It is important to first understand the function of a securities analyst at a brokerage firm. Brokerage firms are Wall Street investment banking firms on the sell side, “selling” investment securities primarily to institutional investors.
Unlike a stock analyst at a mutual fund, bank, or investment management firm, research analysts at a brokerage firm do not cater their research to portfolio managers. Their job is to research a particular industry sector and “sell” their research to the brokerage’s institutional clients.
Analysts narrow their focus on a limited number of companies to track them as thoroughly as possible. They want to be knowledgeable about as many details as possible so they can best assess how both internal and external factors will impact the company.
Having assessed the industry and an individual company’s outlook, analysts must then conclude if the company’s stocks are desirable investments (a Buy rating), have a high probability of devaluation (a Sell rating) or rate them somewhere between, and summarize their conclusions in a research report. All of the companies an analyst tracks must be observed and scrutinized continually, and the assessments communicated to various audiences, including: the brokerage firm’s institutional investor clients, the in-house sales force and traders on the desk, and outside media sources.
Brokerage research analysts do not deal with individual investors or their financial consultants. Rather, they are marketing their views to institutional investors.
The sales force at the brokerage firm caters first and foremost to institutional clients–mutual funds, hedge funds, pension funds, banks, and others. The sales force is continually relaying their analysts’ research to these firms.
While research analysts are required to assign ratings such as “Buy” or “Sell” to investments, institutional investors do not stress these ratings so much as an analyst’s industry knowledge. In fact, the analysts that were ranked highest in an Institutional Investor (II) magazine poll had some of the worst stock picks.
While brokerage analysts typically excel at providing thorough and analytical research about an industry and its companies, their record of rating stocks accurately is mediocre at best. This is because perceptive analysis and an astute understanding of companies and industries have little influence over an analyst’s investment recommendations.
The Wall Street system encourages this trend for five primary reasons:
1. Analyst Compensation. Analysts are compensated for their status on the Street, their access to CEOs, their profile and clout, and depth of knowledge as opposed to the accuracy of their investment ratings. Salaries depend on institutional client polls (e.g. the annual II rankings), their overall influence on the Street, institutional sales and trading evaluations, and generally subjective assessments by research department management.
There are no quantitative performance measurements. Author Stephen T. McClellan of the book “Full of Bull” goes so far as to say to “discount any flamboyant opinion upgrades from April to June” because the timing is suspiciously during when II votes are being angled for.
Consider that in 2006 the mean compensation for an II ranked analyst was $1.4 million versus $590,000 for un-ranked senior analysts. These kinds of incentives tarnish what should be more objective research.
2. Analyst Pressures. Analysts are risk averse to being wrong so they are typically late to change ratings. Brokerage analysts are often harshly critiqued so their reasons for choosing to downgrade a stock from a Hold to a Sell must be nearly unquestionable.
Most choose to ignore negative changes in a company for too long so that by the time the evidence is undeniable, most of a stock’s losses have already happened. For instance, only after Lehman Brothers’ stock fell from $80 per share to $7 did the three largest firms on Wall Street finally downgrade their ratings.
Additionally, brokerage firms realize that a shift of opinion from Hold to Sell will compel only a small portion of stock owners to sell the stock, thereby creating a commission for the firm. On the other hand, an upgrade to a Buy opinion is more easily marketed to all the firm’s investors and will generate vastly more transactions and commissions.
Analysts are therefore incentivized to rate stocks higher than they otherwise might. Consequently, it is virtually impossible to understand how enthusiastic or skeptical an analyst truly is simply from their published ratings.
A rating of Underperform could mean either the analyst suspects the stock will fall within a year or that it will not appreciate as much as its competitors with higher ratings. Conversely, a Hold rating could imply either that the analyst is leaning toward an upgrade to Buy but does not yet have enough evidence or that company’s outlook is poor, but they fear upsetting interested parties by downgrading to a Sell.
3. The Street’s Short Term Bias. Wall Street favors stocks that are rising now, not those that require patience to see significant upside. Just as downgrades are typically late, so too are upgrades to Buy.
Quarterly earnings reports are the Street’s “paramount milestone.” They carry considerable influence over stock valuation and are analyzed critically. Institutions are “trapped on the treadmill of quarterly performance evaluations” with very short investment time horizons.
