Recommendations of Financial Analysts

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Recommendations ofFinancial Analysts
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• Ideally, analysts should be providing objective
  advice to investors on what stocks to buy, using
  their expertise to help their firm's clients make
  money.
• Do they have incentives to do so?
• The answer appears to be NO.

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Empirical Facts
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Analysts follow recommend stocks of good
(highly rated) companies, not good (i.e.,
undervalued) stocks.

• Marketing aids to brokers
• Investor cognitive bias
• Safety-net for their recommendations in case
  
  
  bad times come
• Stocks of highly rated companies do not provide
  high returns

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Annual Holding Period Returns

• Geom. Arith. Stan.
• Series Mean Mean Dev.
• Sm Stk 12.6 18.8 39.7
• Lg Stk 11.1 13.1 20.2
• LT Gov 5.1 5.4 8.1
• T-Bills 3.8 3.8 3.3
• Inflation 3.1 3.2 4.5

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Annual Holding Period Risk Premiums and Real
Returns

• Risk Real
• Series Premiums Returns
• Sm Stk 15.0 15.6
• Lg Stk 9.3 9.9
• LT Gov 1.6 2.2
• T-Bills --- 0.6
• Inflation --- ---

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Asymmetry between buy and sell recommendation
frequencies

• Marketing considerations
• Less than 1 of the recommendations by brokerage
  firm analysts during the 2000 market plunge
  recommended that investors sell shares.
• Even during December 2000, when the Nasdaq was
  way down, 2.1 percent of recommendations were to
  sell and 71 percent of the ratings were to buy.

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Optimistic recommendations to help investment
banking business

• Analysts are working side-by-side with investment
  bankers whose main interest is in pushing the
  IPO, helping a firm with a merger, or arranging a
  bond sale.
• Analysts are under pressure to say only good
  things about the company because it's the
  investment banking end of the business that
  brings in the most money.

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A Morgan Stanley internal memo

• Our objective . . . is to adopt a policy, fully
  understood by the entire firm, including the
  Research Department, that we do not make negative
  or controversial comments about our clients as a
  matter of sound business practice.

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• Analysts and investment bankers are supposed to
  be kept apart by a "Chinese Wall," but the wall
  is full of holes, allowing analysts to become
  cheerleaders for their firm's investment banking
  clients.

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• Analysts offer more favorable long-term earnings
  forecasts and recommendations on companies that
  are underwriting clients to their brokerage firm.
  

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• Sell-side analysts long-term growth forecasts
  are overly optimistic around seasoned equity
  offerings and analysts affiliated with the lead
  underwriter make the most optimistic forecasts.

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• Both regional and national brokerage firms, which
  have conflicts of interest emerging from their
  activities in both underwriting securities and
  making investment recommendations, produce more
  optimistic recommendations than non-brokerage
  firms.

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• Underwriters support the aftermarket of their
  client companies through positive analyst
  coverage and that buy recommendations by
  underwriter analysts contain significant bias.

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• Lead underwriter is almost always the primary
  market maker in aftermarkets.
• Underwriters sponsor new issues by arranging
  analyst coverage, promote the stock through
  marketing efforts, and provide liquidity by
  acting as the broker-dealer in subsequent
  secondary market trading.

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Vertical integration of brokerage and dealer
function

• Internalzation and preferencing
• Dealers are more likely to make markets for
  stocks that are tracked by the analysts
  affiliated with the same company
• Analysts issue earnings forecasts more
  proactively for stocks that are handled by
  affiliated market makers

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Regulatory Actions
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The US SEC issued an "investor alert" in June
2001

• Examine a company's financial reports.
• Find out whether the analyst's brokerage firm
  financed a company's recent stock offerings,
  especially IPOs.
• Learn as much as you can about a company by
  reading independent news reports.

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US Congress hearings

• House Financial Services subcommittee on capital
  markets held a hearing in June 2001 to examine
  whether analysts have become cheerleaders for
  companies the analysts' investment firms own
  stock in or do business for, giving investors
  biased advice.

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Reactions from industry groups

• Industry groups are weighing in with suggestions
  for "best practices" to help make sure that
  analysts are working with the best interests of
  investors in mind, not the investment banking
  clients that can bring millions in fees to their
  companies.

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The Securities Industry Association (SIA)
unveiled new voluntary guidelines for analysts

• Require analysts to clearly disclose their
  holdings in companies they cover and prohibit
  them from trading against their own
  recommendations.
• Analysts should not have their pay directly
  linked to the investment banking transactions
  handled by their firms for companies they cover.

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The National Association of Securities Dealers
(NASD)

• Proposed rules that would require analysts to
  disclose potential conflicts of interest when
  they recommend stocks on television or in other
  public appearances.

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Association for Investment Management Research
(AIMR)

• Calls for better disclosure of potential
  conflicts of interest.
• Cut ties between analysts and investment bankers.
• Ban analysts from trading against their own
  recommendations to clients.

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Reactions from individual companies
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Prudential Securities

• Began requiring analysts to reveal whether they
  or family members have 10,000 or more invested
  in companies they cover.

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Merrill Lynch (July 2001)

• Bans analysts from trading stocks they cover.
  Also applies to spouse and family members.
• Analysts can keep already owned shares, but have
  to disclose them in research reports.
• Securities Investors Association of Singapore
  (SIAS) welcomes the Merrill Lynch decision.

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Roots of the problem and possible remedies
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Different sources of income

• Corporate financing, brokerage services, and
  proprietary trading.
• Create conflicts of interest within the company
  and with its clients.

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Compensation structure for analysts

• Analysts compensation is determined by their
  helpfulness to the banks investment banking
  business.
• Analysts compensation is also determined by
  their helpfulness to the companys brokerage
  and market-making operations.
• This incentive may outweigh their concerns for
  reputation capital.

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To regain investor confidence,

• Sell-side analysts compensation may not be tied
  to investment banking profits.
• Sell-side analysts may not be allowed to make
  comments and recommendations on stocks
  underwritten by their companies. How long?
• Sell-side analysts may be encouraged to issue
  balanced buy and sell recommendations.

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• Educate investors that most analysts know no more
  than what they do about the TRUE value of stocks
  and that they are just sales/marketing people.
• Focus more on L-T asset allocation than S-T
  market timing and/or stock selection.