Figuring Out Who's Who among Financial Analysts - dummies

Figuring Out Who’s Who among Financial Analysts

If you watch any of the financial news cable television stations, you’ve probably seen numerous industry analysts frequently touting certain stocks and panning others. Do you know who those analysts represent? Do you know whether they’re independent analysts, buy-side analysts, or sell-side analysts? Before deciding whether to follow an analyst’s recommendations, be sure that you understand who pays his or her salary and what’s in it for him or her.

Buy-side analysts: You won’t see them

You rarely come in contact with a buy-side analyst, because they work primarily for large institutional investment firms that manage mutual funds or private accounts. Their primary role is analyzing stocks that are bought by the firm for which they work and not necessarily the ones bought by individual investors. Their research rarely is available outside the firm that hired them. Buy-side analysts focus on whether an investment that’s under consideration is a good match for the firm’s investment strategy and portfolio. In fact, buy-side analysts frequently include information from sell-side analysts as part of their overall research on an investment.

Sell-side analysts: Watch for conflicts

When you read stock analyses from brokerage houses, you’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 analyst’s 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 AG 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, Dean Witter, and Credit Suisse First Boston. Few firms that sell stocks and have an investment banking division avoided the scandal.

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 actually 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, particularly in the Internet, telecommunications, and other high tech industries, dropped to being worthless, and investors lost billions.

Merrill Lynch, in trying to settle their problems with Spitzer, agreed to publicly disclose its investment banking connections and list its clients. As of June 2002, Merrill Lynch began stating in all its research reports whether it received or will receive fees for investment banking services from any company that was followed by the Merrill Lynch analysts in the prior 12 months. Other companies followed Merrill Lynch’s lead in settling their disputes with Spitzer.

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 National Association of Securities Dealers, including

  • Structural reforms that increase analysts’ independence. These reforms include a prohibition on investment banking departments supervising analysts or approving research reports.
  • A prohibition on tying analyst’s compensation to specific investment banking transactions.
  • A prohibition on offering favorable research to induce business for the firm.
  • Increased disclosures of conflicts of interest in research reports and public appearances. These disclosures include information about business relationships with or ownership interests in companies that are the subjects of analysts’ reports.
  • Disclosure in research reports of data concerning a firm’s ratings, such as the percentage of ratings issued in each of the buy, hold, and sell categories, and a price chart comparing the rated security’s closing prices and the firm’s rating or price targets over time.
  • Restrictions on personal trading by analysts in securities of companies that they analyze and/or report on.

These rule changes should help 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.

Independent analysts: Where are they?

You are probably wondering where these independent analysts — people who you can trust who don’t have investment banking connections — really are. Although they do exist, most work for wealthy individuals or institutional investors and provide research for people who manage portfolios of much more than a million dollars and pay fees of at least $25,000 per year.

No one really knows exactly how many independent analysts are out there. Estimates range from 100 to several hundred, but their ranks surely will grow now that independent research will be a required part of selling to individual investors.

In addition to independent research that you probably see distributed by your brokerage house, as a small investor you can turn to some of the major investment research firms such as Morningstar and Standard & Poor’s. They offer services to individual investors through their publications and Internet sites at more reasonable fees than many of the small independent analyst firms. Nevertheless, you need to bear in mind that even these analysts are answering to the companies or wealthy individuals that pay the greatest share of their costs.