The Role of a Securities Analyst and Their Biases

It is important to first understand the function of a securities analyst at a brokerage firm. Brokerage firms are Wall Street investment banking firms on the sell side, “selling” investment securities primarily to institutional investors.

Unlike a stock analyst at a mutual fund, bank, or investment management firm, research analysts at a brokerage firm do not cater their research to portfolio managers. Their job is to research a particular industry sector and “sell” their research to the brokerage’s institutional clients.

Analysts narrow their focus on a limited number of companies to track them as thoroughly as possible. They want to be knowledgeable about as many details as possible so they can best assess how both internal and external factors will impact the company.

Having assessed the industry and an individual company’s outlook, analysts must then conclude if the company’s stocks are desirable investments (a Buy rating), have a high probability of devaluation (a Sell rating) or rate them somewhere between, and summarize their conclusions in a research report. All of the companies an analyst tracks must be observed and scrutinized continually, and the assessments communicated to various audiences, including: the brokerage firm’s institutional investor clients, the in-house sales force and traders on the desk, and outside media sources.

Brokerage research analysts do not deal with individual investors or their financial consultants. Rather, they are marketing their views to institutional investors.

The sales force at the brokerage firm caters first and foremost to institutional clients–mutual funds, hedge funds, pension funds, banks, and others. The sales force is continually relaying their analysts’ research to these firms.

While research analysts are required to assign ratings such as “Buy” or “Sell” to investments, institutional investors do not stress these ratings so much as an analyst’s industry knowledge. In fact, the analysts that were ranked highest in an Institutional Investor (II) magazine poll had some of the worst stock picks.

While brokerage analysts typically excel at providing thorough and analytical research about an industry and its companies, their record of rating stocks accurately is mediocre at best. This is because perceptive analysis and an astute understanding of companies and industries have little influence over an analyst’s investment recommendations.

The Wall Street system encourages this trend for five primary reasons:

1. Analyst Compensation. Analysts are compensated for their status on the Street, their access to CEOs, their profile and clout, and depth of knowledge as opposed to the accuracy of their investment ratings. Salaries depend on institutional client polls (e.g. the annual II rankings), their overall influence on the Street, institutional sales and trading evaluations, and generally subjective assessments by research department management.

There are no quantitative performance measurements. Author Stephen T. McClellan of the book “Full of Bull” goes so far as to say to “discount any flamboyant opinion upgrades from April to June” because the timing is suspiciously during when II votes are being angled for.

Consider that in 2006 the mean compensation for an II ranked analyst was $1.4 million versus $590,000 for un-ranked senior analysts. These kinds of incentives tarnish what should be more objective research.

2. Analyst Pressures. Analysts are risk averse to being wrong so they are typically late to change ratings. Brokerage analysts are often harshly critiqued so their reasons for choosing to downgrade a stock from a Hold to a Sell must be nearly unquestionable.

Most choose to ignore negative changes in a company for too long so that by the time the evidence is undeniable, most of a stock’s losses have already happened. For instance, only after Lehman Brothers’ stock fell from $80 per share to $7 did the three largest firms on Wall Street finally downgrade their ratings.

Additionally, brokerage firms realize that a shift of opinion from Hold to Sell will compel only a small portion of stock owners to sell the stock, thereby creating a commission for the firm. On the other hand, an upgrade to a Buy opinion is more easily marketed to all the firm’s investors and will generate vastly more transactions and commissions.

Analysts are therefore incentivized to rate stocks higher than they otherwise might. Consequently, it is virtually impossible to understand how enthusiastic or skeptical an analyst truly is simply from their published ratings.

A rating of Underperform could mean either the analyst suspects the stock will fall within a year or that it will not appreciate as much as its competitors with higher ratings. Conversely, a Hold rating could imply either that the analyst is leaning toward an upgrade to Buy but does not yet have enough evidence or that company’s outlook is poor, but they fear upsetting interested parties by downgrading to a Sell.

3. The Street’s Short Term Bias. Wall Street favors stocks that are rising now, not those that require patience to see significant upside. Just as downgrades are typically late, so too are upgrades to Buy.

Quarterly earnings reports are the Street’s “paramount milestone.” They carry considerable influence over stock valuation and are analyzed critically. Institutions are “trapped on the treadmill of quarterly performance evaluations” with very short investment time horizons.

Individual investors must recognize that analysts are writing for an audience of traders not investors. Analysts are torn between looking at long-term indicators such as earnings estimates or price targets, and the demands of institutional players such as mutual funds who measure performance quarterly and use those figures to compare themselves to the competition.

Consequently, analyst recommendations usually reflect how the stock might perform in a one to five month time span, not one to two years. Lastly, analysts are forced to make quick calls rather than quality ones. Once they have chosen a position, it is more likely they will stick with it even if later evidence suggests something else.

4. The Street’s Positive Bias. This positive bias is analogous to the auto industry. Regardless of the market, auto dealers have a vested interest to always say “buy.”

Similarly, Wall Street has a distorted number of Buy or Hold recommendations. Wall Street does not want to suggest capital preservation or any timely retreat from the market. Even in a deep bear market, brokerage firms need to convince investors to keep buying stocks.

5. The Street’s Big Companies Bias. A final bias is toward big companies/stocks with the greatest market capitalization. These securities are traded most frequently, held most extensively, and have the greatest institutional investor interest.

This also means that large companies tend to be excessively analyzed and reported on. The most researched sectors include technology, telecommunications, and healthcare because research departments place the most analysts where the most trading business is done, not necessarily where the best investment opportunities lie.