The InvestMentor

February 5, 2003

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It's time for a little tough love. "One of its own" is going to speak out against stock analysts. But that's OK. In fact, that's the way it should be, even if it stings a little. Only with pressure from within the investment community and that that is exerted on it by the marketplace, can we rid the analyst pool of the conflicts and inefficiencies that still dog the brokerage field. Greed always trumps regulation in matters of money, and all the new laws in the world won't fix the continued sorry state of analyst stock rating behavior.

This isn't intended to be a condemnation of all stock reports. In fact, they can be invaluable to understanding investment opportunities—if you know how to "read" them. I'll get to that in a minute.

A little background is in order. Analysts typically go one of two ways after completing the brutal three-year curriculum known as the Chartered Financial Analyst (CFA) program: the buy-side or the sell-side. Buy-side firms are mutual funds, hedge funds, and investment management firms, such as mine. In essence, we use our analytics to determine what securities to buy. Sell-side analysts work for brokerage firms, plying their trade in order to assist the brokerage ranks in determining what stocks to sell to clients.

Prior to the market implosion beginning in March of 2000, many of the analyst foibles were overlooked. Everybody was making money, heads needn't have been rolling. Among said foibles were the facts that analyst employers were often providing investment banking business to the company being rated, the rating systems themselves were inherently skewed to the optimistic, and analysts could duck accountability by falling in with the herd.

Until just a couple of years ago, there were rarely any disclosures on analyst reports related to whether a brokerage firm was also acting as the investment banker to the stock being rated. There's a built in conflict that arises from the firm's need to paint a rosy picture of the stock if they're responsible for bringing its debt or equity to market.

The optimistic bias of rating was ubiquitous. In April of 2001, according to First Call, only 1.1 percent of all stock ratings were "Sell"—the rest were essentially "Buy" or "Hold."

And it was very rare to see one analyst purport a view that was divergent from the group. Participating stock investors in the most recent Bull Market will smirk when I mention that the standard M.O. for analysts was to act as a group, when upgrading or downgrading, and changes in opinion always occurred after the stock had made its move upwards or downwards; the reports were superfluous.

So how far have we come? Not very. Spare Prudential and a few other larger firms, most stocks an analyst cover are still potentially subject to being hit up for investment banking business, since most firms still don’t truly separate their research and banking functions.

Also, according to First Call, only 7.3 percent of all ratings are now "Sell". That a step in the right direction, but in a market that's a zero-sum-game (for every buyer there's a seller), that number is way out of line with the true behavior of investors and brokerage firms.

But sadly, very little progress has been made in the area of analysts speaking their mind objectively. This earnings season, I've watched many a stock report slack earnings, followed by the predictable subsequent after-the-fact downgrades—often before the stock price stops sliding. If an analyst downgrades a stock because it's price is too high relative to a new earnings outlook, shouldn't they wait to see where the stock settles in to see if it's responded sufficiently? To watch my peers, it's clear that no one wants to be the last analyst bullish on a falling stock, lest they be accused of having a tainted view. When ironically, that's could be the ultimate sign of objectivity.

I still rely on analyst reports, however, and they are invaluable to anyone doing stock specific research—as long as you accept them for what they are, and use them the way they should be. Here are my rules for using analyst reports:

1. Read the Disclaimers first. They're usually at the end of the report. Note their rating system and its tiers. Seek out reports that have fewer ways of ranking a stock. Also note if the brokerage firm concedes that they've done banking work for the company, or are planning to. Finally, note if the firm "makes a market" in the stock—this means they have an inventory in the stock, and an incentive to move it.

2. Ignore the reported "target price". That number is totally arbitrary and I could demonstrate statistically that analyst target prices are no more closely related to the future price of a stock than any randomly selected number within a range of plus or minus 50% of the current price.

3. Note the "rating", but then disregard it. It's important to know where an analyst is coming from. If they rate the stock a "Sell", you know you're reading a devil's advocate position on why the stock should sink. And that's important, because it's beneficial to…

4. Find one optimistic and one pessimistic report. Try to find two diametrically opposed opinions—the farther apart the better. Contrast and compare their arguments. Draw your own conclusions.

5. Use the reports to stay up on the industry. I follow many stocks from many industries. But I could never keep track of all the dynamics of all the business environments involved without the input from these analysts, who typically spend their entire day immersed in just one field.

I applaud the recent public flogging of dishonorable analysts, and the push to create new laws to encourage transparency in brokerage and banking relationships, as well as gestures from within the analyst community toward isolating the most egregious digressions. But on behalf of the buy-side, I'll say that analysts can still do more to make their reports and ratings of greater value and of higher integrity.

Now there, my colleagues, that wasn't so bad was it?