, would be the best way of doing the
study. Following them during several days of work would present us with a complete picture of
their work, and how they act and interact in different situations. This, however, was unattainable.
Access proved difficult, and narrowed down the different possibilities to interviews and
participant observation on quasi-public events.
The interviews consist of 23 discussions with professional investors and security analysts around
how they interact with each other during the analysis. All interviews concerned the analysis of
one company: The pulp and paper company SCA during 1998 and 1999. Delimiting the study to
one company was one way to arouse the necessary interest among investors and analysts, whose
own work often exclusively concerned this industry. All actors interviewed had some active
relation to SCA as an investment object, either as an analyst of the pulp and paper industry or as
an investor who had traded in the stock during the year preceding the interview. They were
consequently all interested in the company and the discussions surrounding it, and they could
1
The investors and analysts did not, of course, call it an investment object but referred to it with the company name, “SCA”.
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also reflect on the opinions and work of other actors. Thus, by structuring the method according
how the field was organized, basic access was attained.
There was another advantage to discussing pulp and paper as well. It is a traditional industry with
old companies and many competent actors in the stock market. Most analysts have a history
within some major pulp and paper company, and their analysis thus profited from experience and
well-placed contacts. This also made it possible for them to explain the generally accepted
business models and value-chains to the outside researcher, which helped the understanding and
made it possible to focus on the interaction between investors and analysts.
The interviews collected stories and specific examples on how the analysts and investors
communicated and interacted around SCA. All interviews aimed to map this interaction. The
stories were rich in detail and revolved around specific events, like a specific capital market day,
the discussions ahead of particular reports, or the preparations and presentations of individual
reports.
Results
The study explored the cooperation and communication between security analysts and
professional, institutional investors. During the last decade this communication has increased as
investors gradually have moved their attention from brokers and traders to the security analysts.
These analysts have also improved their coverage of their industries and developed a diverse set
of analyst products to accommodate their growing customer base. Today, analysts are generally
expected to spend around 50% of their time on interacting with professional investors – their
customers.
These actors follow closely the listed companies, discussing their present and potential actions,
mapping their history as well as the potential future, and different analysts and investors on at
least two continents do this simultaneously. And while there are variations in their analyses, the
bulk of it is similar enough to enable the work to be compared, interchanged and even shared.
The exchange between investors and analysts consists of several types; written analysis, e-mail
discussions, phone conversations and face-to-face meetings. The subject of the interaction is
always the same: The valuation of the company. This overarching theme can, however, be refined
and described as at least three simultaneous processes that each have their own output: Details of
the company operations, the details of profit forecasts and the details of stock recommendations.
As indicated these processes are not separated; as a matter of fact none is possible without the
other. Details on the operations of the investment object includes forecasts and stock price
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projections, recommendations builds on knowledge about both operations and estimated profits,
and forecasts cannot be completed without details on what the company do. They are more of
different aspects on the valuation process, aspects that shed light on different parts of what it
takes to generate an analysis.
Details on company operations
Details on the forecasts
Investment
object
Details on the recommendations
Figure one: Three parallel processes of the investment object
The actors’ demands on the information around the investment object were expressed in
straightforward terms: New information must fit into the knowledge they already had of the
company, and preferably it should add to it. This is a simple request, but it generates questions on
how this knowledge was assembled and what type of supplement to the knowledge that was
acceptable to the investors. In other words, in what type of knowledge system did they construct
the investment object? What type of construction is the investment object?
In the interviews, the analysts and investors mainly referred to specific examples of good or bad
conversations. These examples suggested that they primarily discussed details, not general trends
or general judgements on the company. The investment object was built on details. One reason
for this might be that the analysis of a company is an ongoing activity, and that the knowledge
about the company operations already is high on a general level. Only the details remain to be
discussed.
“To small investors … I usually just stick to the general terms of
the company. … But the larger customers [investors], who have
their own specialists, they want to hear more details, and they
know the industry well enough so that the discussions always
become well informed.”
(security analyst)
I would like to interpret this attention to details as the way these investment objects are
constructed. The information about the company is broken down into its small components and
rebuilt, in order to ensure a good and through understanding. An investment object consists of
details connected to each other and connections between details.
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This interpretation is supported by the tools investors and analysts use in their discussions – the
valuation models. None of the interviewees would say that they used only one model. Instead
they suggested that they used several to estimate a value of the investment object.
“ I calculate several different measures of profit.
