Investment Banking Analyst Rules - dummies

Investment Banking Analyst Rules

By Matt Krantz, Robert R. Johnson

The game has changed dramatically for investment banking analysts over the past 15 years. Many of the changes were brought about as the result of abuses triggered by conflicts of interest described here. The problems were exacerbated as the compensation of analysts soared and the financial rewards for bending and breaking the rules were astronomical.

Why rules were needed

Investors and potential investors look to security analysts to provide them with professional, unbiased opinions on the investment potential of a stock. After all, the analyst is assumed to have the knowledge and skills to investigate and form a recommendation — generally “buy,” “sell,” or “hold” — on a stock’s future potential.

Many analysts are highly trained individuals who went to the top business schools and were taught various state-of-the-art valuation techniques. Professional certifications (such as the Chartered Financial Analyst [CFA] designation) train analysts on the ins and outs of analyzing companies, and these qualifications signal to investors that these individuals have the skill set to provide sound advice.

Given all this training, what could possibly go wrong? Why around the turn of the recent century did stock analysts earn reputations that rivaled used-car salesmen? It all centered on behavior that resulted from conflicts of interest that were inherent in the role of analyst at investment banking firms, and led to changes in regulation meant to curb abuses and mitigate these conflicts.

During the time of the Internet boom, many analysts — like Jack Grubman, Mary Meeker, and Henry Blodget — became media darlings and commanded multimillion-dollar annual compensation packages. A positive report on a company, or an upgrade of the company’s stock to a “buy” or a “strong buy” by one of these rock-star analysts, could result in significant increases in the price of that company’s stock.

Although few and far between, a negative report or the downgrade of a company’s stock to a “sell” recommendation or even from a “sell” to a “hold” could result in the price plunging as investors sell their holdings.

The not-so-delicate balancing act analysts play

Stock analysts are employed by investment banking firms that do more than simply issue buy, sell, and hold recommendations on individual stocks. Investment banking firms are paid to bring companies public by underwriting IPOs. These firms advise corporate client firms on strategies to increase firm value such as during mergers and acquisitions or in leveraged buyouts. Investment banking firms also invest their money in the markets in proprietary trading activities.

Without clients, investment banking firms wouldn’t exist. Like any company in any industry, the lifeblood of an investment banking firm are clients or customers. Customers want to be happy and investment banking firms want them to be happy. What makes investment banking customers really happy is when their company stock price increases. Stock prices generally don’t rise when analysts issue negative or neutral recommendations on stocks.

Perhaps that explains why analysts are overwhelmingly bullish, and the ratio of buy to sell recommendations by Wall Street firms is typically in the area of 10-to-1. This isn’t an issue that is isolated to U.S. markets. In the Chinese and Korean markets, buy-sell recommendation ratios can approach 20-to-1. Rather than issue a negative recommendation, it’s common for some investment banking firms to simply drop coverage of a firm.

Corporate firms want a relationship with an investment banking firm that will continue to increase demand for the company’s stock even well after the IPO. Corporations are less likely to maintain a relationship with an investment banking firm that doesn’t provide favorable coverage on its stock. Thus, there is pressure on analysts to issue favorable recommendations on the firms with which they have investment banking relationships.

Perhaps this explains why, for instance, Henry Blodget allegedly referred to Internet search company InfoSpace as a “piece of junk” and a “powder keg” in internal e-mails, while simultaneously recommending the stock to investors.

Providing advice to both the corporation and investors in that corporation would appear to represent a conflict of interest. This has led many critics of investment banking firms to wonder if it’s really possible for these firms to effectively serve two masters — the corporations and the investors. This is the tightrope that the investment banking firm attempts to navigate.

A change in analyst recommendation — particularly from a prominent analyst — from a “hold” to a “buy” or from a “buy” to a “hold,” for instance, can lead to dramatic stock price changes following the release of the recommendation. A pending recommendation change is valuable information that is coveted by market participants.

Investment banking firms engage in proprietary trading using their own funds and have large clients who would benefit from advance notice of any recommendation changes. Suffice it to say, the investment banking side of the business is very interested in developments from analysts.

If the conflict of interests outlined here weren’t enough, there may be other incentives that have driven analysts to make certain recommendations on stocks that are not driven by the fundamentals of the company. In a widely reported scandal, Salomon Smith Barney telecommunications analyst

Jack Grubman raised his rating on AT&T from a “neutral” to a “buy” rating in 1999. Grubman later admitted in an internal e-mail that his decision was motivated, at least in part, by a desire to get his children placed in an exclusive NYC preschool program. Conflicts, it seems, like ice cream, come in a variety of flavors.