Security Analysts and
Conflicts of Interest
Jay R. Ritter
Cordell Professor of Finance
University of Florida
Security analysts who work for brokerage firms
that do investment banking, trade stocks
(brokerage), and provide research on these stocks
are known as “sell-side” analysts
I will focus exclusively on equity analysts
What do security analysts do?
Public pronouncements
– Buy/sell recommendations
– Target prices
– Earnings forecasts
– Written reports
What do security analysts do?
Private (telephone calls)
– Summarizing information
– Passing along private (inside) information
Sell-side security analysts are like professors
We don’t make money by selling our research
papers to PBFJ and other journals
We get paid indirectly through a higher salary if we
publish influential research papers
• Security analysts are paid indirectly if they
attract
- investment banking deals
- trading commissions that include soft dollars
• Soft dollars are investor commissions paid for
services in excess of pure trade execution.
Conflicts of interest
• Need to get information from management
• Need to appease investors long in stock
• Need to attract banking mandates
What do practitioners think?
“If an analyst is negative on you, you are not
going to hand their bank a significant role in
your stock issuance, that’s for sure. That
person becomes the mouthpiece to the
investment community for your firm.”
Amylin Pharmaceuticals CFO Mark Foletta,
as quoted in Investment Dealer’s Digest.
These conflicts create an incentive to issue
optimistic recommendations
During the TMT (Tech, Media, and Telecom)
bubble of the late 1990s, these conflicts of interest
became severe
Where were the regulators?
Recent years have seen major changes
The commissions per share paid by institutional
investors in the US have collapsed in the last
seven years from an average of about 4.5 cents
per share to about 1.5 cents per share
This is a weighted average of ECNs, “crossing
networks”, and full-service brokers
100
90
80
BUY
70
Per Cent
60
50
HOLD
40
30
20
10
SELL
0
July
00
Jan
01
July
01
Jan
02
July
02
Jan
03
July
03
Jan
04
July
04
Proportion of buy, hold, and sell recommendations from U.S. sell-side analysts, 2000-2004.
Source: Reuters Estimates
The Financial Services Authority (FSA)
in the UK has encouraged unbundling
The salaries of sell-side analysts have been falling
Many sell-side analysts have moved to the buy-side
In Europe and North America, junior analyst jobs
have been outsourced to India
More research is being offered on Asian stocks
What are the most important qualities of a good analyst?
a) Accurate earnings forecasts
b) Timely buy and sell recommendations
c) Insightful written reports
d) Setting up meetings with management
e) Accessibility/responsiveness of phone calls
f) Industry knowledge
Private value of information
Investors are willing to pay for information
only when it is valuable
Value can be measured as the ability to
generate positive abnormal returns
The private value of public information is zero
The private value of private information can be
considerable
This distinction is at the heart of the conflicts of
interest problem
Academic research
Grossman and Stiglitz (1980 AER) “The
Impossibility of Informationally Efficient Markets”
--There is an equilibrium degree of inefficiency
Underwriters
Affiliated: Managing syndicate members
– Lead underwriter(s)
– Co-managers
Unaffiliated
– Non-managing syndicate members
– All others
Are conflicts of interest different for affiliated
and unaffiliated analysts?
– Incumbent’s advantage
– Currying favor
Bradley, Jordan, and Ritter (2008 RFS) “Analyst
Behavior Following IPOs: The ‘Bubble Period’
Evidence”
Academic research focuses on public, measurable
info like EPS forecasts
Institutional investors don’t care about this info
But are these measurable variables correlated with
useful telephone calls?
A good book
Confessions of a Wall Street Analyst (2006)
by Dan Reingold with Jennifer Reingold
Dan Reingold was an II all-star analyst
who covered telecoms from 1984-2003
Summary
Analyst conflicts are difficult to regulate
because of the economics of information
Information has different public and private
value, so there is an externality
Academics are able to measure the public
pronouncements, which institutional
investors don’t care about