Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Should We Ignore Stock Research From Big Bank Analysts?

By

Just like with bond rating agencies, sell-side equity research is fraught with conflicts of interest.

PrintPRINT
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.
< Previous
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
PrintPRINT

Busy? Subscribe to our free newsletter!

Submit
 

WHAT'S POPULAR IN THE VILLE