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.  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.  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.  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.  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?