Recommendations of
Financial Analysts
Structure of a brokerage firm

Front office operations
• All activities that involve client contact

Back office operations
• All activities that support the front office
operations

Proprietary operations
• Cash and risk management activities and
any speculative trading that the firm
conducts for its own accounts
Front office operations

Sales and trading department
• Sales brokers interact with clients
• Floor brokers arrange trades at
exchanges

Corporate finance department
• Investment banking operations

Research department
• Analysts provide services to various
departments

Customer service department
• Help their clients manage their accounts
Back office operations





Maintaining accounts
Clearing and settling trades
Providing the information systems
that the firm uses to transmit market
data, quotes, orders, etc
Ensuring that the firm extends credit
only to good credit risks
Ensuring compliance with regulations
Proprietary operations



All trading activities that the firm
conducts for its house account
For pure brokers, these include cash
management and the borrowing and
lending of securities
Include principal trading as a dealer,
speculator, or arbitrager
Broker profitability

Revenues
• Commissions (deregulated in1975)
• Soft commissions
• Payment for order flow
• Interest
• Underwriting fees
• Mergers and acquisition fees

Costs – labor costs and interest
payments
More on dual trading problem


Dual traders trade both as dealers and as
brokers (known as broker-dealers)
They fill client orders themselves for
internalized orders
• For client buy (sell) orders, they want sell (buy)
at high (low) prices – Conflict of interest!!

They compete with clients when they want
to trade on the same side of the market
• They want to trade first to get better price and
also to benefit from the market impact of the
others’ trades
• Front running
• Some markets prohibit all dual trading
Ideally, analysts should be
providing objective advice to
investors on what stocks to buy,
using their expertise to help their
firm's clients make money.

Do they have incentives to do so?

The answer appears to be “NO.”
Empirical Facts
Analysts follow & recommend
stocks of good (highly rated)
companies, not good (i.e.,
undervalued) stocks.
• Marketing aids to brokers
• Investor cognitive bias
• Safety-net for their
recommendations in case
bad times come
• Stocks of highly rated companies
do not provide high returns
Figure 1. Average Number of Analysts for Each S&P Stock
Ranking
20
18
NYSE/Am ex com panies
16
Nasdaq com panies
Number of Analysts
14
12
10
8
6
4
2
0
A+
A
A-
B+
B
B-
S&P's Common Stock Rankings
C
D
NR
Annual Holding Period Returns
Geom.
Arith.
Series
Mean% Mean%
Sm Stk 12.6
18.8
Lg Stk
11.1
13.1
LT Gov
5.1
5.4
T-Bills
3.8
3.8
Inflation 3.1
3.2
Stan.
Dev.%
39.7
20.2
8.1
3.3
4.5
Annual Holding Period Risk Premiums
and Real Returns
Series
Sm Stk
Lg Stk
LT Gov
T-Bills
Inflation
Risk
Premiums%
15.0
9.3
1.6
---
---
Real
Returns%
15.6
9.9
2.2
0.6
---
Asymmetry between buy and sell
recommendation frequencies
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Marketing considerations
Less than 1% of the
recommendations by brokerage firm
analysts during the 2000 market
plunge recommended that investors
sell shares.
Even during December 2000, when
the Nasdaq was way down, 2.1
percent of recommendations were to
sell and 71 percent of the ratings
were to buy.
Optimistic recommendations to
help investment banking
business


Analysts are working side-by-side
with investment bankers whose main
interest is in pushing the IPO, helping
a firm with a merger, or arranging a
bond sale.
Analysts are under pressure to say
only good things about the company
because it's the investment banking
end of the business that brings in the
most money.
A Morgan Stanley internal memo

“Our objective . . . is to adopt a
policy, fully understood by the
entire firm, including the
Research Department, that we do
not make negative or
controversial comments about
our clients as a matter of sound
business practice.”

Analysts and investment bankers
are supposed to be kept apart by
a "Chinese Wall," but the wall is
full of holes, allowing analysts to
become cheerleaders for their
firm's investment banking clients.

