Recommendations ofRecommendations ofFinancial AnalystsFinancial Analysts

Structure of a brokerage firmStructure of a brokerage firm Front office operationsFront office operations

• All activities that involve client contactAll activities that involve client contact Back office operationsBack office operations

• All activities that support the front office All activities that support the front office operations operations

Proprietary operationsProprietary operations• Cash and risk management activities and Cash and risk management activities and

any speculative trading that the firm any speculative trading that the firm conducts for its own accountsconducts for its own accounts

Front office operationsFront office operations Sales and trading departmentSales and trading department

• Sales brokers interact with clientsSales brokers interact with clients• Floor brokers arrange trades at Floor brokers arrange trades at

exchanges exchanges Corporate finance departmentCorporate finance department

• Investment banking operationsInvestment banking operations Research department Research department

• Analysts provide services to various Analysts provide services to various departmentsdepartments

Customer service departmentCustomer service department• Help their clients manage their accountsHelp their clients manage their accounts

Back office operationsBack office operations Maintaining accountsMaintaining accounts Clearing and settling tradesClearing and settling trades Providing the information systems Providing the information systems

that the firm uses to transmit market that the firm uses to transmit market data, quotes, orders, etcdata, quotes, orders, etc

Ensuring that the firm extends credit Ensuring that the firm extends credit only to good credit risksonly to good credit risks

Ensuring compliance with regulationsEnsuring compliance with regulations

Proprietary operationsProprietary operations

All trading activities that the firm All trading activities that the firm conducts for its house accountconducts for its house account

For pure brokers, these include cash For pure brokers, these include cash management and the borrowing and management and the borrowing and lending of securitieslending of securities

Include principal trading as a dealer, Include principal trading as a dealer, speculator, or arbitragerspeculator, or arbitrager

Broker profitabilityBroker profitability RevenuesRevenues

• Commissions (deregulated in1975)Commissions (deregulated in1975)• Soft commissionsSoft commissions• Payment for order flowPayment for order flow• InterestInterest• Underwriting feesUnderwriting fees• Mergers and acquisition feesMergers and acquisition fees

Costs – labor costs and interest Costs – labor costs and interest paymentspayments

More on dual trading problemMore on dual trading problem Dual traders trade both as dealers and as Dual traders trade both as dealers and as

brokers (known as broker-dealers)brokers (known as broker-dealers) They fill client orders themselves for They fill client orders themselves for

internalized ordersinternalized orders• For client buy (sell) orders, they want sell (buy) For client buy (sell) orders, they want sell (buy)

at high (low) prices – Conflict of interest!!at high (low) prices – Conflict of interest!! They compete with clients when they want They compete with clients when they want

to trade on the same side of the marketto trade on the same side of the market• They want to trade first to get better price and They want to trade first to get better price and

also to benefit from the market impact of the also to benefit from the market impact of the others’ tradesothers’ trades

• Front runningFront running• Some markets prohibit all dual trading Some markets prohibit all dual trading

Ideally, analysts should be Ideally, analysts should be providing objective advice to providing objective advice to

investors on what stocks to buy, investors on what stocks to buy, using their expertise to help their using their expertise to help their

firm's clients make money.firm's clients make money.

Do they have incentives to do so?Do they have incentives to do so?

The answer appears to be “NO.”The answer appears to be “NO.”

Empirical FactsEmpirical Facts

Analysts follow & recommend Analysts follow & recommend stocks of good (highly rated) stocks of good (highly rated)

companies, not good (i.e., companies, not good (i.e., undervalued) stocks.undervalued) stocks.

• Marketing aids to brokersMarketing aids to brokers• Investor cognitive biasInvestor cognitive bias• Safety-net for their recommendations in Safety-net for their recommendations in

case case bad times come bad times come

• Stocks of highly rated companies do not Stocks of highly rated companies do not provide high returnsprovide high returns

Figure 1. Average Number of Analysts for Each S&P Stock Ranking

0

2

4

6

8

10

12

14

16

18

20

A+ A A- B+ B B- C D NRS&P's Common Stock Rankings

Nu

mb

er

of

An

aly

sts

NYSE/Amex companies

Nasdaq companies

Geom.Geom. Arith.Arith. Stan.Stan.

