Stock Analysts: Should You Listen?

By Michael Schmidt AAA

Analysts have been actively evaluating companies as long as there have been stocks, but they're more popular and get more exposure than ever thanks to round-the-clock stock market news and online resources. Analysts' notoriety has also increased. But while analysts typically have similar credentials, they aren't all the same.

For example, since positive and negative earnings surprises can have dramatic effects on stocks, you may wonder, how can a company beat the estimates with so many eyes watching? How can one analyst have a buy rating and one a sell rating? How can investors tell who will be right? (What's in an analyst report and what should you do with this information? Find out here: Analyst Recommendations: Do Sell Ratings Exist?)

The first place to check is the fine print on any research report and find out how the analyst is compensated. From there you can decide whether it's in the analyst's interest to tell you something other than the truth.

An Analyst's Qualifications
Securities analysts typically have academic backgrounds in business-related studies at the undergraduate and graduate level. They may also have professional designations like a CFA, CPA and JD. There is also growing minority of sector of analysts, who sprout from their prospective areas of expertise like healthcare, engineering and technology. These analysts can have any type of academic credentials including medical doctors who have functioned as pharmaceutical analysts. (A couple of letters can mean a big difference. Find out which designation you need and how to get it. Check out CPA, CFA Or CFP - Pick Your Abbreviation Carefully.)

What Do Analysts Do?
The daily duties of all analysts will vary depending on the reporting calendar of the companies they are following. For example, financial institutions like Bank of America (NYSE:BAC) typically report earnings in the few weeks proceeding the end of a quarter. An analyst covering this company would be very busy prior to and after the announcement of earnings.

Prior to earnings, analysts tend to be busy estimating what earnings they think will be reported. Their estimates are based on guidance from the company (which is limited), economic conditions and their own independent models and valuation techniques. On the day of earnings announcement, the analyst typically dials into the conference calls that most companies arrange to discuss the reported earnings and any company-specific details like one-time earnings gains or impairments. After the announcement, analysts are busy communicating not only the reported results but their own interpretations of why they were higher or lower than the expected numbers.

What Kind of Analyst Is Best?
The two main categories of analyst are typically either buy side and sell side analysts. The main difference between the two is the types of firms they work for and, in some cases, how they are compensated. There are many types of buy side analysts working for firms that sell their research for a fee; they can work for an asset manager and invest in the stocks they cover. Buy side includes investment institutions such as mutual funds, which buy securities for personal or institutional investment purposes.

Sell side analysts, on the other hand, typically work in a transaction-based environment selling their research to the buy side group, hence their name. A sell side analyst working for a brokerage firm can cover a group of stocks, industries, sectors or even entire market segments. Sell side analysts have been under a bit more scrutiny due to the close relationships they have with the companies they issue buy ratings for.

The Growth of Analysts
Prior to the technology bubble and its subsequent collapse, most sell side companies engaged freely in investment banking and subsequently covered the stocks they brought to market. It's not hard to assume that the analysts had close relationships with the companies they covered and that the investment ratings were mostly positive for the stocks the companies took public.

While some companies still participate in investment banking and provide coverage on the companies they bring to market, there have been controls put in place to ensure honest valuation methods through provisions in the Sarbanes-Oxley Act of 2002. Further regulation has been implemented to ensure that a certain level of independence remains between sell side analysts and the companies they research. (After the infamous collapse of companies like Tyco, Enron and WorldCom, the government responded to try and prevent it from happening again. To learn more, check out How The Sarbanes-Oxley Era Affected IPOs.)

Most of the major Wall Street brokerage firms were actually required by the U.S. government to change the way they provide research. Some firms that indulged in fraudulent business practices were fined substantial sums and their brokers and analysts were barred from the industry. Many investment firms have split their research into separate departments, isolating them from the deal end of the business to promote independent recommendations. Some of these changes were mandatory based on new legislation and some were voluntary to promote at least the appearance of independent analysts. While the industry has come a long way, there is still some progress on the sell side to be made since some of a sell side analyst's compensation can come from the transaction fees associated with the companies they cover.

So which type of analyst adds more value? The answer is both. (For a further comparison on these type of analysts, read Testing 3 Types of Analysts.)

Buy Side Or Sell Side?
Buy side analysts often have some sort of vested interest in the stock. A buy side analyst working for a mutual fund or investment management company typically owns the stock he or she is covering. While there's no guarantee, the changes in ratings on a company may indicate the direction of their buying patters. If they start "initial coverage" it may mean that they are considering adding the stock to their portfolios or have already started accumulating the stock.

When a buy side analyst has a very positive rating on a stock, it may be an indication that they have already purchased their allocated weighting. Since mutual fund companies report their holdings delayed 30 days, a sell rating issued may also indicate that the buy side analyst has already liquidated his position in the company. Since the rating is an opinion in the eyes of the analyst, there are no hard and fast rules for when they release the ratings changes.

Buy side analysts have an incentive to place a buy recommendation on held stocks and a sell recommendation on stocks recently sold. If these suggestions are enough to push the price in the direction that would "justify" the analyst's research, evidence would suggest that the analyst has profitable stock picking abilities. As a result, the mutual fund or investment firm would experience higher business volumes.

The Business of Analysis
There are also companies that provide research for sale and are in the sell side category. Websites provide advice on stocks, options and funds. Their research can be sourced from fundamental or technical analysis or a combination of both. Newsletters, which can be in print or online, are sold containing the advice of the company. The only way to judge the effectiveness of this research is to look into the company's track record, as it may present most of its successful tips and cover up the flops. After all, companies are in the business of selling a product, and advertising their best attributes is a way to promote these products. These types of firms typically sell research to either individuals or institutional investors.

While the smaller newsletters are more exciting, old standbys like Valueline and Standard & Poor's cover the majority of the listed stocks globally and provide what they consider independent ratings for a fee. They are credited with what investors call "tear sheets" because you could tear out the page the stock was described on and keep it separately for fast references.

The main criticism for these large firms has always been that they can't physically devote the time needed to make judgment calls on stocks and that they tend to hire less-experienced analysts. While some of that may be true, they do apply consistent models and scrutiny to the stocks they cover and are truly independent. They also have a legacy and their reputation to uphold, which promotes a good environment to produce independent research.

Sell side analysts may also have a vested interest in the companies they are covering in the form of generating ideas for their clients or bringing attention to a company that they plan to hold or have business relationships with. Prior to the technology bubble, there were a number of sell side analysts who were directly covering stocks in which the investment banking side of the business they worked for was bringing to the market. Those analysts had not been following the "Chinese Wall" concept designed to keep research and investment banking separate. While some of this activity still goes on, new regulatory and voluntary changes in the process have taken place and there seems to be some improvement. Unfortunately, there will always be the potential for conflict.

The Bottom Line
There seems to be no clear-cut solution to what type of analyst to follow. Recently, there have been significant changes to the way research is produced and it will take time for the effects to take hold. If you look back over the history of the research process, the basic fundamentals have not changed. If you want to know what analyst to follow, you have to perform the same tests that stand time; read the fine print, compare their calls to those of other analysts, find out how they are compensated and look at their track record making sure to cover the great picks and their flops. The bottom line is, don't just take one analyst's word for it. (Interested in becoming an Analyst? Read Becoming A Financial Analyst.)

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