Have you ever wished that you had the time to research a security that you owned or wanted to buy? Conducting in-depth research on a company takes a substantial amount of time and there is a mountain of information that must be sifted through in order to do it well. For busy investors, this is where analysts come in. These financial professionals provide investors with the basic information on particular securities, giving them the tools they need to gauge the attractiveness of certain investments.

TUTORIAL: Financial Ratios

The increased popularity of analyst ratings over many years has expanded their influence over the price of securities. The slightest change in an analyst's rating for a particular stock can make the stock take off - or send it into a tailspin. Some people believe that analysts have too much power; others point to the conflicts of interest today's analysts face. Whatever the reason, it's important that all investors understand the different categories of analysts and what drives each analyst's recommendations.

Types of Analysts

Buy-side analysts work for large institutional investment firms such as mutual funds, hedge funds or insurance companies. They offer recommendations on securities found in the accounts of their employers. These analysts focus their research on specific sectors or securities that are of interest to the investment firm. These reports are mainly for internal use.

Generally employed by broker-dealers and investment banks, sell-side analysts are a part of the retail investment division. Their recommendations and ratings are created to sell an investment and are typically offered free of charge to the clients of the brokerage firm. The reports issued by sell-side analysts are generally more detailed and focused than those of the buy-side analysts. (If you're looking for a career in this field, find out more in Becoming A Financial Analystand Sizing Up A Career As A Ratings Analyst.)

These analysts are not employed or associated with any specific brokerage firms or fund companies. Independent analysts aim to provide unbiased and objective ratings. Independent analysts receive compensation either from the companies they research, which is called fee-based research, or by selling subscription-based reports. (For more on this topic, see Fee-Based Research: The Good, The Bad And The Ugly.)

Conflicts of Interest

Investment Banking Relations
This is one of the most significant areas of conflict of interest for analysts. Investment banks are financial institutions that perform services such as underwriting (issuing stocks and bonds); they also act as an intermediary between the issuers of securities and the investing public. In essence, when a company decides to go public, it will obtain the services of an investment bank to help facilitate the process and sell the new securities to investors. Consequently, an analyst may face a conflict of interest for the following reasons:

  • If the analyst of a particular security works for the same investment bank that is underwriting the new issue, he/she may be inclined to give a positive recommendation to ensure that the offering is successful. This is not unlike the way a car dealership might operate: all cars have advantages and disadvantages, but most car dealers will tell you that their brand makes the finest cars.
  • Investment banks are like most other businesses. They are always trying to increase profits, and they can attract more business by issuing favorable reports about their clientele. Favorable reports keep existing client companies happy and facilitate repeat business. This can give prospective companies the impression that they will benefit from the same favorable reports should they pay for the services of a particular investment bank.

Brokerage Commissions
Brokers typically generate revenues from the commissions associated with buy and sell transactions made by account holders. Although these brokerages don't charge for the research reports that they provide, they are still profit-oriented organizations. The intent of their research is to create customer interest in a particular stock, which ultimately leads to more transactions.

Analyst Compensation
When analyst compensation is associated with the performance that their ratings generate, another conflict of interest may arise. Compensation that is directly based on the number of new investment banking deals generated by the analyst's reports, or upon the profitability of the investment bank in general can put subtle (and perhaps, unintentional) pressure on the analyst to issue positive reports and recommendations.

Through direct ownership or through a pooled stock purchase plan, analysts and employees of the investment bank may own the very stocks that they are recommending. Analysts may, therefore, be reluctant to issue poor reports or recommendations on a security that they own because it could affect their personal profits.

Despite the number of conflicts of interest that can affect an analyst's recommendations, we should note that the U.S. government and the Securities and Exchange Commission (SEC) have established regulations in order to clamp down on the various conflicts facing analysts. (To learn more about these SEC regulations, see Reg AC: What Does It Mean To Investors?)

How Do I Determine Analyst Objectivity?

In most cases, you will find an analyst's conflicts of interest (if any) identified in the disclaimer found near the end of any analyst report. The disclaimer discloses the type of relationship that the research firm has with the company being analyzed and how compensation is paid to the analyst or research firm (should they be compensated at all). Be warned, however, that just reading the disclaimer won't make you able to fully discern the relationship between the analyst and the company on which it is reporting.

Analysts Aren't All Bad
The historical impression of analysts as the "whipping boys" of the financial industry is another one of those instances where a few unscrupulous people have ruined the reputations of the rest. Regardless of what recommendation an analyst provides on a stock, research reports are still loaded with company information such as highlights from the last year's results, ratio analysis, past growth trends and other pertinent information that would take an individual many, many days to compile.

No matter what opinion you may have about analysts and their industry, we hope this article has left you with a rough idea of what analysts do. Next time you scour through a research report, you'll know a little more about how to judge the integrity of the research, as well as that of the analyst who conducted it.

If you are interested in learning more about this subject, check out the article The Changing Role Of Equity Research In Today's Market.

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