Analyzing Stock Analyst Recommendations

Research analysts study publicly traded companies and make recommendations on the securities of those companies. Most specialize in a particular industry or sector of the economy. They exert considerable influence in today's marketplace. Analysts' recommendations or reports can influence the price of a company's stock, especially when the recommendations are widely disseminated through television appearances or through other electronic and print media. The mere mention of a company by a popular analyst can temporarily cause its stock to rise or fall even when nothing about the company's prospects or fundamentals has recently changed.


Analysts often use a variety of terms such as buy, strong buy, near-term or long-term accumulate, near-term or long-term over-perform or under-perform, neutral, hold, to describe their recommendations. But the meanings of these terms can differ from firm to firm. Rather than make assumptions, investors should carefully read the definitions of all ratings used in each research report. They should also consider the firm's disclosures regarding what percentage of all ratings fall into either "buy," "hold/neutral," and "sell" categories.

While analysts provide an important source of information in today's markets, investors should understand the potential conflicts of interest analysts might face. For example, some analysts work for firms that underwrite or own the securities of the companies the analysts cover. Analysts themselves sometimes own stocks in the companies they cover, either directly or indirectly, such as through employee stock-purchase pools in which they and their colleagues participate.

As a general matter, investors should not rely solely on an analyst's recommendation when deciding whether to buy, hold, or sell a stock. Instead, they should also do their own research, such as reading the prospectus for new companies or for public companies, the quarterly and annual reports filed with the SEC, to confirm whether a particular investment is appropriate for them in light of their individual financial circumstances. This alert discusses the potential conflicts of interest analysts face, describes the New York Stock Exchange (NYSE) and NASD rules concerning analyst recommendations, and provides tips for researching investments.

Who Analysts Are and Who They Work for

Analysts historically have served an important role, promoting the efficiency of our markets by ferreting out facts and offering valuable insights on companies and industry trends. Analysts generally fall into one of three categories:

Sell-side analysts typically work for full-service broker-dealers and make recommendations on the securities they cover. Many of the more popular sell-side analysts work for prominent brokerage firms that also provide investment banking services for corporate clients, including companies whose securities the analysts cover.

Buy-side analysts typically work for institutional money managers, such as mutual funds, hedge funds, or investment advisers that purchase securities for their own accounts. They counsel their employers on which securities to buy, hold, or sell and stand to make money when they make good calls.

Independent analysts typically aren't associated with firms that underwrite the securities they cover. They often sell their research reports on a subscription or other basis. Some firms that have discontinued their investment banking operations now market themselves as more independent than multi-service firms, emphasizing their lack of conflicts of interest.

Potential Conflicts of Interest

Many analysts work in a world with built-in conflicts of interest and competing pressures. On the one hand, sell-side firms want their individual investor clients to be successful over time because satisfied long-term investors are a key to a firm's long-term reputation and success. A well-respected investment research team is an important service to customers.

At the same time, however, several factors can create pressure on an analyst's independence and objectivity. The existence of these factors does not necessarily mean that the research analyst is biased. But investors should take them into account before making an investment decision. Some of these factors include:

1) Investment Banking Relationships: When companies issue new securities, they hire investment bankers for advice on structuring the deal and for help with the actual offering. Underwriting a company's securities offerings and providing other investment banking services can bring in more money for firms than revenues from brokerage operations or research reports. Here's what an investment banking relationship may mean:

a) The analyst's firm may be underwriting the offering: If so, the firm has a substantial interest, both financial and with respect to its reputation in assuring that the offering is successful. Analysts are often an integral part of the investment banking team for initial public offerings assisting with "due diligence" research into the company, participating in investor road shows, and helping to shape the deal. Upbeat research reports and positive recommendations published after the offering is completed may "support" new stock issued by a firm's investment banking clients.

b) Client companies prefer favorable research reports: Unfavorable analyst reports may hurt the firm's efforts to nurture a lucrative, long-term investment banking relationship. An unfavorable report might alienate the firm's client or a potential client and could cause a company to look elsewhere for future investment banking services.

c) Positive reports attract new clients: Firms must compete with one another for investment banking business. Favorable analyst coverage of a company may induce that company to hire the firm to underwrite a securities offering. A company might be unlikely to hire an underwriter to sell its stock if the firm's analyst has a negative view of the stock.

2) Brokerage Commissions: Brokerage firms usually don't charge for their research reports. But a positive-sounding analyst report can help firms make money indirectly by generating more purchases and sales of covered securities which, in turn, result in additional brokerage commissions.

3) Analyst Compensation: Brokerage firms' compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, some firms link compensation and bonuses, directly or indirectly, to the number of investment banking deals the analyst lands or to the profitability of the firm's investment banking division.

4) Ownership Interests in the Company: An analyst, other employees, and the firm itself may own significant positions in the companies an analyst covers. Analysts may also participate in employee stock-purchase pools that invest in companies they cover. And in a growing trend called "venture investing," an analyst's firm or colleagues may acquire a stake in a start-up by obtaining discounted, pre-IPO shares. These practices allow an analyst, the firm he or she works for, or both to profit, directly or indirectly, from owning securities in companies the analyst covers.

Disclosure and Recent Rule Changes

The rules of the NYSE and NASD require analysts in some circumstances to disclose certain conflicts of interest when recommending the purchase or sale of a specific security. On May 10, 2002, the SEC approved proposed changes to these rules, strengthening the disclosures that analysts and firms must make. The NYSE and NASD decided upon an implementation schedule of between 60 and 180 calendar days for the new rules in order to provide reasonable time periods for firms to develop and implement policies, procedures and systems to comply with the new requirements. These rules implement key structural reforms aimed at increasing analysts' independence and further managing conflicts of interest. They also require increased disclosure of conflicts in research reports and public appearances.

What Conflicts May Mean to You

The fact that an analyst or the analyst's firm may have a conflict of interest does not mean that his or her recommendation is flawed or unwise. But it's a fact you should know and consider in assessing whether the recommendation is wise for you.

It's up to you to educate yourself to make sure that any investments you choose match your goals and tolerance for risk. Remember that analysts generally do not function as your financial adviser when they make recommendations, they are not providing individually tailored investment advice, and they're not taking your personal circumstances into consideration.

Learn the steps to Uncovering Conflicts With Analyst

Although all information has been written in good faith and reviewed, please email us at help@stockmarketbeginnersguide.com to report any inaccuracies.