They are the voice of authority in the financial world.
Their forecasts and opinions influence millions of investors and billions of dollars in publicly traded stocks and bonds. Their recommendations can drive the Nasdaq up or shut a company down.
They are Wall Street’s army of research analysts, thousands of men and women at hundreds of brokerages and investment banks, and dozens of independent boutiques, who make a full-time study of corporate America.
They run the numbers. They grill the players. They sort the winners from the losers.
But how honest are they? Twice this year, Arthur Levitt, head of the Securities and Exchange Commission, has publicly questioned the reliability of research coming out of Wall Street.
Just last month, Levitt said he feared a “web of dysfunctional relationships” between brokerages and their corporate clients was putting pressure on analysts to sugarcoat the truth about many of the companies they cover.
Levitt and others also worry that the analysts’ seemingly optimistic view of the market’s prospects could set investors up for a nasty fall.
“Sometimes,” says Dennis Ryland, a fund manager at the Private Management Group in Irvine, Calif., “the analysts seem like PR people, regurgitating what they hear in conference calls and read in disclosure statements.
“Occasionally, you come across some research that just blows you away from somebody who actually spent some time, did some real work and got beyond the scope of the quarterly conference calls. But you don’t see that very often.”
The analysts have their supporters. They point to a number of studies that show consensus stock recommendations can accurately predict stock movements.
And while some analysts no doubt are in the thrall of the companies they cover, they are in the minority, those who defend analysts say.
It’s a debate with important implications for individual investors. As more Americans take control of their investment portfolios, they need to know how much faith they should put in the information that flows out of Wall Street and winds up on stock-analysis Web sites.
“There’s definitely pressure on these guys to avoid saying anything negative,” says Chuck Hill, research director at First Call, which tracks analyst recommendations. “But they don’t have to give up their objectivity. Most good analysts don’t.”
Inside brokerages, there has always been a tension between the research department’s mandate to report on companies and the investment banking department’s mandate to develop lucrative business relationships with those very same companies.
“I don’t think anything’s really changed,” says Jon Fosheim, one of the founders of Green Street Advisors, an independent research firm in Newport Beach, Calif., that specializes in real estate investment trusts. “The conflicts have always been there.”
But in the past, there was at least a theoretical wall between research and investment banking or corporate finance, the department where stocks and bonds are underwritten and mergers and acquisitions arranged. The separation permitted the brokerage’s analysts to assess candidly the brokerage’s corporate finance clients in reports written for the brokerage’s investing clients.
In recent years, the line between the departments has blurred.
“It’s harder for the brokerage houses to get paid for research than it used to be,” says First Call’s Hill. “How do you justify having these analysts on board if they’re not going to generate some commission business on their own on the research side? I think that’s led to more pressure to have these guys produce for the investment banking side of the house.”
Few analysts are shameless shills. They are ranked–and in many cases, compensated–based on tables put out by the Greenwich Survey, Institutional Investor and The Wall Street Journal, which track how accurate their forecasts and recommendations are.
An analyst who simply parroted management would be an ex-analyst pretty quickly. But analysts frequently hold their tongues and avoid making negative comments about companies that their firms represent.
Take stock recommendations. The average investor hearing that an analyst has issued a recommendation on a stock might assume that means buy. The average investor would be mistaken. In analyst parlance, only a strong buy is a buy. An actual buy recommendation is normally a code word.
If they say “buy,” that’s ho-hum, says Hill at First Call, which compiles consensus stock ratings on companies. And if they say “hold,” well that’s basically a code word for “sell” with most analysts.
So when an analyst issues a rare sell, or a rarer strong sell, recommendation on a company, the shares often won’t budge. The reason? The smart money probably bailed out when the recommendation was issued months before. (This phenomenon is rarely observed, however, because most analysts stop covering companies rather than issue a sell or strong sell recommendation, another trick of the trade.)
“It’s madness,” says Louis M. Thompson Jr., head of the National Investor Relations Institute, a professional association for corporate IR people. “People have figured out that there’s not a lot of credibility in this.”
Analysts who don’t pull their punches pay the price.
In June, a banking analyst at Bear Stearns, Sean Ryan, was reportedly silenced after he repeatedly criticized the management of First Union, a North Carolina bank that did a lot of bond trading with Bear Stearns.
Levitt alluded to Ryan’s woes in his speech in November, and last April the Wall Street veteran told a Securities Industry Association seminar that unspoken pressures on analysts were coloring their reports and making them sound more like corporate boosters than no-nonsense researchers.
Levitt and others have also criticized the way analysts allow themselves to be used by companies to create pleasant earnings surprises quarter after quarter. (The average company now beats analyst estimates by 2.7 percent after every quarter.)
Dan Givoly, a professor at the Graduate School of Management at University of California, Irvine, has studied how management manipulates analysts. “There are three ways a company can beat expectations,” Givoly says. “One way, the old-fashioned way, was that the company could simply do better.
“Another way is to manipulate earnings. . . . But the third way is that the company can manage expectations. It influences analysts by releasing biased disclosures, downplaying expectations right before earnings are released so they constitute good earnings.”
That’s good for the stock, Givoly says, but undermines the independence of the analysts.
“Obviously, it compromises everything,” he says.
