The Role of the Securities Analyst and Its Biases

Securities Analyst

It is important to first understand the function of a securities analyst in a brokerage firm. A brokerage firm is a Wall Street investment banking firm on the sell side, “selling” investment securities primarily to institutional investors.

Unlike stock analysts at mutual funds, banks, or investment management firms, research analysts at brokerage firms do not serve their research to portfolio managers. Their job is to research specific industry sectors and “sell” their research to the broker’s institutional clients.

Analysts narrow their focus to a number of companies to track them as fully as possible. They want to know as much detail as possible so that they can properly assess how internal and external factors will impact the company.

After assessing each company’s industry and prospects, analysts must then conclude whether the company’s stock is a desirable investment (Buy rating), have a high probability of devaluation (Sell rating) or value it somewhere in between, and summarize their conclusions in a research report. All companies that analysts track must be constantly observed and scrutinized, and assessments communicated to a variety of audiences, including: clients of brokerage firms, institutional investors, internal salespeople and traders at the desk, and outside media sources.

Brokerage research analysts do not deal with individual investors or their financial consultants. Instead, they market their views to institutional investors.

Salespeople at brokerage firms serve institutional clients first and foremost – mutual funds, hedge funds, pension funds, banks and others. Salespeople continue to pass on their analyst research to these companies.

While research analysts are asked to provide ratings such as “Buy” or “Sell” for investments, institutional investors do not place much emphasis on these ratings as industry knowledge analysts. In fact, the analysts who were ranked the highest in Institutional Investor (II) magazine polls have some of the worst stock picks.

While brokerage analysts usually excel at providing thorough and analytical research on the industry and its companies, their accurate stock rating records are top notch. This is because perceptive analysis and astute understanding of the company and industry have little effect on an analyst’s investment recommendations.

The Wall Street system is driving this trend for five main reasons:

1. Analyst Compensation. Analysts are compensated for their status on the Road, their access to the CEO, their profile and influence, and depth of knowledge as opposed to the accuracy of their investment ratings. Salaries depend on polling institutional clients (e.g. annual II rating), their overall influence on the Road, evaluation of the institution’s sales and trade, and general subjective assessment by research department management.

There is no quantitative performance measurement. Writer Stephen T. McClellan of “Full of Bull” went so far as to say “the discount on any flamboyant opinion increases from April to June” because of the suspicious timing of the second ballot.

Consider that in 2006 the median compensation for a ranked II analyst was $1.4 million versus $590,000 for an unrated senior analyst. This type of incentive taints what would otherwise be more objective research.

2. Analyst Pressure. Analysts avoid the risk of being wrong so they are usually too late to change ratings. Brokerage analysts are often criticized so harshly that the reason they choose to downgrade a stock from Hold to Sell is almost unquestionable.

Most choose to ignore negative changes in the company for too long so that by the time the evidence is undeniable, most of the stock losses have already occurred. For example, it was only after Lehman Brothers’ stock fell from $80 per share to $7 that the three biggest companies on Wall Street finally lowered their ratings.

In addition, brokerage firms realized that a shift in opinion from Hold to Sell would only force a minority of shareholders to sell shares, thus creating a commission for the company. On the other hand, an upgrade to a Buy opinion is easier to market to all the company’s investors and will result in more transactions and commissions.

Therefore, analysts are motivated to value stocks higher than they should. As a result, it is almost impossible to understand how enthusiastic or skeptical an analyst is just from the ratings they publish.

An underperform rating could mean the analyst expects the stock to fall within a year or it won’t appreciate as much as its higher-rated competitor. Conversely, a Hold rating may imply that analysts are leaning toward an upgrade to Buy but don’t have enough evidence yet or that the company’s prospects are poor, but they are afraid to assign an interest party by downgrading the rating to Sell.

3. The Short-Term Bias of the Road. Wall Street likes stocks that are rising right now, not ones that require patience to see significant gains. Just as downgrades are usually late, so are upgrades to Buy.

The quarterly earnings report is Street’s “most important milestone”. They carry considerable influence over stock valuations and are critically analyzed. Institutions are “stuck on the treadmill of quarterly performance evaluation” with a very short investment time horizon.

