Are Analysts Playing Us for Suckers?Published: July 04, 2001 in Knowledge@Wharton
Savvy investors have long been wary of following Wall Street analysts’ "buy" and "sell" recommendations too slavishly. Even the best analyst, after all, can be wrong about the future. But now investors - savvy and unsophisticated alike - are wondering whether the problem runs deeper: Are analysts playing them for suckers? It’s a concern increasingly voiced by securities regulators and some members of Congress as well.
Triggering suspicions is a simple fact: Wall Street analysts relentlessly cheered the dot-com mania that pushed technology stocks to stunning gains in 1999. But even after those stocks went into a tailspin in 2000, few analysts reversed course to urge investors to sell.
"It’s not unreasonable to say that if these analysts were truly independent we would not have had the bubble and crash that we did have," says Wharton finance professor Andrew Metrick. Adds T. Clifton Green, finance professor at Emory’s Goizueta Business School: "It’s kind of a running joke, just how few ‘sell’ recommendations there are versus ‘buy’ recommendations. There is confirmable evidence that these analyst recommendations do have an impact on prices."
The analysts’ professional organization and the trade group for the securities firms claim the industry has strong ethical guidelines and that problems are not nearly as pervasive as the current attention suggests. But many academics and other observers say there is indeed a problem, rising from Wall Street’s growing reliance on the fees earned helping public companies sell new blocks of stock. Increasingly, analysts play a key role on these investment-banking teams, giving them good reason to tout the stocks of client companies, as well as companies that might become clients. "Obviously, people in general are reluctant to bite the hand that feeds them," says Wharton finance professor Robert F. Stambaugh.
Objectivity is important, adds Metrick. "From a social perspective – maximizing everyone’s welfare – it is useful to have some group of analysts who have specialized skills in figuring stuff out and then credibly transmitting that information to the rest of us. It seems clear that the group we thought 10 years ago could perform this function cannot."
But there has yet to be any research to demonstrate conclusively that analyst bias has a strong long-term effect on the market as a whole, he notes. While a biased recommendation may cause an individual stock to rise or fall over the short term, over time that is counterbalanced by unbiased recommendations from other analysts. Moreover, in the days, weeks and months that follow a biased recommendation, the importance of an analyst’s views will recede as earnings, revenue and other key information come out.
Analyst bias therefore probably is not a major problem for buy-and-hold investors with long time horizons, Metrick says.
But over the past few years, many investors have become active traders, using inexpensive online brokerages to place short-term bets. Many such investors were brutalized by the dot-com crash. Investors with more cautious approaches were hurt as well, investing in mutual funds that were forced to use cash inflows to buy stocks at inflated prices.
Kent Womack, a finance professor at Dartmouth’s Amos Tuck School of Business Administration, found in a late-‘90s study that analysts’ "buy" recommendations outnumbered "sell" recommendations by about six to one early in that decade. By last year, he and others found the ratio had soared to 50 to 1, sometimes 100 to 1.
If an analyst’s job is to spot stocks that can beat market averages, only a fraction of stocks should deserve "buy" recommendations. So the skewed numbers trouble many market watchers.
The New York Attorney General’s office, which has Wall Street in its jurisdiction, has begun a probe into possible analyst conflicts. And in April, acting Securities and Exchange Commission chairman Laura S. Unger cautioned Wall Street that her agency could view biased analysts recommendations as violations of antifraud laws, subject to civil action and perhaps even criminal prosecution.
On June 14, the House Committee on Financial Services subcommittee on capital markets, insurance and government-sponsored enterprises conducted a hearing titled Analyzing the Analysts: Are Investors Getting Unbiased research from Wall Street? Several witnesses said bias is a significant problem, and a number of committee members agreed.
Rushing to get ahead of the issue, the Securities Industry Association announced two days earlier that it had adopted a series of "best practices" guidelines to discourage conflicts and make sure analysts place investors’ interests first. Analysts and their firms should clearly disclose holdings in companies they cover and should not, for instance, sell shares in a stock they are urging clients to buy, the SIA said. The SIA said analysts’ pay should not be directly tied to their success in helping their companies land investment-banking deals, and it recommended that research departments not be required to report to investment banking units.
The guidelines, the SIA said, "provide general guidance and do not create legally enforceable obligations or duties. Adherence to these practices is voluntary…" The industry’s 14 largest firms have endorsed it, the SIA said.
Testifying at the subcommittee hearing, SIA President Marc E. Lackritz argued that the high ratio of "buy" to "sell" recommendations "seems appropriate" given the bull market from 1988 through 1999, when the average stock was in fact a good investment. "Critics of analysts were much less vocal then," he said, acknowledging that analysts do have "a few bloodied noses" in the wake of the bursting Internet bubble. "Just about everyone working in, reporting on and commenting about securities recently has tripped at least a few times."
Subcommittee members were skeptical about how effective the SIA’s voluntary guidelines could be, with Democratic Rep. Paul. E. Kanjorski of Pennsylvania grumbling that the guidelines came "a little late." Investors, he said, are like athletes playing on a team in which the referees are paid more if the other team wins.
Also at the hearing, Thomas A. Bowman, president and CEO of The Association for Investment Management and Research, the analysts’ professional organization, said: "We do not dispute that some … firms pressure their analysts to issue favorable research on current or prospective investment banking clients." But, like Lackritz, he argued the best approach is a set of voluntary "AIMR Research Objectivity Standards," which his organization will soon issue for comment.
Experts list various reasons an analyst may color research findings. Analysts, for instance, need good relations with the companies they cover to assure easy access to information. "Sell" recommendations don’t go over well with corporate executives, and there have been numerous reports of companies "freezing out" critical analysts.
