How Serious Are Analysts Conflicts of Interest

1
How Serious Are Analysts Conflicts of Interest?

• Leslie Boni, University of New Mexico
• Kent L. Womack, Tuck School at Dartmouth

2
So Far Hearings, Settlements, and Rules Changes

• Summer 2001 Congressional Hearings Analyzing
  the Analysts
• Complaints from retail investors post-market
  highs
• May 2002 Merrill Lynch 100 Million Settlement
  with NY State
• Agrees to change how analysts monitored and paid
• Summer 2002 New NASD NASD Rule 2177 NYSE Rule
  472
• Separates Research and Investment Banking
• Prohibits companies from reviewing own
  ratings/targets
• Prohibits offering favorable research for I/B
  business
• Increases disclosure (incl. personal trading and
  history)
• 2003 Ongoing Global Research Settlement with
  12(?) Large Firms
• 1.4 Billion in fines and funds for
  restitution,
• independent research, education
• Elimination of analyst compensation from I/B and
  participation in road shows

3
Whats the Academic Literature Say about the
Conflicts?

• Affiliated investment bankers are overly
  optimistic at IPO
• Michaely and Womack (1999) Conflict of
  Interest and the Credibility of Underwriter
  Analyst Recommendations, Review of Financial
  Studies
• Analysts are an important factor when companies
  pick bankers
• Krigman, Shaw, and Womack (2001) Why Do Firms
  Switch Underwriters? Journal of Financial
  Economics
• Analysts are optimistic to obtain access to
  management
• Lim (2001) Rationality and Analysts Forecast
  Bias, Journal of Finance
• Optimistic analysts are more likely to move to
  better firms
• Hong and Kubik (2003) Analyzing the Analysts
  Career Concerns and Biased Earnings Forecasts.
  Journal of Finance

4
Analysts, Industries, and Price Momentum (Boni
and Womack, 2003)

• Can analysts rank future winners and losers in
  their industry?
• Analysts are industry specialists.
• Proper test of stock-picking ability is an
  industry-based analysis.
• Analysts signal rankings with upgrades and
  downgrades.
• Examine self-financing portfolios (long net
  upgraded stocks, short net downgraded stocks).
• Dataset
• U.S. stocks. 150,000 recommendations on 7,766
  companies from 433 brokerages. Time period Jan.
  1996 June 2001.
• Findings
• Analysts can rank stocks Returns 1.4 per mo.,
  18 per yr .
• Returns are better if stocks have fewer analysts
  covering them.

5
Analysts, Industries, and Price Momentum (Boni
and Womack, 2003)
Recommendation-Change Portfolios
Mean 1.4 Standard deviation
1.7 Sharpe Ratio 0.57
Jegadeesh and Titman (1993) Price Momentum
Portfolios
Mean 1.3 Standard deviation 11.6 Sharpe
Ratio 0.08
6
The Value of Analyst ResearchRetail versus
Institutional Investors Perspectives

• Boni and Womack (2003) Financial Analysts
  Journal, forthcoming
• How do we reconcile
• Institutional investors say they still value
  analysts research despite the potential for
  conflicts of interest.
• Retail investors complained analysts didnt get
  them out of tech stocks post-market highs.
• Dataset
• U.S. stocks. 150,000 recommendations on 7,766
  companies from 433 brokerages.
• Time period Jan. 1996 June 2001
• About 50 of recommendations are from largest 25
  firms
• Industry categories SP/Morgan Stanley GICS
  codes.

7
Transition Matrix of Analysts Recommendations I/
B/E/S Data for 1996 through 1st Half 2001
Downgrades 50
Upgrades 50
Buy 67 Hold 30 Sell 3
8
Figure 1 Consensus Levels Software Industry and
Microsoft
9
Returns from U.S. Stocks Retail Investors
Perspective (1996 through 1st Half 2001)
10
Returns from U.S. Stocks Instl Investors
Perspective (1996 through 1st Half 2001)
11
Value of Analysts Recommendations (1996 2Q
2001)

• Analysts on average are industry experts.
• Buying all stocks with analyst buy consensus
  levels beat the SP Index.
• Buying upgraded stocks was better!
• Buying upgraded stocks short selling downgraded
  stocks was much better!
• Tech-only strategies
• Buying consensus levels or upgrades beat the SP
  on average
• but lost big from 2Q 2000 on.
• Buying tech upgrades short selling tech
  downgrades was a big winner
• even from 2Q 2000 on!
• Tech stocks harder to analyze? Conflicts more
  severe? Or Both?

12
Did Analysts Recommendations Encourage Investors
to Overweight Tech Stocks?
13
Is independent research better?Is brokerage
without investment banking better?

• Brokerage Brokerage Independent
• with I/B Only
  Research
• Pressure for
• Optimism from
• Investment Banking ? - -
• Companies Covered ? ? ?
• Buy-Side Clients ? ? ?
• Brokerage Commissions ? ? ?
• Firms Trading Positions ? ? ?
• Analysts Trading Positions ? ? ?

14
New rules and settlements go too far? Not far
enough?

• Fixes to date dont eliminate many of the
  pressures for optimism.
• Unclear why independent research or brokerage w/o
  I/B will be better.
• Research budgets cut. Analysts cut. Reduced
  coverage or coverage eliminated for some
  Industries and stocks.
• Some companies will have to purchase coverage.
• Need greater revenues from brokerage commissions.
  Churning?
• Reduced competition by analysts increases value
  of recommendations.
• Problems if brokerage firms choose independent
  research to fund
• Why fund independents with lower buysell ratio
  than own firm?
• Why fund independents that are better at stock
  picking than own firm?
• Good independents will realize this and not go
  after funding/linkages?
• Retail investors will continue to be at a
  disadvantage!?!?!?