SeriesSeriesMean%Mean% Mean%Mean% Dev.%Dev.%

Sm StkSm Stk 12.612.6 18.818.8 39.739.7

Lg StkLg Stk 11.111.1 13.113.1 20.220.2

LT GovLT Gov 5.1 5.1 5.4 5.4 8.1 8.1

T-BillsT-Bills 3.8 3.8 3.8 3.8 3.3 3.3

InflationInflation 3.1 3.1 3.2 3.2 4.5 4.5

Annual Holding Period ReturnsAnnual Holding Period Returns

RiskRisk Real RealSeriesSeriesPremiums%Premiums% Returns% Returns%Sm StkSm Stk 15.0 15.0 15.615.6Lg StkLg Stk 9.3 9.3 9.9 9.9LT GovLT Gov 1.6 1.6 2.2 2.2T-BillsT-Bills --- --- 0.6 0.6

InflationInflation --- --- --- ---

Annual Holding Period Risk Premiums Annual Holding Period Risk Premiums and Real Returnsand Real Returns

Asymmetry between buy and sell Asymmetry between buy and sell recommendation frequenciesrecommendation frequencies

Marketing considerationsMarketing considerations Less than 1% of the recommendations Less than 1% of the recommendations

by brokerage firm analysts during the by brokerage firm analysts during the 2000 market plunge recommended 2000 market plunge recommended that investors sell shares.that investors sell shares.

Even during December 2000, when Even during December 2000, when the Nasdaq was way down, 2.1 the Nasdaq was way down, 2.1 percent of recommendations were to percent of recommendations were to sell and 71 percent of the ratings sell and 71 percent of the ratings were to buy.were to buy.

Optimistic recommendations to Optimistic recommendations to help investment banking help investment banking

businessbusiness Analysts are working side-by-side Analysts are working side-by-side

with investment bankers whose main with investment bankers whose main interest is in pushing the IPO, helping interest is in pushing the IPO, helping a firm with a merger, or arranging a a firm with a merger, or arranging a bond sale. bond sale.

Analysts are under pressure to say Analysts are under pressure to say only good things about the company only good things about the company because it's the investment banking because it's the investment banking end of the business that brings in the end of the business that brings in the most money.most money.

A Morgan Stanley internal memoA Morgan Stanley internal memo

““Our objective . . . is to adopt a Our objective . . . is to adopt a policy, fully understood by the policy, fully understood by the entire firm, including the entire firm, including the Research Department, that we Research Department, that we do not make negative or do not make negative or controversial comments about controversial comments about our clients as a matter of sound our clients as a matter of sound business practice.” business practice.”

Analysts and investment bankers Analysts and investment bankers are supposed to be kept apart by are supposed to be kept apart by a "Chinese Wall," but the wall is a "Chinese Wall," but the wall is full of holes, allowing analysts to full of holes, allowing analysts to become cheerleaders for their become cheerleaders for their firm's investment banking firm's investment banking clients.clients.

Analysts offer more favorable Analysts offer more favorable long-term earnings forecasts and long-term earnings forecasts and recommendations on companies recommendations on companies that are underwriting clients to that are underwriting clients to their brokerage firm.their brokerage firm.

Sell-side analysts’ long-term Sell-side analysts’ long-term growth forecasts are overly growth forecasts are overly optimistic around seasoned optimistic around seasoned equity offerings and analysts equity offerings and analysts affiliated with the lead affiliated with the lead underwriter make the most underwriter make the most optimistic forecasts. optimistic forecasts.

Both regional and national Both regional and national brokerage firms, which have brokerage firms, which have conflicts of interest emerging conflicts of interest emerging from their activities in both from their activities in both underwriting securities and underwriting securities and making investment making investment recommendations, produce more recommendations, produce more optimistic recommendations optimistic recommendations than non-brokerage firms.than non-brokerage firms.

Underwriters support the Underwriters support the aftermarket of their client aftermarket of their client companies through positive companies through positive analyst coverage and that buy analyst coverage and that buy recommendations by underwriter recommendations by underwriter analysts contain significant bias.analysts contain significant bias.

Lead underwriter is almost always Lead underwriter is almost always the primary market maker in the primary market maker in aftermarkets. aftermarkets.

Underwriters sponsor new issues Underwriters sponsor new issues by arranging analyst coverage, by arranging analyst coverage, promote the stock through promote the stock through marketing efforts, and provide marketing efforts, and provide liquidity by acting as the broker-liquidity by acting as the broker-dealer in subsequent secondary dealer in subsequent secondary market trading.market trading.

Vertical integration of brokerage Vertical integration of brokerage and dealer functionand dealer function

Internalzation and preferencingInternalzation and preferencing Dealers are more likely to make Dealers are more likely to make

markets for stocks that are markets for stocks that are tracked by the analysts affiliated tracked by the analysts affiliated with the same companywith the same company

Analysts issue earnings forecasts Analysts issue earnings forecasts more proactively for stocks that more proactively for stocks that are handled by affiliated market are handled by affiliated market makersmakers

Regulatory ActionsRegulatory Actions

The US SEC issued an "investor The US SEC issued an "investor alert" in June 2001alert" in June 2001

Examine a company's financial Examine a company's financial reports.reports.

