If you've ever watched a financial news program, you've probably heard the reporter reference "analysts". These analysts, called sell-side analysts, are believed to provide an unbiased opinion based on proprietary research on a company's securities. Sell-side analysts do not buy or sell stocks and bonds. Rather, they make recommendations on how they believe the stock or bond will perform. These analysts use investment jargon that is often difficult to decipher, yet they have great influence on the movement of stocks in the short-term. Understanding the role of the sell-side analyst should shed some light on the short- term movement of stocks.
How Sell-Side Research Works
Sell-side analysts typically follow a similar work path, which is: an analyst meets with a company's management team, discusses the sources of revenues, products or services and develops a financial model based on the company's estimates as well as the analyst's expectations. The analyst then maintains a constant watch over the company, reviewing many sources of data to determine if s/he feels confident with his/her model or makes revisions based on new information. The analyst often puts a label, called an investment rating, on the company's stock or bonds - usually in terms of "buy", "sell" or "hold". The estimates derived from the models of several of the sell-side analysts also can be averaged together to come up with a single expectation called the "consensus" estimate.
Sell-side research is often "marketed" to firms called buy-side investment managers - these are the investment professionals that make the purchase and sale of securities. Examples of these firms include pension or mutual fund managers. Buy-side firms do not usually pay for or buy the sell-side research outright. Usually the buy-side firm pays soft dollars to the sell-side firm, which is a roundabout way of paying for the research. Soft dollars can be thought of as extra money paid when trades are made through the sell-side firms. So in essence, the sell-side analysts' research directs the buy-side firm to make trades through their trading department, creating profit for the sell-side firm. (Learn more about this form of payment for research in the FAQ: What are soft dollars?)
There is an inherent conflict within a sell-side firm, although, due to past legal settlements, this conflict should be removed. The conflict is this: analysts' make recommendations to buy or sell a company's securities. These companies often are also clients of the sell-side banks-paying fees to the banks for investment services. Investment banking is a huge source of profit for the banks, and if an analyst makes a negative recommendation, the investment banking side of the business may lose that client. Secondly, the analyst needs access to a company's management team. If the analyst is negative, occasionally the company may deny access, making researching a company very difficult.
As purveyors of news, financial reporters tend to reference sell-side research. The reporters discuss investment terms such as consensus estimates, investment ratings and reported vs. revised. During earnings season, these news programs often discuss consensus numbers, usually comparing an actual company financial report to the consensus estimate. If a company beats the consensus estimate, its security usually rises in price, while the opposite occurs if a company misses the estimate. So despite whether or not a company has a profit or loss, its security can rise or fall in price, based on missing or beating expectations. However, there are times when a company beats consensus estimates and the security falls. Why does that happen? Occasionally sell-side analysts fail to revise their estimates, but their expectations do change. Sometimes financial news will refer to a "whisper number". A whisper number is an estimate that is different from the consensus estimate. This whisper number becomes the newest, although unwritten, consensus expectation. (Learn more about these numbers in Whisper Numbers: Should You Listen?)
Analysts also tend to put investment ratings on the securities. These ratings are a way to qualify how the analyst views the potential for stock price appreciation. When an analyst changes his/her rating, the security's price may change. This depends on how close investors follow the analyst's recommendations. An upgrade generally tends to increase the price while a downgrade does the opposite. However, it is not only the change but the reason for the change that is important to understand.
Sell-side analysts often make changes to a company's financial reports to reflect ongoing operations rather than one-time items that may impact a current quarter's results. These changes get incorporated into the financial model that the analyst develops for the company and impacts the expectations or estimates. Analysts refer to the changes as revised numbers versus the actual numbers reported.
Impact of Sell-Side Ratings on Stock Prices
The rating that analysts place on a company's stock often impacts the stock price in the short term. When an analyst "initiates" coverage on a company, s/he usually assigns a rating in the form of "buy", "hold" or "sell". This rating is a signal to the investment community, portraying how the analyst believes the stock price will move in a given time frame. The rating can sometimes be a reflection of the expected stock movement, and not a reflection of how the analyst feels the company will perform. For example, if the company has very strong growth prospects in the next six months and the stock is undervalued based on the analyst's estimates, then a "buy" rating may be placed on the stock. Conversely, weak growth prospects may warrant a "sell" rating. However, if the same company has strong growth prospects, but the stock price has increased to such a point that it has exceeded estimates and is considered overvalued, the analyst may place a "sell" on the stock. After the initial rating is placed on the stock, analysts may update the rating. These updates result in upgrades (from a "sell" to a "hold" or "buy") or downgrades (from a "buy" to a "hold" or "sell").
Financial media frequently refer to sell side research notes when discussing the potential or actual movements in stocks. Understanding the impact of this research is crucial for investors to answer critical questions like why does a stock move when there is no recent news on it or the industry or why does a change in investment rating impact the stock price and what does all this mean for the long- or short-term stock price? Without acknowledging the "pull" that sell-side research has on the short-term price movement of stocks, investors may take this price movement to mean something else, thus making an erroneous investment decision.