Some investors rely on stock analysts for opinions as to which firm’s stocks are overvalued and which are undervalued. Analysts can provide a service for investors by offering ratings on each stock. There is evidence that in some cases, analysts have recognized a firm’s problems before other investors in the stock market have done so. For example, a downgrade of a stock by a respected analyst often precedes a decline in the stock’s price.

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Why investor should not rely on stock analyst? Why stock analyst may not prevent deceptive accounting? I am going to reveal it in this post. Follow on…

 

Role of Analysts Employed By Securities Firms

By natural, stock analysts are commonly expected to have the skills and resources to see through deceptive accounting. Therefore, some investors rely on analyst’s recommendations, so that they do not have to use their own time to determine which stocks are over- or undervalued. To the extent that analysts can see through deceptive accounting, they can steer investors to the firms whose favorable accounting numbers are truly warranted and away from those whose numbers are not.

However, analysts will not necessarily be able to detect a firm’s deceptive accounting. There is a conflict of interests that encourages analysts to provide biased ratings. Analysts who are employed by securities firms tend to assign high ratings to the firms that they rate. Low ratings could create negative publicity for the firms that they rate, and the employers of those analysts would lose business from those firms.

Example

If the analyst of Securities Firm P rates Firm X as a “sell,” then Firm X is not likely to consider hiring Securities Firm P to help it with a possible merger or with a placement of new stock. Some analysts counter that they are under no pressure by their firm when assigning ratings. Yet, there are very few cases in which analysts employed by securities firms have assigned a “sell” rating to a firm that may potentially need consulting services.

In the case of Enron, 16 of the 17 analysts who worked for securities firms rated Enron a strong buy before its problems were publicized. One analyst at a securities firm that was providing some consulting services for Enron downgraded Enron’s stock in August 2001 (a few months before Enron’s financial problems were publicized) and was fired shortly thereafter.

 

Some analysts employed by securities firms have received additional compensation when they helped the firm generate new business.

Example

Assume that Firm Y wants to issue more stock, but will issue new stock only if it believes that its stock will be in demand by investors. An analyst employed at Securities Firm S assigns a superior rating to the stock of Firm Y, which makes investors have more confidence in this stock. Consequently, Firm Y decides to issue additional stock. It hires Securities Firm S to conduct the stock offering in exchange for $3 million in fees. Securities Firm S passes on 1 percent of this amount, or $30,000, to its analyst in the form of an additional bonus for generating that business.

In the above example, Securities Firm S did not order its employee analyst to assign superior ratings to all stocks. However, the securities firm did provide more compensation when the analyst generated business. The analyst knows that it is much easier to attract clients when potential clients have been given a superior rating.

 

The actual link between analyst compensation and the business generated by the analyst is not always direct. That is, an analyst’s contract will not necessarily state that the compensation will equal a specified percentage of the business generated for the employer. However, the analysts that generate more business tend to receive higher compensation. In any case, it is difficult to imagine that an analyst would be highly compensated by the employer when assigning low ratings to many of the client’s stocks.

Whether analysts assign inflated ratings to stocks because they are pressured to do so by their employers or because it is what they sincerely believe, their recommendations are of limited value. If you were at the racetrack, and the horse race expert stated that all the horses were excellent, the information would have no value. In the same manner, analysts’ insight is limited if they view all stocks as great buys.

The Enron scandal illustrated the conflict of interests of analysts. The attorney general of New York and the Securities and Exchange Commission (SEC) initiated their own investigations of inflated ratings. For example, internal email messages by analysts were criticizing the very stocks that they were rating highly.

 

The conflicts of interest stretch beyond the relationship between analysts and the investment banking business. The volume of brokerage transactions can also be affected by analyst ratings, as investors may buy stocks because of the high ratings assigned to them. In addition, some securities firms have subsidiaries that manage stock portfolios (such as mutual funds) for individuals. Analysts may be hesitant to rate some stocks poorly if they are held by portfolio managers who work within the same organization.

 

Role of Unaffiliated Analysts

Some analysts whose sole business is to rate stocks are not affiliated with a securities firm. Since they do not offer other services for the firms that they rate, they have no reason to provide biased ratings. These firms tend to have more sell recommendations than the affiliated analysts. However, even analysts without any bias may have difficulty rating firms that distort their financial statements. Until there are guidelines that force the accounting to reflect the firm’s actual operations, the abilities of analysts are limited.

 

New Rules For Analysts

On May 8, 2002, the SEC announced new rules for analysts that have been phased in. These rules are intended to generate unbiased recommendations by analysts and remove some of the conflicts of interest that have caused biased recommendations in the past.

A summary of the key changes is detailed below:

  • A securities firm that underwrites (sells) shares during an initial public offering (IPO) cannot report on that stock until 40 days after the IPO. This rule is intended to prevent the firm from using its analysts to promote the stocks it is selling. Historically, many IPOs have been complemented with favorable research reports by the analysts of the firms that served as underwriters. Critics argued that the analysts and underwriters were working together to place the stock, and that the analysts’ research on the stock was biased.
  • Analysts cannot be supervised by the investment banking department within the securities firm. This rule is intended to separate the analyst perspective from the investment banking perspective. Analysts should assign ratings to stocks without concern about whether the ratings will generate business for the investment banking department.
  • Analyst compensation cannot be directly tied to business transactions, such as the number of deals that were the result of analyst ratings. This rule may allow analysts to rate a stock in an unbiased manner.
  • Analyst ratings must disclose information about the recent investment banking business (if any) that the analyst’s firm has conducted for that firm, and about the analyst’s ownership of the stock.
  • Analyst ratings must also disclose the meaning of each type of rating. For example, ratings such as underweight or moderate must be defined so that investors understand what the rating means. In addition, analyst ratings must also provide a summary of the proportion of its ratings that are in each rating class. Under the new rules, investors will be more aware of the grade inflation that exists. When analysts of a specific securities firm rate 95 percent of all stocks as a buy, investors should recognize that the rating is not very informative.

 

The rules may prevent some blatant conflicts of interest, but there are some conflicts that will still continue, regardless of the rules:

  • First, even when analysts are completely separated from the investment banking department, their performance evaluation may still be affected by their ability to generate new clients for the securities firm. They are likely to be rewarded for generating more client business (even if there is not a specific formula in their contracts), which means that they still have an incentive to rate prospective clients highly.
  • Moreover, most analysts will still not be willing to assign low ratings to stocks of large firms that frequently need investment banking services, because of the potential harm (lost business) to the investment banking department.

 

The only way to truly prevent the conflict of interest between investment bankers and analysts is to separate the ownership of the entities. Since such a separation is unlikely to occur, analyst ratings will still be biased upward. The new SEC rules are essentially enforcing disclosure that will help investors recognize that analyst ratings are biased. However, some investors still will not recognize the bias. They may think that the majority of ratings are high because the analysts provide ratings only for a select set of stocks that they truly believe in.