Benn R. Konsynski, professor of decision and information analysis at Goizueta, has sat on the boards of a number of public companies over the past 10 years. "There’s constant pressure on all sides to accommodate, when it may or may not be in the best interest of the public," he points out.
Some observers note that the dot-com bubble saw IPOs from many companies that, in more ordinary times, would have raised money from risk-embracing venture capital firms rather than investors. "There were tons of companies that were going public without profits," says Wharton’s Metrick. Historically, only biotech firms have done this.
If companies want to sell stock, that’s what investment banks are for. It seems inevitable, then, that many Internet-stock investors would be disappointed, since companies that are losing money present greater risks than companies that are making it.
Nonetheless, critics feel it’s the analyst’s job to point out the risks, not to broadcast overly rosy projections to help clients peddle stocks. "Wall Street research has become hopelessly corrupt," Benjamin Mark Cole, author of the recent book The Pied Pipers of Wall Street – How Analysts Sell you Down the River, told the House subcommittee.
In the early 1970s, brokerage commissions supplied 60% of the industry revenues, Cole said. But commissions fell after the federal government deregulated them in 1975, and commissions today provide less than 16% of revenues. To replace this loss, the industry turned to investment banking. In 1974, he pointed out, "the U.S. securities industry underwrote $42 billion worth of stocks and bonds. In 1999, the industry underwrote $2.24 trillion, more than 50 times the pre-1975 level."
Thus, investment banking became the power center in securities firms, and analysts became beholden to them, he added.
Emory’s Green notes that prior to the 1990s analysts’ reports were read primarily by money managers and sophisticated investors – people equipped to discount puffery. Increasingly, though, small investors are going it alone using discount brokers, analysts reports and other information culled from the Internet. These people are more likely to take analysts’ recommendations at face value. Moreover, he adds, the constant media coverage of the financial markets can give even small bits of news the power to move a stock.
Indeed, a recent study by Green and Jeffrey A. Busse, a finance professor at Goizueta, found that the CNBC TV segments Morning Call and Midday Call can have a near instantaneous effect on the prices of stocks discussed by guest analysts. "We find that prices respond to the reports within seconds of the initial mention," the study states, "with positive reports fully incorporated within one minute."
While analysts have taken much criticism lately, there is academic evidence that analysts can indeed spot winning stocks. Brad Barber of the Graduate School of Management at the University of California, Davis, found that over the 10-year period ending in 1996, stocks receiving strong "buy" recommendations beat the average stock by a little more than 4 percentage points a year, a significant margin.
Yet there also is academic evidence that bias can have real impact on shareholder returns. Dartmouth’s Womack and Roni Michaely, a finance professor at Cornell University, examined the issue in a 1999 study titled Conflict of Interest and the Credibility of Underwriter Analyst Recommendations." They found analysts to be more optimistic about stocks underwritten by their own firms than they were about stocks underwritten by others. But those optimistic forecasts tended to be wrong: In the 24 months following IPOs, stocks recommended by analysts associated with the underwriting firms trailed stocks recommended by non-underwriters by 15.5 percentage points. The underwriting analysts did much better when they recommended stocks their firms had not underwritten.
Using a different methodology and covering a more recent period that includes last year’s dot-com meltdown, Investars.com, a company that tracks analysts’ stock-picking performance, found that the investment-banking conflict can have devastating effects on investor returns. In a look at 19 major investment banks from Jan. 1, 1997 through June 12, 2001, the study found that a portfolio of stocks recommended by analysts whose firms had "IPO relations" lost 51% of its value. At the same time, the stocks recommended by analysts without IPO relations fell by only 1%. An IPO relation means the analyst’s employer is involved in the initial public offering of the stock on which the analyst made a recommendation.
Investar calls its methodology the ROSS ranking, for Rate of Success system. Essentially, it involves hypothetical buying or selling of blocks of shares worth various amounts, depending on an analyst’s recommendation. For example, $450,000 would be "invested" in a stock receiving a "strong buy" recommendation and $300,000 would be put into a stock with a "buy" recommendation, while a stock receiving a "sell" recommendation would be shorted.
"The ROSS rankings highlight the grade inflation built into the brokerages’ stock recommendations - a world in which downgrades are relatively rare and ‘sell’ recommendations are an endangered species," Investar CEO Kei Kianpoor said in a statement.
Former SEC Chairman Arthur Levitt expressed deep concerns about analysts’ conflicts, and last year convinced his colleagues to adopt Regulation FD – for "full disclosure" – as a partial remedy. Under Reg. FD, a company that gives information to an analyst must quickly make it available to the public as well. Levitt hoped better disclosure would make biased analyses stand out, deterring the practice. Konsynski believes Regulation FD may indeed solve much of the problem. If an analyst cannot get favored treatment, he has less reason to curry favor, he says.
Stambaugh points out it has yet to be conclusively demonstrated that professional money managers cannot work around the conflict problem. But he notes that investors who are less sophisticated may be unable to detect bias in analysts’ reports, and thus may be better off relying on pros such as mutual fund managers to do it for them.
Cole, author of the book on analyst bias, told Congress subcommittee members that more money should be spent on securities enforcement actions at the SEC and U.S. Attorney’s Office. He suggested that Congress require brokerages to establish a uniform standard for rating the quality of analysts’ recommendations and that these "batting averages" be posted on an industry web site.
Subcommittee members, while appearing concerned about the issue, indicated it would require extensive additional study before they would propose any kind of remedy, if they do. "The committee will move very slowly," said its chairman, Richard H. Baker, Republican of Louisiana. But he noted that the ways of Wall Street may have to change, now that millions of small investors have plunged into the market.
"It is one thing for one shark to eat another," Baker said. "It is quite a different thing for a shark to eat the minnows."