Chapter 8. Analysts


Chapter 8. Analysts

When Salomon Smith Barney's former star analyst Jack B. Grubman finally downgraded his assessment of WorldCom stocks to "neutral," the stock had already lost 90 percent of its value and was trading at $4 per share. [1] Merrill Lynch's former star analyst Henry Blodget never recommended selling Internet Capital, even though its stock price fell from $143 a share to 31 cents a share. [2] In fact, less than one month before Enron filed for bankruptcy, 11 out of 16 analysts had "buy" or "strong buy" ratings for Enron stocks. [3] Imagine! Are analysts terrible at analyzing? If so, why did Grubman make about $20 million a year?

Basically, analysts are paid to generate revenue for their firms. This, in and of itself, should not be surprising. However, you may think that they do this by providing their clients with unbiased analysis that is more often right than wrong, but this generally may not be the case. Instead, many analysts do more than just follow stocks. For example, Grubman attended board meetings and helped plan strategy for some of the firms that he analyzed . In fact, he helped Qwest recruit Joseph P. Nacchio as its CEO, and he provided assistance to Global Crossings in its acquisition of Frontier Communications. [4] These are not the normal duties of an analyst ”at least, they didn't used to be.

Perhaps the most significant divergence from the traditional function of analyzing is that more and more analysts became involved in the investment banking arm of their firms. On the surface, it may not seem troubling that analysts go beyond their explicit job descriptions. However, there is a serious conflict of interest problem. Consider this: Those same firms that Grubman analyzes are also investment banking clients of Grubman's employer, Salomon Smith Barney. Investment banking generates huge fees. Given this, would Grubman ever issue a non- glowing assessment of a firm that is also an investment banking client? What if Grubman also helped out with the investment banking deal? What are analysts really being paid to do? Are their recommendations for investors or for banking clients?

This chapter discusses securities analysts. We first consider their traditional roles in our capital markets ”to conduct research and recommend securities to clients. Then we look at their overall stock-picking abilities . They seem to be okay at it, but a recent SEC regulation may make their job a bit tougher. We go on to explore how analysts get compensated, which is important to understand when you consider the major conflict of interest that analysts face. Specifically, many analysts work for an investment bank, so they end up analyzing the same firms that their bank may wish to obtain as clients. Regulations to address this conflict of interest have passed. Will they work?


The Traditional Role of the Analyst

Analysts are supposed to analyze. This is their traditional role. For the firms that they are supposed to evaluate, they look at the operating and financial conditions, the immediate and long- term future prospects, the effectiveness of management teams , and the general industry outlook in order to make a useful assessment. Most analysts follow a specific industry so that they can gain expertise in a particular sector. For example, Grubman follows telecom stocks and Blodget used to cover Internet stocks. Based on their evaluations, analysts will make earnings predictions . Usually, they will try to predict the quarterly earnings per share (EPS) numbers . These predictions are useful to investors who rely on these estimates to determine the health of the companies in which they may or may not own stock. For example, many investors use P/E ratios (stock price divided by EPS) as an important gauge of a stock's attractiveness as an investment. Some investors like to examine forward-looking P/E ratios. That is, they use a P/E ratio in which the earnings are the estimate for the next year. Therefore, these earnings estimates of analysts are important and useful to investors.

Perhaps more importantly, the analyst is also supposed to make a recommendation to investors. For example, an analyst may recommend the buying or selling of a particular stock. These recommendations usually boil down to one-word or two-word recommendations such as "accumulate" or "buy." Unfortunately, these one-word recommendations are not standardized in the brokerage industry, which may lead to some confusion. Table 8-1 illustrates this point. [5]

Table 8-1. Three Examples of Analyst Recommendations

A

B

C

Buy

Strong Buy

Recommended List

Outperform

Buy

Trading Buy

Neutral

Hold

Market Outperformer

Underperform

Sell

Market Perform

Avoid

 

Market Underperformer

The table shows the stock rating system used by three different analysts' firms. A quick glance at the table reveals some potential problems. One analyst may use a five-category scale while another may use a four-category scale. Further, while both analysts A and C use a five-category scale, analyst A has two categories below average, but analyst C has only one category below average. Note also that a "buy" recommendation from analyst A is his highest recommendation, but for analyst B, it is only his second-highest rating. Lastly, each firm's definition of a market outperformer may be different. Is it for the upcoming one-year or two-year period? Is 5 percent or 10 percent considered outperformance? The answers depend on the analyst's firm.

However, given the recent scrutiny that is being placed on the analyst recommendations, there has been a trend toward making analysts' ratings uncomplicated. For example, analysts at Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Prudential will all be using a three- tier rating system to eliminate the ambiguity between ratings such as "strong buy" versus "buy." [6]

With regard to these recommendations, perhaps the most important point is that they are supposed to be timely . For example, if on a particular day an interested investor finds that the analyst's recommendation for a given stock is a "buy," then that recommendation should reflect the analyst's most updated opinion. This means the recommendation should be updated quite frequently. If a news item breaks that could potentially affect an analyst's recommendation, he or she has to revise and disseminate an updated recommendation immediately. For his or her largest customers, an analyst may even make a phone call. However, a revision to a recommendation may sometimes have to go through an approval process, which may take a couple of days. Lengthy research reports that are mailed out or personally presented to potential investors may also be a bit less than timely. Nonetheless, analysts are generally relied upon for timely advice.

The traditional role of analysts is to conduct thorough analyses of the firms that they are assigned to cover in order to make earnings estimates and trading recommendations. Further, they should also make timely stock recommendations. Are analysts good at these functions?