 Return on investment
 Gross margin
 Dividends, even though that is not so important
 P/E, (stock price over earnings)
 EV/EBIT (Equity value over earnings before income and taxes)
 Price/net asset value
And a discounted cach-flow model, which is our own firms variant.”
(Analyst on which models are used in the valuation)
Of these, however, only the last demands a thorough investigation of the company operations:
The cash flow model. This model was introduced to a larger group of analysts in 1990, with the
McKinsey consultants Copeland, Koller and Murrin’s book “Valuation” (Copeland et al 1990).
The book is a 500 page step-by-step manual for company valuation, and it has had enormous
impact on the way valuation is done in the stock market. As indicated in the quote, most firms
have their own version of the model, adapted to different markets, customers and industries. The
purpose of the model of the model is nevertheless the same: to connect different events within
and outside the company with profit. Events connected with profit.2 An illustration from the
book demonstrates the structure of these connections:
The objective of a cash-flow analysis is to find the value-drivers (to the right in the diagram).
Underlying these drivers are the company operations, or more precisely the elements of company
operations that can be connected to profits. Most discussions regarded how specific details
would or would not affect the cash flow of the investment object. This speculation in the future
was labeled ‘scenario-building’ and apparently made up a large portion of the conversations and
communication between investors and analysts.
“[The investors] call and say: “Could you do some calculation on
this scenario”, and then I send them that. And then they call and
say “Come up, let’s discuss this”, and so you sit there and
discuss with them. Most of them knows them company well and they
discuss a lot of details back and forth.
(Security analyst)
2
Or more precisely, the ratio Return on Investment, ROI.
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Rate of return
on invested
capital, r
Value of
growth
opportunities
Value of
business
Value of assets
in place
Amount of net
new
investment
Period of
competitive
advantage, N
Weighted
average cost
of capital,
WACC
Level of
NOPLAT
Investment
rate
K
Net operation
profit less
adjusted
taxes, NOPLAT
Rate of return
on invested
capital, r
Invested
capital in
place
Figure two: Value drivers connecting operations with value
This interpretation of the structure of the investment object suggests that it is composed of
connections with other, smaller, objects. The investment object is broken down into components
of the company operations, which are subsequently connected to the elements of profit and loss.
For example, the investment object was explained through a reference to internal components,
like its production system, the cost of it or some measure of cost/quality assessment. Or it was
connected to external components like market growth, inflation expectation or Federal Reserve
interest rates.
The list of objects that potentially could be connected like this is of course endless, and investors
and analysts basically described their work as finding objects that explained more of the
company, and also to refine the connection between the company and its explanatory objects. All
this was done within the normal routines of company valuation, and strengthens the initial
conclusion that the production of the investment object includes attention to the company
operations.
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No of
employees
Net margins
Trade
Outlook
Europe
No of Analyst
newsidentity
papers
Competitor’s ExchangeP/E
rates
Taxes
France
Time to
trim
paperline
Splitting up
SCA?
Structural
case with
spanish
company?
No of
teams
Structura
case with
finnish
company?
Earlier
return on
investment
Cost of
production
Cost of
machine
replacement
Growth
of P&G
Cost of
staff
Cost of
paper
Investor
identity
Consumption in
Growth in Germany
Indonesia
Figure three: The investment object is constructed through its connections
A final observation regards the intensity of this process. During the time of the fieldwork, a total
of 26 security analysts followed the company in both Stockholm and London. The number of
investors interested in the company is difficult to estimate, but there should be several potential
investors who talk to these security analysts. While the investors often have a number of other
industries to track, they were nevertheless focused on the pulp and paper industry, whenever the
analysts could bring something interesting to their attention.
“Well, when [I present an analysis] many things happen. We do
intensive road shows. I will be out on meetings three days in
Sweden, seven meetings per day, and then go to London, the Nordic
countries and other European cities. After a little less than two
weeks it is over.
…
This time they called back to discuss it. That is the best
encouragement you can get, when they call and ask about something;
then you know you made an impression. But at the meeting they also
ask questions, sometimes. This time everything went very well,
they bought into my message.
(Security analyst on the reactions to an extended update)
The analysts are always on alert for new information about the company, of course, but they are
also working to find new angles on the information that was already known to everyone. Since
they are paid according to how much they contribute to their customers, they have an incentive
to keep sending analysis to the investors.
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“It is always good to meet with the customers, then you can be
convinced that you’ll get paid. But you never know how much
they’ll pay you; they just allocate their flow without saying
anything.
