Saturday, August 01, 2009
What Do Analysts' Recommendation Really Mean?
Market are often moved - temporarily though - by research analysts' reports and recommendations even when nothing about the company's prospects or fundamentals have recently changed. What does all these really means to investors? Research analysts study publicly traded companies and make recommendations on the securities of those companies - most specialize in a particular sector of the economy. They exert considerable influence in today's marketplace. Some analysts appear regularly through television appearances or through other media. The mere mention of a popular analyst - Henry Blodget, the star Internet analyst, or Meredith Whitney - can cause considerable movement in stock prices.
For investors - especially retail investors - it is important to know the conflicts of interests involve and who these analysts really work for. In 2003, a historical landmark agreement was arrived between 10 of the biggest Wall Street firms and the New York Attorney General and SEC. The regulators dropped year-long investigations into biased research by the biggest, most prestigious Wall Street firms. In exchange, the firms agreed to pay fines totaling $1.4 billion. More importantly, the firms agreed to fundamentally change the way they do business. Research analysts will no long serve as sales arms to investment bankers - the people who arrange stock and bonds offerings to the public. Analysts will not accompany investment bankers to so-called sales pitch meetings where firms sell investment banking services to corporations. Nor will analysts be able to attend road shows in which investment bankers try to find buyers for share placements and offerings. Investment bankers can no longer weigh in on analysts' performance reviews or play any role in analyst's compensation. Any interaction between analysts and investment bankers must be now monitored by the firm's lawyers. And many other new changes.
Why did Wall Street accept such ignominious terms? Simply, the firms violated the basic tenet of their business - that the investors come first. During the investigation, the NY attorney general then, Eliot Spitzer, subpoenaed emails of analysts at the firms. The emails revealed what some had long suspected - analysts often recommend shares of companies that have an investment banking relationship with the firm and yet, privately, analysts deride these same companies. One then famous Internet analysts, in one email referred to a company as "a piece of junk" and others as "dogs" or "crap." And yet he recommended the same company to investors.
Though the firms deny it, the emails seem to show that analysts were using buy recommendation as bait to win business for their firm's investment bankers. The analysts knew they could boost their compensation if they helped snag investment banking deals.
Publicly, the firms maintained the fiction of a so-called Chinese wall that existed between research and investment banking. However, the Chinese wall serves more like a marketing tool than a shield against conflicts. Privately, the two functions are allowed or even encouraged to work closely together. The Street's culture assumed it was acceptable to ignore conflicts that might harm individual investors as long as the IPO business was thriving. Balancing the profit motive with the public interest had long gone out of fashion. Greed in the end prevailed and clouded the business judgment of a lot of smart people. For a few billion dollars in short term profits, brokerage firms tarnished their own brands and trust.
Analysts have always had to wrestle with conflicts of interest. During the tech-boom era, too many analysts had given up any semblance of objectivity about the company they covered and had become outright cheerleaders for an unsustainable technology stock boom. What happened? In the bull market of the 1990s, analysts had become lazy. Instead of going through the laborious task of deciphering company earnings reports, or probing suppliers, customers or competitors for the truth about a company's current performance and future prospects, they were addicted to handouts of inside information from companies. So analysts were no longer asking tough questions that challenge a company's positive spin in a bid to protect their access to inside information. When stock prices came tumbling down, few analysts even warned investors to sell. Investors lost a lot of money but the firms lost their credibility.
When consumers buy a car or computer, they check consumer reports like CNet or Car Magazine. When they buy a house, they have it surveyed and inspected. But when it comes to buying stocks, who do they turn to if analysts are shills for corporations? Analysts are supposed to try to predict the company's future - and its stock price - so that investors know when to buy, sell or hold. There're basically three types of analysts: 1) Buy-side analysts typically work for institutional money managers such as mutual funds, hedge funds, pension funds or insurance companies; 2) Sell-side analysts typically work for full service broker-dealers and make recommendations on the securities they cover. Many of the more popular sell-side analysts work for prominent brokerage firms that also provide investment banking services who help corporate clients to issue stocks and bonds and; 3) Independent analysts typically aren't associated with firms that underwrite the securities they cover. They often sell their research reports on a subscription basis, for example, ValueLine and Morningstar.