Find out whether the analyst's Find out whether the analyst's brokerage firm financed a brokerage firm financed a company's recent stock company's recent stock offerings, especially IPOs.offerings, especially IPOs.

Learn as much as you can about Learn as much as you can about a company by reading a company by reading independent news reports.independent news reports.

US Congress hearingsUS Congress hearings

House Financial Services House Financial Services subcommittee on capital markets subcommittee on capital markets held a hearing in June 2001 to held a hearing in June 2001 to examine whether analysts have examine whether analysts have become cheerleaders for become cheerleaders for companies the analysts' companies the analysts' investment firms own stock in or investment firms own stock in or do business for, giving investors do business for, giving investors biased advice.biased advice.

Reactions from industry Reactions from industry groupsgroups

Industry groups are weighing in Industry groups are weighing in with suggestions for "best with suggestions for "best

practices" to help make sure practices" to help make sure that analysts are working with that analysts are working with

the best interests of investors in the best interests of investors in mind, not the investment mind, not the investment

banking clients that can bring banking clients that can bring millions in fees to their millions in fees to their

companies.companies.

The Securities Industry The Securities Industry Association (SIA) unveiled new Association (SIA) unveiled new

voluntary guidelines for analystsvoluntary guidelines for analysts Require analysts to clearly disclose Require analysts to clearly disclose

their holdings in companies they their holdings in companies they cover and prohibit them from trading cover and prohibit them from trading against their own recommendations.against their own recommendations.

Analysts should not have their pay Analysts should not have their pay directly linked to the investment directly linked to the investment banking transactions handled by their banking transactions handled by their firms for companies they cover.firms for companies they cover.

The National Association of The National Association of Securities Dealers (NASD)Securities Dealers (NASD)

Proposed rules that would Proposed rules that would require analysts to disclose require analysts to disclose potential conflicts of interest potential conflicts of interest when they recommend stocks on when they recommend stocks on television or in other public television or in other public appearances.appearances.

Association for Investment Association for Investment Management & Research (AIMR)Management & Research (AIMR)

Calls for better disclosure of Calls for better disclosure of potential conflicts of interest.potential conflicts of interest.

Cut ties between analysts and Cut ties between analysts and investment bankers.investment bankers.

Ban analysts from trading Ban analysts from trading against their own against their own recommendations to clients.recommendations to clients.

Reactions from individual Reactions from individual companiescompanies

Prudential SecuritiesPrudential Securities

Began requiring analysts to Began requiring analysts to reveal whether they or family reveal whether they or family members have $10,000 or more members have $10,000 or more invested in companies they invested in companies they cover.cover.

Merrill Lynch (July 2001)Merrill Lynch (July 2001)

Bans analysts from trading Bans analysts from trading stocks they cover. Also applies stocks they cover. Also applies to spouse and family members. to spouse and family members.

Analysts can keep already owned Analysts can keep already owned shares, but have to disclose shares, but have to disclose them in research reports.them in research reports.

Securities Investors Association Securities Investors Association of Singapore (SIAS) welcomes of Singapore (SIAS) welcomes the Merrill Lynch decision.the Merrill Lynch decision.

Roots of the problem and Roots of the problem and possible remediespossible remedies

Different sources of incomeDifferent sources of income

Corporate financing, brokerage Corporate financing, brokerage services, and proprietary trading. services, and proprietary trading.

Create conflicts of interest within Create conflicts of interest within the company and with its clients.the company and with its clients.

Compensation structure for Compensation structure for analystsanalysts

Analysts’ compensation is Analysts’ compensation is determined by their “helpfulness” determined by their “helpfulness” to the bank’s investment banking to the bank’s investment banking business.business.

Analysts’ compensation is also Analysts’ compensation is also determined by their “helpfulness” determined by their “helpfulness” to the company’s brokerage and to the company’s brokerage and market-making operations. market-making operations.

This incentive may outweigh their This incentive may outweigh their concerns for reputation capital.concerns for reputation capital.

To regain investor confidence,To regain investor confidence, Sell-side analysts’ compensation Sell-side analysts’ compensation

may not be tied to investment may not be tied to investment banking profits.banking profits.

Sell-side analysts may not be Sell-side analysts may not be allowed to make comments and allowed to make comments and recommendations on stocks recommendations on stocks underwritten by their companies. underwritten by their companies. How long? How long?

Sell-side analysts may be Sell-side analysts may be encouraged to issue balanced buy encouraged to issue balanced buy and sell recommendations.and sell recommendations.

Educate investors that most Educate investors that most analysts know no more than what analysts know no more than what they do about the TRUE value of they do about the TRUE value of stocks and that they are just stocks and that they are just sales/marketing people.sales/marketing people.

Focus more on L-T asset allocation Focus more on L-T asset allocation than S-T market timing and/or than S-T market timing and/or stock selection.stock selection.