(Security analyst on how his firm receives compensation)
“We evaluate them on analysis competence, service, volume/price.
It is a mix of these three that determines how valuable they are
to us.”
(Investor on how they evaluates analysts)
The result of this system, together with the fact that there often happens enough in the world of
the company to develop new analysis and new information, is that analysts and investors always
discuss the investment objects. There exists a continuous search for new versions of the
investment object, and the quest for profit is the engine of this work. The construction process
creates precise connections between the company and other objects, and is fueled by constant
communication and search for new ideas.
DISCUSSION
The stability of the investment object is difficult to assert from the field material, which was not
based on a longitudinal study. Nevertheless, the investors and the analysts treated the investment
object as relatively stable, and felt they often had a stable object to analyze – they rather wished it
to change more often so that they could perform more analysis of it. It is perceived as stable, and
events within normal course of affairs could be handled by the stock market without changing
the identity of the investment object.
One reason for this stability is the high density of connections. Consider for a moment the
traditional model of how these investment objects are created, through reflection of an external
company. The company should be reflected in the analysis, and if the analysis is well made the
resulting investment object is a mirror image of the company. This might lead us to believe that
there exists one strong connection between the company and the investment object. If such a
description sounds extreme, or unreasonable, consider the traditional valuation of a company
based on accounting numbers. Profit over book value – that is an example of one single
connection that still is widely used. Or take stock price over earnings (P/E), a number which still
is regularly reported in all financial magazines and tables.
In the stock market today, the investment object is stabilized through a myriad of connections to
numerous external objects. Often these objects are themselves connected to each other, creating
a system of circulating references (Latour 1998) that makes it relatively stable. If the chain of
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reference is broken, the stability is threatened and the investment object has to be reconnected.
But there is a temporal stability achieved through the density of the connections.
The short-term stability might be thus explained, but how does the analyzing process in the stock
markets support stability over time?
One answer to this question might be found in the continuous communication between actors in
the stock market. As showed in the earlier section, this communication was stimulated by the
need for analysts to remain visible to the investors. In order to gain the investors attention,
analysts worked to fit new information and new interpretations to the investment object.
This work represents a continuous inflow of energy to the investment object, which was never
left alone. The investment objects is more than an attractive idea about perfect information, it is a
necessary object for both analysts and investors ability to work. None of them could function
without an investment object that appears as a stable alternative to invest in. Analyst must
communicate this investment object to the investors, and investors must communicate their
rationales to their superiors and investment boards (Hellman 2000). The reason for their concern
with the investment object differ somewhat.
For investors the existence of an investment object is a prime concern, since they must justify
their investments in that particular kind of stock. All modern valuation theory start out from the
notion that there exists unique investment opportunities, whose future could be calculated
(Dewey 1939). Furthermore, institutional investors have for a long time been required to show
that they do solid investments as compared to gamble on the stock exchange (Morgan 1962). In
order to function as an investor, they have to have a stable investment object.
For analysts, it is instead the maintenance of the investment object that is important. They
receive their ranking (in papers as Wall Street Journal, Financial Time and Institutional Investor)
based on how the investors find their advice, and this ranking is often decisive for their career.
Apart from this public recognition their customers also, as mentioned earlier, evaluate them
continuously. If analysts do not constantly add to the investment object, the investors will forget
both analysts and their brokerage firms.
So these two actors both have a strong interest in building and re-building the investment object,
an interest that explains why the investment object would not wobble when objects in its
surroundings change. Even these changes are, from this perspective, necessary to achieve
stability, since they induce further interest and concern over the welfare of the investment object.
This suggests a mechanism that can stabilize even the complicated constructions, even in a world
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with universal change. It is somewhat of a paradox, that stability could be explained by the fact
that actors constantly tries to tear the object down, so that they can rebuild it themselves.
FINAL REMARKS
Above conclusions are preliminary, a rough draft of the findings of the study. However, they do
suggest that much work in the stock market can be explained using the concept of stability, and
the notion that constructed objects must be supported with some sort of technology and
supplied with energy from somewhere. If the investment object is viewed in this way, as a
product of specific references to different other objects but not in any way a mirror of that
company, it enables the analysis to focus on the stock market and the traded stocks as objects in
their own right. This might lead us to conclude that the stock market is not a simple extension of
the producing companies, but rather a separate construction with objects that are unique and
adapted to their needs. Which, incidentally, is just how many stock market actors understand
their work.
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