What Financial Report Readers Should Know about Sell-Side Analysts

By Lita Epstein

As an individual investor and financial report reader, you most likely see reports from sell-side analysts. These analysts work for brokerage houses or other financial institutions that sell stocks to individual investors. You get reports written by these analysts when you ask your broker for research on a particular stock.

You can’t take everything you get from sell-side analysts as gospel. Their primary purpose is to help a company’s salespeople make sales. As long as your interests match the interests of the broker and brokerage house, the sell-side analytical reports can be helpful.

But as scandals after the Internet and technology stock crash of 2000 showed, conflicts of interest can exist between a brokerage house’s need to make money by selling stock and an individual investor’s need to make money by owning stock that goes up in value.

Many investors lost 50 percent or more of the money they invested in stock during the 1990s and early 2000s before the stock market crashed. Many brokerage houses were more concerned with making money by selling stocks than they were with helping investors put together stock portfolios that met their goals and took into consideration their tolerance for risk.

And investors weren’t well served by the analysts, who should have been accurately reporting the risks of investing in many of the companies whose financial reports they analyzed for investors.

You must take the responsibility yourself to read and analyze reports. You can’t depend on an analyst unless you pay that analyst out of your own pocket to do the analysis.

Brokerage companies used to avoid scandals and conflicts of interest by protecting themselves with what’s called a Chinese Wall. Analysts kept their work separate from the investment banking division (which sells new public offerings of stocks or bonds and arranges mergers and acquisitions), and their compensation wasn’t dependent on what business they helped to bring in.

At some point in the past 20 years, this wall broke down, and sell-side analysts became partners with the investment banking side to help the firm make money. If a company won new investment banking business, it rewarded analysts with fees or commissions.

Sell-side analysts’ Chinese Wall was reconstructed to a certain extent after the tech stock scandals. The Securities and Exchange Commission (SEC) finally got involved in April 2002 and ended up endorsing rulemaking changes developed by the New York Stock Exchange and the National Association of Securities Dealers. These new rules do the following:

  • Prohibit investment banking divisions from supervising analysts or approving their research reports.

  • Ban the practice of tying analysts’ compensation to specific investment banking transactions.

  • Prohibit analysts from offering favorable research to bring in investment banking business for a firm.

  • Disclose conflicts of interest in research reports and public appearances. Brokerage houses must include information about business relationships with, or ownership interests in, any company that’s the subject of an analyst’s report.

  • Restrict personal trading by analysts in securities of companies they analyze or report on.

  • Dictate that a firm disclose data about its historical ratings and a price chart that compares its ratings with closing prices.

As an investor, you can quickly determine whether a conflict exists between your interests and the financial interests of a brokerage house or analyst when you see the new disclosures required. You can also look at the brokerage house’s historical ratings for a company’s stock and see how successful it has been in accurately reporting the stock’s value in the past.

When you read a sell-side analyst’s report and see that the brokerage firm gets fees for investment banking services from the company that’s the subject of the report, realize that the brokerage firm makes more money from its investment banking business than it does from you. Take what you find useful from the report, but be sure to do your own additional research.