A while back I wrote this:
Here are two models of sell-side equity research.
- Sell-side analysts are in the business of finding out what stocks will go up and then telling you.
- They tell you to Buy stocks that will go up, Hold stocks that will stay flat (why?), and Sell stocks that go down.
- You believe them, and do that.
- Sometimes they lie to you, but it is always a shock when they do.
- Sell-side analysts are in the business of helping institutional investors get access to corporate management teams.
- They flatter management teams by giving most companies good ratings, to maintain access.
- They help their clients, because investors who meet with management tend to outperform investors who don’t.
- The clients aren’t too worried about the Buy/Sell/Hold stuff.
The Wall Street Journal has a terrific article demonstrating, beyond any real doubt, that Model 2 is right and Model 1 is wrong. If you believe that the job of a sell-side analyst is to tell people which stocks to buy and which ones to sell, you need to stop believing that right now, because it is not true. You shouldn’t be embarrassed about getting this wrong; lots of people did. For instance, this guy thought that, and he actually was a sell-side analyst:
David Strasser, a former retail analyst at Janney Montgomery Scott LLC, says some investors told him they had little interest in his research and were only paying for meetings he could set up with companies.
“I wanted to be valued for my analytical abilities, but arranging meetings became such a critical part of the job,” says Mr. Strasser, adding that he was sometimes asked to sit outside the room so investors could ask questions without him.
But now he knows better (“he left the research industry to join a venture-capital firm”), and so do you. The evidence is overwhelming:
Many securities firms tally the number of times their analysts take company executives on the road to meet clients and use the number to help decide analysts’ annual bonuses.
At some firms, as much as one-third of analysts’ yearly pay can be tied to corporate access, says James Valentine, the founder of training and consulting firm AnalystSolutions LLC.
I mean, look. To be fair: That leaves another two-thirds. Analysts aren’t just schedulers. They do analyze. They go to the meetings themselves — usually! — and listen to what the managers say and then try to find useful insights for their readers. They put together financial models, and project companies’ earnings and stock prices. And yes, yes, yes, they put out Buy and Hold and — rarely — Sell ratings. And that stuff can be useful to investor clients. A clever insight from an analyst can give a client a good trade idea. An industry background piece from an analyst can help a client get up to speed on a new sector. An analyst’s model can help the client think about how the company makes its money. There is a lot of potential value there, beyond just the scheduling.
But there is also just the dumb simple narrow question of: Which is more important, the corporate access, or the Buy/Sell/Hold recommendation? And on that question, there is just no doubt. Clients want the access, and are willing to sacrifice Buy/Sell/Hold accuracy to get it:
Analysts’ relationships with company executives, including the ability to line up private meetings for investor clients, have become an increasingly vital revenue source. And that is increasing the pressure for analysts to be bullish on the publicly traded companies they follow.
This makes sense: The investors are in the business of making investment decisions. They want information — management meetings and analysts’ research — that will help them make those decisions. They don’t particularly want someone else to make the investment decisions for them. If you run a big mutual fund, your job is to decide which stocks to buy. You might use a research analyst for background or insight or management meetings, but you’re not going to buy because she says Buy.
And investors do have to sacrifice some Buy/Sell/Hold accuracy for the access, because some companies will explicitly refuse to do client meetings with research analysts who have Sell ratings on their stocks.
“It’s a decision I have to make on my sell-rated stocks: whether I will forgo the opportunity for corporate access, which clients will explicitly pay for,” says Laura Champine, a retail analyst at Roe Equity Research. Some previous bosses at other firms told her to “just drop coverage” instead of putting out sell ratings, she says, while declining to comment on where that happened.
Notice that the analysts don’t really have to sacrifice anything else. They can still write insightful industry background pieces, and have thoughtful conversations with clients about a company’s future, and summarize their takeaways from management conversations. They can even write negative reports, really.1 They just have to slap the word “Buy” on top. And so “just 6% of the roughly 11,000 recommendations on stocks in the S&P 500 index are sell or equivalent ratings.”
Now, one potential reaction here is: This is terrible. The analysts are lying to people. Instead of telling investors their true feelings — that they think investors should sell a company’s stock — they tell investors to hold, or even buy, that stock, just so they can get the investors a meeting with the company’s management. The investors are deceived. They are losing money because of this conflict of interest.