SOME HISTORY DRIVING THE CONFLICT OF INTEREST
Analysts by themselves produced no income. Not until 1975 did the center of gravity shifted from focusing on brokerage commission to investment banking revenue. Brokerage commission were the Street's biggest revenue source until SEC deregulated commissions in 1975. The big money no long came from brokerage commission but from institutions such as mutual and pension funds and from investment banking. Under this new model, analysts' loyalties also shifted. Individual investors' interest fell to the bottom of the food chain while powerful institutions and corporate clients rose to the top. Quickly, analysts learned to carry their load by grafting themselves onto the investment banking team. They refrain from writing anything negative about current or potential clients and corporate managers began picking underwriters on the basis of how well the bank's analysts treated them. A sell recommendation on a company is basically a kiss-of-death when competing for the company's business. By the 1990s, the ties between analysts and corporate clients deepened. Company's executives now knew how to keep analysts on a tight leash by occasionally leaking important information, such as a sales figure or "guidance" on quarterly earnings. Companies also massaged their earnings to come as close as possible to the consensus numbers that analysts were peddling, preferably beating them by a cent. To normal investors, analysts seemed prescient. Some were worshiped. With a brief appearance on a financial news show or column, they could push a company's share price to the stratosphere. Analysts had all stopped making sell recommendation for unwilling to bite the hand that feeds them. Investors began to rely more and more on financial news as the stock market went higher and higher. Wall Street analysts would wave their magic hand by taking to the airwave to wax poetic stories about one company after another. On shows, analysts were asked to name his "top 5" stocks but viewers were never told that the analyst's employer likely was the investment banker for most, if not all, of the companies on his list of hot stocks.
Seldom do individual investors are aware of analysts' conflict of interest. Conflicts of interest are aplenty. While insiders know about how Wall Street really works, most individual investors don't. Analysts often use a variety of terms such as "market perform," or "neutral," to indicate to sophisticated investors and mutual funds that it's time to unload a stock. Those in-the-know understand the code; most individual investors do not. At the height of the tech mania in 2000, optimism from analysts resulted in 92 buy recommendations for every sell recommendation. By the end of July 2001, when the S&P500 fell by 12% and Nasdaq fell by 59%, analysts were still issuing 65% buy recommendations. Statistically, only half of all stocks can perform better than the median - a fact that many individual investors again do not understand.
Analysts cannot serve two masters. The joke analysts gave was that they work 75% of their time for investors and 75% of their time for corporate clients. But unbeknown to most individual investors, corporate clients has won out. It is common for analysts to offer to "provide coverage" - code for positive coverage - in exchange for corporate financing deal. Corporate clients naturally want their stock up and analyst's recommendation can only aid them. A positive report leads to a higher share price which in turn pleases shareholders, and increases the value of the management's stock options, make the company less vulnerable to a takeover, and allow management to use the company's shares as currency for acquisitions. A glowing report also helps to boost the price of the shares the investment banks get for underwriting, or managing the IPO. It increases the value of the investment bank's private equity stake in the company as well. And if a favorable report induces retail investors to purchase more shares, the brokerage side of the business also earns more commission.
Fund managers can easily discourage analysts from issuing sell recommendations - until the fund has disposed of the shares - because they can punish analysts who fail to heed this unwritten rule by refusing to use the analyst's brokerage firm to execute trades. Buy-side analysts play this game too. By taking to the airwave, they can talk up a share price either to dress up quarterly returns or to unload shares on an unsuspecting public.
Now as you can see, everyone knew the rules except the small investors. Practically, everyone's back get scratched - except the retail investor. And analysts played the game well. In 1980, analysts' pay were $100 grand. By 2000, their pay can top $10 to $15 million a year. Many are paid according to their share of the investment banking deals they help to attract. Compensation indeed dictates behavior. Celebrity analysts too became indispensable to the investment banking team. Moreover, when analyst's recommendation are clouded, not only do small investors get toast, but more importantly, this distortion shifts capital away from worthy companies to those able to purchase positive research reports with their investment banking dollars. Over time, this could undermine the efficient allocation of capital, which is the reason why stock markets were set up in the first place. Retail investors when reading analysts' reports must understand that while you may never have to write a check to pay for it, that research report is never free because there is a hidden cost and individuals have to pay for it one way or another. This is one reason why the loyalty of analysts shifted from brokerage commission to investment banking in the first place. Brokerage commissions don't produce enough revenue to support the research function. Individual investors don't want to pay much which deprives analysts of a revenue source. So guess who they give their attention to in order to get paid?
Loopholes are still plenty even though with the new disclosure rules approved in 2002. It's the individual investor's responsibility to know more than what is recommended by analysts or in the grapevine. Sure you could read analysts' reports but it should not be the deciding factor in whether you buy or sell a stock. Reports are a good way to start your research, for you to understand what you buy, use it intelligently and simply, just consider them as one more piece of the information you need to piece the jigsaw puzzle together. Compensation certainly determines behavior. So it'd serve you well to know the conflicts of interest, namely: 1) Investment banking relationships of the analyst's company with the corporate clients - analyst's firm may be underwriting the IPO, client companies prefer favorable research reports and positive reports attract new clients ; 2) Brokerage commissions; 3) Analyst compensation structure; 4) Private equity interest in the recommended company.