Individual investors must recognize that analysts are writing for an audience of traders not investors. Analysts are torn between looking at long-term indicators such as earnings estimates or price targets, and the demands of institutional players such as mutual funds who measure performance quarterly and use those figures to compare themselves to the competition.
Consequently, analyst recommendations usually reflect how the stock might perform in a one to five month time span, not one to two years. Lastly, analysts are forced to make quick calls rather than quality ones. Once they have chosen a position, it is more likely they will stick with it even if later evidence suggests something else.
4. The Street’s Positive Bias. This positive bias is analogous to the auto industry. Regardless of the market, auto dealers have a vested interest to always say “buy.”
Similarly, Wall Street has a distorted number of Buy or Hold recommendations. Wall Street does not want to suggest capital preservation or any timely retreat from the market. Even in a deep bear market, brokerage firms need to convince investors to keep buying stocks.
5. The Street’s Big Companies Bias. A final bias is toward big companies/stocks with the greatest market capitalization. These securities are traded most frequently, held most extensively, and have the greatest institutional investor interest.
This also means that large companies tend to be excessively analyzed and reported on. The most researched sectors include technology, telecommunications, and healthcare because research departments place the most analysts where the most trading business is done, not necessarily where the best investment opportunities lie.
Unlike the individual investor, mutual funds and other institutions must purchase substantial volumes of stocks. Because these are a brokerage firm’s key target audience, there is not a sizable enough financial payoff for analysts to recommend smaller stocks.
Given these factors that can distort brokerage analyst’s stock recommendations, individual investors must understand that most ratings cannot be taken as literal advice for a personal portfolio. There is some value in the Street’s securities research for the individual investor, however.
First, research reports are excellent for providing background understanding and the essential business metrics of companies and industries. Figures such as the earnings outlook and profit forecasts are examined as are the business’ operations, management, market, competition, potential challenges, and financial stability.
Secondly, if investors listen in on companies’ public conference calls, they can be attuned to analysts’ questions and executive responses. Analysts have a greater awareness of a company’s culture, goals, and management style, sometimes having direct access to CEOs.
Having more information than those outside of Wall Street, analysts can ask more pointed questions on conference calls and hint at critical issues or what the company may be attempting to cover up. Finally, analysts can offer detached, unemotional observations about how certain events might influence the company’s future.
Wall Street may act as though it is fit to offer investment advice to individuals, but that is not what it is structured to do. The Street is structured to “trade securities, perform securities transactions, distribute and sell securities as a dealer, and do corporate finance deals.
Wall Street is not suited to be an investment manager, financial advisor, or stock selector. These services are a conflict of interest with the bedrock brokerage and banking functions.”
With a better understanding of how research on Wall Street operates, individual investors can employ the following tips for a better investment strategy:
* Look for stocks that are not currently being pushed by analysts or widely recommended, but still show promise and sound financials. Analyst upgrades to Hold are often a good signal to Buy. Any opinion change that involves a downgrade should be read as a literal Sell recommendation.
* Make an early investment in healthy and promising smaller companies not yet over-covered by Wall Street. Small stocks offer individual investors the best opportunity for future upside.
* Because Wall Street is subject to a short-term bias, the best prospects for individual investors involve looking at long-term value versus quarterly performance. Individuals are not judged on a quarterly basis like institutional investors, giving them the potential to realize more substantial gains over the course of two to three years.
* Take note of a “lone wolf analyst,” one who is willing to singularly downgrade their stance. Analysts often mirror each others’ opinions and it takes courage for one to be honest about a negative stance.
* Note an analyst’s level of experience. Younger analysts do not have the same relationships with executives or the seasoned perspective that senior ones do. Look for at least ten years of experience.
* Conference calls offer individual investors the closest to an inside look at a company as they can find. It is helpful to be attuned not only to what is said but to the tone of the call and what is left to be read between the lines. Notice what types of questions analysts are asking the executive.
* Take advantage of being an individual investor who does not have the biases and distractions that analysts on the Street have. Take the time to be like a research analyst independently, listening in on conference calls, reviewing earnings models and examining companies’ financials.
Samantha Johnson is the online content creator for Business Book Summaries. Business Book Summaries (BBS) provides comprehensive, concise summaries of the best business books available. Using stringent criteria, only the top business books published each year are selected to be summarized.
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