Individual investors should be aware that analysts write for an audience of traders not investors. Analysts are confused between looking at longer-term indicators like earnings forecasts or price targets, and the demands of institutional players like mutual funds that measure performance quarterly and use those numbers to compare themselves to the competition.

As a result, analyst recommendations typically reflect how the stock will perform over a period of one to five months, rather than one to two years. Lastly, analysts are forced to make speed calls rather than quality ones. Once they’ve chosen a position, they’re more likely to stick with it even if later evidence suggests something else.

4. Street Positive Bias. This positive bias is analogous to the automotive industry. Regardless of the market, car dealers have a vested interest in always saying “buy”.

Similarly, Wall Street has a distorted number of Buy or Hold recommendations. Wall Street doesn’t want to suggest capital preservation or a timely retreat from the market. Even in a deep bear market, brokerage firms need to convince investors to continue buying stocks.

5. Big Street Company Bias. The last bias is towards large companies/stocks with the largest market capitalization. These securities are the most frequently traded, most widely held, and have the greatest interest from institutional investors.

It also means that large companies tend to be overanalyzed and underreported. The most researched sectors include technology, telecommunications, and healthcare because the research department places the most analysts where the business trades the most, not necessarily where the best investment opportunities lie.

Unlike individual investors, mutual funds and other institutions have to buy shares in large quantities. Because this is the main target audience of brokerage firms, there is no financial reward large enough for an analyst to recommend a smaller stock.

Given these factors that can distort a broker analyst’s stock recommendations, individual investors should understand that most ratings should not be taken as literal advice for a personal portfolio. However, there is some value in Street securities research for individual investors.

First, research reports are excellent for providing an understanding of the background and important business metrics of companies and industries. Figures such as earnings prospects and profit forecasts are examined as are business operations, management, markets, competition, potential challenges, and financial stability.

Second, if investors listen to a company’s public conference call, they can tune in to analyst questions and executive responses. Analysts have greater awareness of the company’s culture, goals and management style, sometimes having direct access to the CEO.

Having more information than is available outside Wall Street, analysts can ask sharper questions on conference calls and hint at critical issues or what the company might be trying to cover up. Finally, analysts can offer detached and unemotional observations of how certain events may affect a company’s future.

Wall Street may act as if it is appropriate to offer investment advice to individuals, but that is not what it is structured to do. The Street is structured to “trade securities, perform securities transactions, distribute and sell securities as dealers, and perform corporate financial transactions.

Wall Street is not cut out to be an investment manager, financial advisor, or stock picker. This service constitutes a conflict of interest with the basic brokerage and banking function.”

With a better understanding of how research on Wall Street operates, individual investors can use the following tips for better investment strategies:

* Look for stocks that are not currently being pushed by analysts or widely recommended, but still show promise and sound financials. Analyst upgrade to Hold is often a good signal to Buy. Any change of opinion involving a downgrade should be read as a literal Sell recommendation.

* Make early investments in healthy and promising small companies not yet covered by Wall Street. Small stocks offer individual investors the best opportunity for future gains.

* Since Wall Street is subject to short-term bias, the best outlook for individual investors involves looking at long-term value versus quarterly performance. Individuals are not valued on a quarterly basis like institutional investors, giving them the potential to realize larger returns over two to three years.

* Pay attention to a “lone wolf analyst,” one who is willing to lower their stance. Analysts often mirror each other’s opinions and it takes courage for someone to be honest about a negative attitude.

* Pay attention to the level of experience of the analyst. Younger analysts don’t have the same relationship with experienced executives or perspectives as seniors do. Look for at least ten years of experience.

* Conference calls offer individual investors the closest look into the company they can find. It can be helpful to match not only with what is said but also with the tone of the call and what is left to read between the lines. Pay attention to what types of questions analysts ask executives.

* Benefit from being an individual investor without the biases and distractions that analysts on the Street have. Take the time to become like an independent research analyst, listening to conference calls, reviewing revenue models, and examining company finances.