Analysts offer more favorable
long-term earnings forecasts and
recommendations on companies
that are underwriting clients to
their brokerage firm.

Sell-side analysts’ long-term
growth forecasts are overly
optimistic around seasoned
equity offerings and analysts
affiliated with the lead
underwriter make the most
optimistic forecasts.

Both regional and national
brokerage firms, which have
conflicts of interest emerging
from their activities in both
underwriting securities and
making investment
recommendations, produce more
optimistic recommendations than
non-brokerage firms.

Underwriters support the
aftermarket of their client
companies through positive
analyst coverage and that buy
recommendations by underwriter
analysts contain significant bias.


Lead underwriter is almost always
the primary market maker in
aftermarkets.
Underwriters sponsor new issues
by arranging analyst coverage,
promote the stock through
marketing efforts, and provide
liquidity by acting as the brokerdealer in subsequent secondary
market trading.
Vertical integration of brokerage
and dealer function



Internalzation and preferencing
Dealers are more likely to make
markets for stocks that are
tracked by the analysts affiliated
with the same company
Analysts issue earnings forecasts
more proactively for stocks that
are handled by affiliated market
makers
Regulatory Actions
The US SEC issued an "investor
alert" in June 2001



Examine a company's financial
reports.
Find out whether the analyst's
brokerage firm financed a
company's recent stock offerings,
especially IPOs.
Learn as much as you can about
a company by reading
independent news reports.
US Congress hearings

House Financial Services
subcommittee on capital markets
held a hearing in June 2001 to
examine whether analysts have
become cheerleaders for
companies the analysts'
investment firms own stock in or
do business for, giving investors
biased advice.
Reactions from industry
groups
Industry groups are weighing in
with suggestions for "best
practices" to help make sure
that analysts are working with
the best interests of investors in
mind, not the investment
banking clients that can bring
millions in fees to their
companies.
The Securities Industry
Association (SIA) unveiled new
voluntary guidelines for analysts


Require analysts to clearly disclose
their holdings in companies they cover
and prohibit them from trading
against their own recommendations.
Analysts should not have their pay
directly linked to the investment
banking transactions handled by their
firms for companies they cover.
The National Association of
Securities Dealers (NASD)

Proposed rules that would
require analysts to disclose
potential conflicts of interest
when they recommend stocks on
television or in other public
appearances.
Association for Investment
Management & Research (AIMR)



Calls for better disclosure of
potential conflicts of interest.
Cut ties between analysts and
investment bankers.
Ban analysts from trading
against their own
recommendations to clients.
Reactions from individual
companies
Prudential Securities

Began requiring analysts to
reveal whether they or family
members have $10,000 or more
invested in companies they cover.
Merrill Lynch (July 2001)


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Bans analysts from trading
stocks they cover. Also applies to
spouse and family members.
Analysts can keep already owned
shares, but have to disclose them
in research reports.
Securities Investors Association
of Singapore (SIAS) welcomes
the Merrill Lynch decision.
Roots of the problem and
possible remedies
Different sources of income


Corporate financing, brokerage
services, and proprietary trading.
Create conflicts of interest within
the company and with its clients.
Compensation structure for
analysts



Analysts’ compensation is
determined by their “helpfulness”
to the bank’s investment banking
business.
Analysts’ compensation is also
determined by their “helpfulness”
to the company’s brokerage and
market-making operations.
This incentive may outweigh their
concerns for reputation capital.
To regain investor confidence,


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Sell-side analysts’ compensation
may not be tied to investment
banking profits.
Sell-side analysts may not be
allowed to make comments and
recommendations on stocks
underwritten by their companies.
How long?
Sell-side analysts may be
encouraged to issue balanced buy
and sell recommendations.


Educate investors that most
analysts know no more than what
they do about the TRUE value of
stocks and that they are just
sales/marketing people.
Focus more on L-T asset allocation
than S-T market timing and/or
stock selection.