In the early days of infectious disease research, a physician of towering reputation declared a new finding that – when explained to a group of medical students – they could neither comprehend in language nor understand in process. One of these students (who went on to start one of the premier hospitals in the United States) asked a student a few classes ahead of him what the distinguished faculty member meant. He responded, “Oh, he only speaks in tongues. His statements aren't meant for us. They communicate pronouncements to people we will rarely see and never meet.”
You sometimes get the feeling that Wall Street analysts are like our eminent professor. Recommending stocks in language individual investors can’t quite comprehend through processes so complex we don’t understand their very premises. Several of our readers mentioned using analyst reports as a starting point in their research. We have never been particularly keen on investment analysts and their respective recommendations. We thought we’d share why this is so and what its impact is on individual investors.
What Makes Analysts Tick
There are two types of analysts on Wall Street. Buy side analysts work for institutional investors such as mutual funds, pension funds, and hedge funds. Sell side analysts work for brokerage firms, investment banks, and independent research firms. Buy side analysts’ customers are their internal fund brethren. Many mutual fund managers will also pay for sell side research to further enhance their own internal buy side research. For the sake of brevity, I wanted to focus on sell side analysts, as this is where recent research has really done some outstanding work.
In 2014, there was a tremendous paper reporting on research related to buy side analysts. Entitled “Inside the 'Black Box' of Sell-Side Financial Analysts”, the research was conducted by Lawrence D. Brown (Temple), Andrew C. Call (Arizona State University), Michael B. Clement (University of Texas at Austin) and Nathan Y. Sharp (Texas A&M). The full study can be found here. The authors were greatly interested in the steps and influences that make up the process of stock recommendations.
Several findings in the report really stood out. First – and most importantly – performance of their recommendations actually has little to do with their motivation and compensation. As seen in the graphic below, both profitability and accuracy were respectively seventh (7th) and ninth (9th) out of nine (9) options in importance to compensation[1].
| Category | Average Rating** | Very Important (5-6)* | Not Important (0-1)* |
| Your Industry Knowledge | 5.0 | 72.2% | 1.9% |
| Your standing in analyst rankings of broker votes | 4.7 | 66.9% | 5.0% |
| Your professional integrity | 4.7 | 64.0% | 3.6% |
| Your accessibility and/or responsiveness | 4.7 | 63.5% | 2.2% |
| Your written reports | 4.2 | 39.0% | 2.8% |
| Your relationship with management of the companies you follow | 4.1 | 44.6% | 7.2% |
| The profitability of your stock recommendations | 3.9 | 35.1% | 5.5% |
| Your success at generating underwriting business or trading commissions | 3.7 | 44.2% | 20.2% |
| The accuracy and timeliness of your earnings forecasts | 3.6 | 24.1% | 7.8% |
* Represents total percentage of respondents
** Represents average score
Second, it was a surprise that when questioned about the consequences of predicting earnings far below consensus, twenty-one percent (21%) stated it was likely to increase their client’s perception of their credibility[2]. Going into the study, researchers were convinced it would be the opposite – that predicting higher estimates would look better. Roughly fifteen percent (15%) thought it was highly likely they would lose access to corporate management or be shut out of conference calls, while a surprising thirty-eight percent (38%) felt that was highly unlikely to happen.
Finally, within the context of the first two findings, sell side analysts don’t see individual investors as important to their research. Granted these are not their core customers but it is equally vital to point out their stock recommendations are based on client need, not individual investor needs. Retail brokerage clients were dead last in the question of how important were certain clients to your employer[3]. Hedge funds and mutual funds (not surprisingly) were deemed most important by roughly eighty percent (80%) of respondents.
Why This Is Important
When we get emails or suggestions that are based on sell side analyst research or recommendations, we generally thank the writer most generously then quietly file the suggestion away. We do this for three (3) major reasons.
Stock Picks Are Not About Performance
Analysts have no real performance pressure. In their study, Browne, Call et al. found that "accurate earnings forecasts and profitable stock recommendations have relatively little direct impact on their compensation." When you think about the fact that analyst recommendations are not about performance but perceived value, you recognize that sell side analyst recommendations are not aligned with individual investor priorities. Ultimately, many investors want to outperform the markets. By resorting to taking sell side analyst advice you are extremely unlikely to do so (we will address why this is in a later article).
Stock Picks Are Unique to Their Universe
Much as you wouldn't use a bear trap to catch a mouse, analysts and investors are working in far different scales and targets. Of sell side analysts’ picks, roughly 73% were recommendations in the mid to large cap universe. Of these picks, the majority had roughly 50% less volatility than the markets themselves. As we’ve discussed in previous articles, analysts are not playing to win but rather playing to not lose. Which brings us to our third reason.
Analysts Use Stock Picks To Send Messages – Just Not to You and Me
Sell side analysts live and die by their access to corporate management. Many times their picks are designed to send a message to either their end customer (hedge funds and mutual funds) or company management. When your top priority is to maintain both access and approval of brokers, the silent language of stock recommendations is about communication. Unfortunately that's something the individual investor neither needs nor understands.
Conclusions
Analysts play a significant role in how hedge fund and mutual fund managers choose their investments. The research they complete and findings they issue are frequently targeted for institutional investors whose goals are vastly different than the average investor. This doesn’t make their research useless. It’s just important to understand what and how they are trying to communicate. Much like our medical school professor, analysts’ recommendations and estimates are “meant for people we rarely see and almost never meet.” It’s important to remember they are a single data point amongst many. In the final analysis, the research you conduct and models you use must meet your own investment goals.
As always, we look forward to your thoughts and comments.
[1] Information is from Table 8, “How Important Are the Following to Compensation, page 56.
[2] See Table 11 Panel A: Summary statistics for the EF version, page 60
[3] See Table 12, page 62
