What Traders Should Know about Sell-Side Analysts

When traders read stock analyses from brokerage houses, they’re more than likely reading information from sell-side analysts. These analysts work primarily for brokerage houses and other financial distribution sources where salespeople sell securities based on the analysts’ recommendations.

The primary purpose of sell-side analysts is providing brokerage salespeople with information to help make sales. As long as the interests of the investor, the broker, and the brokerage house are the same, sell-side analysts’ reports can be useful sources of information. A conflict arises, however, when sell-side analysts also are responsible for helping their brokerage houses win investment-banking business.

New York State Attorney General Spitzer exposed why this conflict is a primary reason for all the scandals you’ve read about regarding star analysts, such as Henry Blodget of Merrill Lynch, whose e-mails privately called stocks dogs, toast, or junk at the same time he and his team were publicly recommending that their customers buy the same stocks.

Why do this? Well, according to Spitzer’s charges, Blodget’s recommendations brought in $115 million in investment banking fees for Merrill Lynch, and Blodget took home $12 million in compensation.

Merrill Lynch was only the first to be exposed. Similar charges were raised against many other firms, including Morgan Stanley and Credit Suisse. Few firms that sell stocks and have an investment banking division avoided the scandal. These companies didn’t learn much from the scandals. Merrill Lynch was taken over by Bank of America because of errors made during the mortgage crisis.

At one time in the distant past, analysts were separated from investment banks by what companies called a Chinese Wall. Analysts’ work supposedly was kept completely separate from deals that were being generated in a company’s investment-banking business. At some point, the lines between the two broke down and analysts were included in the process of generating deals for mergers, acquisitions, and new stock offerings.

By writing glowing reports, analysts helped their companies sign more lucrative investment banking deals, all the while putting their small investors at great risk of losing all their money by buying the recommended stocks. When the market bubble burst in 2000, many of the stocks that were recommended because of these deals dropped to being worthless, and investors lost billions.

Ratings companies, such as Standard & Poor’s and Moody’s, were exposed for similar weaknesses when the subprime mortgage crises imploded in 2008. Rather than protect the investors of mortgage securities, the ratings companies put making money first. They gave these securities top ratings and they later proved to be junk.

The United States Securities and Exchange Commission (SEC) finally stepped into the fray in April 2002 and announced it was broadening the investigation into analysts’ roles and was developing new regulations regarding analyst disclosure. The SEC ultimately endorsed rulemaking changes recommended by the New York Stock Exchange and the Financial Industry Regulatory Authority (FINRA), including the following:

  • Cannot Promise Favorable Research: Analysts are prohibited from offering a favorable rating or specific price target to encourage investment-banking business from companies. Firms also must abide by a quiet period, meaning they cannot issue a report on a company within 40 days after an initial public offering (IPO) or within 10 days after a secondary offering if the firm acted as manager or co-manager of that offering.

    IPOs are offerings made for a company selling its first shares to the public. Secondary offerings are for companies that already have stock sold on the open market but are issuing new stock.

  • Limitations on Relationships and Communications: Research analysts cannot be supervised by the investment banking department. Investment-banking personnel are even prohibited from discussing research reports with analysts prior to distribution, unless staff for the legal or compliance department is present. Analysts also are prohibited from sharing drafts of their research reports with companies that they are writing about unless they are just checking facts.

  • Analyst Compensation: Analysts’ compensation can no longer be tied to a specific investment-banking transaction. If analysts’ compensation is based on general investment-banking revenues, that must be disclosed in the firm’s research reports. You can review these disclosures and determine how much weight you want to give their analyst’s recommendations.

  • Restrictions on Personal Trading by Analysts: Analysts and members of their households cannot invest in a company’s securities prior to the IPO if the company is in the business sector the analyst covers. They also can’t trade securities in the companies they follow for 30 days before and 5 days after they issue a research report about a company.

  • Disclosures of Financial Interests in Covered Companies: Analysts must disclose if they own shares in recommended companies. Firms must also disclose if they own 1 percent or more of a company’s securities. You can determine if the analyst or his or her company stand to gain from the reports they issue.

  • Disclosures about Ratings Given: Firms must clearly explain in their research reports the meaning of any ratings given. They must also provide the percentage of each type of rating given. You can assess how reliable their ratings are. For example, if a firm gives a very high percentage of buy or sell recommendations, you may want to more carefully compare its ratings to others or ignore it completely.

  • Disclosures during Public Appearances: If you’ve seen analysts on TV or heard them on radio recently, you may notice they disclose if their firm is an investment-banking client of (or has any other direct connection to) the firm they are discussing. This too is a new rule that was implemented since 2002.

These rule changes helped investors identify conflicts of interest that can compromise the objectivity of the sell-side analyst’s report. Pay close attention to the disclosures and the relationships between the brokerage houses and the companies that their analysts’ reports cover. Take these connections into consideration when including their buy or sell recommendations in your plans for future stock transactions.

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