October 12, 2017

The dirty secret behind Sell-Side Analysts

Definition: A sell-side analyst works for a brokerage firm and evaluates companies for future earnings growth and other investment criteria. They sometimes place recommendations on stocks or other securities, typically phrased as "buy", "sell", or "hold." They offer their recommendations to clients.

Now to the article:

Here are two models of sell-side equity research.

Model 1
  • 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.
Model 2
  • 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.
Today's 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.


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.


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.


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.

This is a story of analysts (maybe) lying to investors because that's what the investors want. The investors want the corporate access. You know that because they tell the analysts that, and because they explicitly pay for it. 

The investors don't care so much about the Buy/Sell/Hold stuff. You know that because they tell the analysts that (sometimes), and because their demand for corporate access has led to more bullish research. If they cared more about ratings accuracy, you'd see less bullish ratings and less corporate access.

Read more at https://www.bloomberg.com/view/articles/2017-01-20/wall-street-analysts-give-investors-what-they-want

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