Analyze this: Listening to experts doesn't always work

A recent study tracked investor reaction to more than 50,000 reports issued by 2,794 analysts between 1993 and 1999. While the data show that both large and small investors react to analyst counsel, the larger — and presumably more sophisticated — traders tend to make more money doing so. Compared to those making larger trades, smaller investors seem less aware of conflicts that securities analysts may face, and this lack of understanding translates into less profitable stock-market decisions.

Smart investors watch the top securities analysts and follow the "buy," "sell" or "hold" recommendations these gurus of gain announce. Right? Well, sometimes. A recent study tracked investor reaction to more than 50,000 reports issued by 2,794 analysts between 1993 and 1999. While the data show that both large and small investors react to analyst counsel, the larger — and presumably more sophisticated — traders tend to make more money doing so.

Compared to those making larger trades, smaller investors seem less aware of conflicts that securities analysts may face, and this lack of understanding translates into less profitable stock-market decisions.

Follow the money

When the Securities and Exchange Commission was examining conflicts of interest among brokerage firms and their research analysts, acting SEC chair Laura Unger told the investigating SEC subcommittee, "The overriding majority of analysts operate on the highest ethical plane." Still, there was reason for concern.

"In the past, sometimes the investment bankers had input on what kind of bonus the analysts earned," says Michael Mikhail, an associate accounting professor at the W. P. Carey School of Business. According to Unger's subcommittee testimony on July 21, 2001, seven of nine firms inspected "reported that investment banking had input into analysts' bonuses and the analyst hiring process."

At one firm, Unger said 90 percent of an analyst's bonus was based on investment banking revenue. Mikhail explains why that might be so. Traditionally, he says, securities analysts supported the investment banking side of their business with research and industry knowledge that could help bankers woo new business.

If bankers are saddled with analysts who are down on a firm, those bankers might have trouble earning that firm's business. Unger's July 21 testimony echoes this view: "Interviews with former analysts revealed that it was well understood by all of these analysts that they were not permitted to issue negative opinions" about the clients of affiliated investment bankers. Another possible conflict is stock ownership itself, Mikhail adds.

According to Unger, the SEC's 2001 investigation found dozens of analysts buying shares of companies they covered, and three were found making trades that were contrary to their research-report recommendations. On top of pressure from bankers, analysts may encounter subtle arm-twisting from executives at the firms they investigate. Mikhail explains that analysts face pressure to maintain good relations with top management because the executives supply vital information.

"If you're a critical analyst, management may not be as willing to return calls or include you on financial conference calls," Mikhail says. Without such access, he adds, it may be difficult to evaluate a company effectively. All of these circumstances caught the attention of Eliot Spitzer, attorney general for the State of New York, who charged some of Wall Street's heaviest hitters with producing biased research.

On January 15, 2003, 10 large investment banks anted up $1.4 billion in fines when they settled the suit Spitzer had initiated. Meanwhile, that same year, the SEC passed "Regulation Analyst Certification," which requires analysts to disclose potential conflicts of interest in a company they're covering, as well as verify that reports reflect honest views.

As a result of such regulatory and legal actions, Mikhail says, many investment-banking firms have segregated the research and banking sides of their businesses. Still, the professor wondered about the accuracy of regulators' worries that small, less sophisticated investors had failed to grasp the potential for conflicts in the analyst's role and, therefore, made suboptimal investment decisions during the 1990s.

Mikhail joined with Beverly Walther from Northwestern University and Richard Willis of Vanderbilt University to see if regulator concerns actually manifested in trader behavior. They did. Regardless of how analysts called the play, smaller traders were more likely to get clobbered while the big traders earned robust returns.

The power of skepticism

Mikhail et al. traced the difference in small- and large-trader profits to the differences in trader behavior between these two groups. In conducting this research, the team tapped an investment research database to see what recommendations had been made by analysts during the time period under study — 1993 through 1999 — and also looked at trading volume in a five-day window centered on the date a recommendation was issued without an earnings or dividend announcement that might also spur buying and selling activity.

Small traders were defined as those making trades under $7,000. Large traders in this study bought and sold over $30,000 worth of stock at a time. Because of the pressure for analysts to produce positive reports, Mikhail and his colleagues assumed that analysts' upgraded evaluations and "buy" recommendations were less credible than downgrades and "sell" suggestions. Apparently, large investors agreed.

