The US Justice Department’s recent civil lawsuit against credit rating agency Standard & Poor’s
(NYSE:MHP) sparked a debate about the role of bond rating agencies and whether or not they are able to provide independent ratings.
The issue at hand is a fundamental conflict of interest for the likes of S&P, Moody’s
(NYSE:MCO), and Fitch, who compete to get investment banks to pay them to rate their securities.
A similar conflict of interest also exists in sell-side equity research, where an investment bank could issues stock research on a company on the one hand, and actively sell the same stock to its clients on the other.
For example, if a publicly held company like Apple
(NASDAQ:APPL) were to conduct a follow-on offering, it would be unlikely to hire an investment bank who has a Sell rating on its stock to be the deal’s underwriter, Nick Landell-Mills, a former Citi
(NYSE:C) equity analyst, tells Minyanville.
“A bank can’t go to the stock market from a commercial perspective and try and sell shares when their analyst is saying it’s overvalued,” says Landell-Mills. “There’s no regulation that says you can’t do that, but in practice it would never happen.”
Banks argue that their stock analysts operate independent of their investment banking colleagues due to the so-called "Chinese wall" between the two divisions, which prevents information sharing that might influence any decisions. The 2003 Global Analyst Research Settlement
between the SEC and 10 Wall Street firms further emphasized the importance of the wall. Since then, for instance, analysts’ compensation stopped being tied to the amount of investment banking revenue they either directly or indirectly brought to their employer.
Landell-Mills argues, however, that the Chinese wall does not exist in practice because there's still a lot of informal and unofficial communication between a bank’s research and investment banking departments.
“They go drinking after work, attend social events, or meet for lunch, so there’s communication between them,” Landell-Mills explains.
When asked about the Chinese wall, Aswath Damodaran, a finance professor at the Stern School of Business at New York University, acknowledged its presence but said that it did not make a difference in ensuring independent stock coverage.
“The bias of an equity research analyst comes from having to maintain good relations with the firms they cover, since they can be shut out entirely from the process if they are viewed unfavorably by these firms,” Damodaran told Minyanville in an email interview.
“Sell-side equity research analysts are the tools for momentum investing. They don't value stocks. They price them. While they sometimes act as cheerleaders for companies that their firms may have investment banking relationships with, their bigger problem is their herd mentality. Thus, even with no conflicts of interests, I would not attach much value to their recommendations,” he elaborated.
According to Landell-Mills, institutional investors, who make up the bulk of equity research readers, are more than familiar with the potential biases of stock analysts.
“It’s been well-understood for years in asset management that if a company has a Hold recommendation, that actually means Sell, and if it has a Buy it means Hold and if it has a Strong Buy, it means Buy,” he explains.
Since everyone knows the game and how it’s played, is the inherent conflict of interest not that big a deal then? Not quite, says Landell-Mills.
“Even though everybody knows these informal rules, you’ve got all these small retail investors who don’t know the rules and they get caught out,” he shares, adding that the difference in impact between a Hold or Sell recommendation is enormous. “If you don’t say Sell, it just doesn’t come across. Hold doesn’t come across as powerfully as coming out and saying Sell. So even though you have all these informal rules, it still doesn’t have the same effect psychologically [on investors.]”
For Damodaran, institutional investors are part of the problem because, like equity analysts, they “are just as much creatures of momentum.”
“As I see it, sell-side equity research analysts and institutional investors deserve each other and they have the results, or lack thereof, to show for it,” he quipped. It might seem surprising that banks, who presumably would be concerned about their reputations for putting out accurate research, would issue dodgy advice. After all, investors can always check up on the reputations of equity analysts by turning to the business publication, Institutional Investor,
which ranks analysts annually based on the accuracy of their calls. However, Landell-Mills says that wining banking business from commercial companies is far bigger a priority.
“The Morgan Stanley
(NYSE:JPM), and Goldman Sachs
(NYSE:GS) brands are so strong and so well-entrenched in investors’ minds that their analysts can make the worst mistakes or the worst recommendations one month, and publish an equity research report the month after that everyone still reads because it’s Goldman,” explained Landell-Mills on the hold investment banks have over investors, traders, and asset managers.
“We need to stop putting these banks on pedestals but that’s extremely hard to do. They are big organizations who generate a lot of profit. So it’s natural to think: It’s Goldman and it’s successful, so I want to associate with it and I want to listen to what they’re doing and thinking,” he continued.
Realizing that there was a gap in the market for objective equity research, Landell-Mills started his own buyer-pays independent firm, Indigo Equity Research
, in 2009. Both institutional and retail investors can access his firm’s research, which he says does not focus on proving a Buy, Sell, or Hold recommendation.
“I focus on describing the company and what’s going on, and I provide an opinion, and I leave it to the reader to decide what he wants to invest in based on his risk profile,” shares Landell-Mills. “Because what I found when I worked in private banking was that you can walk into one meeting with a private client and recommend selling Amazon
(NASDAQ:AMZN), and walk into the next meeting with a different client five minutes later and offer the reverse recommendation. It really depends on the individual’s situation, his view of the market, whether he thinks the market is going up or down, and if he wants to be heavily exposed to volatility.”
Landell-Mills says that it is unlikely that independent equity research firms like his will go mainstream because investment banks simply are much better connected to the business and money management world.
“[Investment banks’ analysts] will visit all the asset managers in person, where they do presentations, and connect them to companies’ management,” he says. “For example, they would take the management of General Electric
(NYSE:GE) or AT&T
(NYSE:T) to meet the asset managers. They provide all these services, like taking them out for lunch, on business trips, to skiing, or to Las Vegas. These events occur much less than before, but they still happen.”
Even if independent research firms are able to avoid conflicts of interest, Damodaran was still skeptical of their ability to offer high-quality stock recommendations.
“The average active portfolio manager delivers about 1% less than the S&P 500
(INDEXSP:.INX). The average analyst, with or without bias, is going to do about the same. After all, what is the competitive advantage that an analyst has over the rest of us in a market like the US, where all information is available for anyone with an online connection?” he said.
Retail investors, Damodaran added, should ignore all equity research reports. “Read them for comedic value, not for investment value.”