Compared to small investors, the large players traded less in response to upgrades and "buys." Instead, large investors were more likely to trade in response to "hold" or "sell" recommendations. "These findings are consistent with large traders better understanding analysts' disincentives to downgrade their recommendations or issue holds/sells," the researchers write in a paper entitled, "When Security Analysts Talk, Who Listens?"

Smaller investors were net purchasers of securities regardless of the type of recommendation revisions: upgrade, downgrade or reiteration of previous advice. However, small investors also traded more in response to upgrades and buys, indicating that it wasn't simply the attention-grabbing news value of the recommendation that caught their eyes and opened their wallets.

They were buying what they thought they should buy based on their analyst's advice. But, Mikhail points out that sometimes a "buy" recommendation can be better interpreted as a "sell." If a stock has been downgraded from "strong buy" to "buy," it's "bad news," he says. "In the short window surrounding that recommendation revision, stocks that have been downgraded to 'buy' tend to see as much of a price decline as a stock that's been downgraded to 'sell,'" he adds. These 'buys' could be hurting small-trader returns, he notes.

Mikhail and his team also found that large traders seem to pay more attention to the content of analysts' reports than small traders do. To evaluate this, the researchers considered how many rungs up the five-rung ladder a recommendation moved. That is, "strong sell" was considered the lowest rung, "sell" was next, then "hold," etc. "Say someone had a 'hold' on a stock, and then moved the recommendation up to 'strong buy,'" Mikhail says.

"We assumed that an analyst's report would have more information in it than one moving a stock from 'buy' to 'strong buy.'" The team made this assumption because prior research indicated that, indeed, bigger jumps came with more detailed reports. After looking at the trades with this in mind, Mikhail and his fellow researchers conclude: "Large investors traded more in response to the amount of information contained in the analysts' recommendation."

The team also looked for the one piece of information in an analyst's report that is generally in machine-readable format: the earnings forecast. "Big investors factored it in, but small investors ignored it," Mikhail notes. Not surprisingly, large investors wound up earning better returns than their smaller counterparts. In fact, the larger investors made money on both good- and bad-news recommendations, while the smaller investors lost money, no matter what the analysts said.

Think big

The study confirms that smaller investors sometimes fail to recognize biased research, Mikhail notes, but there is good news to be shared. Between the SEC's Regulation AC, Spitzer's Wall Street wins and a general public outcry, "There have been a lot of changes in the last couple of years to protect investors." For one thing, Regulation AC requires analysts to disclose such information as banking relationships or stock ownership.

That makes it easier for any investor to detect conflict of interest. Mikhail urges investors to take advantage of this information. "When the average investor chooses to follow analysts, he or she needs to be cautious and have some understanding about the incentives faced by the analyst making the recommendation," he says. It makes a difference.

For instance, some researchers have found that following recommendations of analysts who are affiliated with bankers can lower annual returns up to 15 percent below what investors might earn by following unaffiliated analysts. Mikhail also advises investors to "look at the content of the report, not just an analysts 'buy' or 'strong buy' recommendation."

And, greet "buy" recommendations with some skepticism. "Investors need to keep in the back of their minds that those recommendations tend to be less credible," he adds. A final consideration: "Track records really do matter," Mikhail notes. That is, good analysts stay good, bad ones stay bad, and the longer the track record an analyst has as a money-maker, the more potential return investors can make.

"On average, an analyst with a five-year winning track record will do better than someone with a one-year winning track record," Mikhail explains. He adds that there are a variety of publications that publish analyst rankings, and it's a good idea to look into them. After all, if you're going to follow a securities analyst, it pays to follow a champ.

Bottom Line

• Sell-side securities analysts the ones who make "buy," "sell," or "hold" recommendations on stocks sometimes face pressure from the investment banking side of their businesses to issue positive reports.
• Large investors make trades that reflect an understanding of such potential conflicts. Smaller investors don't.
• Larger investors tend to make money on both "buy" and "sell" analyst recommendations, while smaller investors tend to lose, regardless of the analyst's advice.
• Recent SEC regulations now require analysts to disclose potential conflicts and, therefore, these regulations can protect investors. But, investors must do their homework. Check for conflicts, examine track records and view "buy" recommendations as less credible than "hold" or "sell" suggestions.