Who Are the Stock Analysts

Stock analysts come in two varieties: buy-side and sell-side. Investment bankers, including most full-service brokerages, hire sell-side analysts to research stocks of interest. Originally, brokerages derived most of their income from commissions on stock sales, hence the term, sell-side analysts. These days, investment banking accounts for the lion’s share of full-service brokerage income, but the sell-side label is still applied.

Brokerages employ scores of analysts. Each typically covers a specific industry such as semiconductor equipment or restaurants. Analysts write research reports on their industry as a whole, and on specific companies within the industry. The analysts devise sales and earnings forecasts, buy, hold, or sell recommendations, and target prices for companies they follow. They update their forecasts and recommendations after each company’s quarterly report is released and at other times as events warrant. Sell-side analysts ratings and reports are widely distributed, and third parties such as First Call, Zacks Research, and Multex tabulate their ratings and estimates and publish them in the form of analysts’ consensus ratings and forecasts.

Mutual funds, pension plans, and other institutional players read the sell-side analysts’ reports, but many also employ their own analysts. These buy-side analysts do their own research and arrive at their own opinions about a company’s future prospects. The buy-side analysts’ reports are rarely publicized.

All of the ratings and forecasts that we hear about or see compiled, come from sell-side analysts. Analysts publish an in-depth report describing the business model, industry, and competitive situation when they begin coverage of a new company. After that, most analysts’ reports are short updates, typically responding to an earnings report or other news affecting the company’s outlook. Each report or update includes the analysts’ current buy/sell recommendation (rating), as well as earnings forecasts for upcoming quarters and for the current and next fiscal years. The report also provides background information justifying changes in the ratings or forecasts.

Analysts’ Ratings

The point of an analyst’s report is to advise clients whether to buy or sell the company’s stock. However, it’s not that simple. For instance, an investor planning on holding for five years might be buying a stock that an investor with a shorter horizon is selling. So analysts developed a variety of rating variations, and, to further confuse the issue, each brokerage has its own terminology. For instance, Goldman Sachs will put a stock on its Recommended List if it thinks it’s going up in short order, while Merrill Lynch might label it a short-term buy, and Prudential Securities would say strong buy. The only way you can be sure of a specific ratings definition is to consult the brokerage’s rating explanation, sometimes included with the report and sometimes not.

It’s not as complicated as it sounds, because in my experience, all analysts’ ratings other than strong buy equate to sell. Regardless of the spin, anything short of strong buy means that the analyst is not excited about the stock’s prospects and probably wouldn’t add it to his own portfolio.

“Sell” Is a Four-Letter Word

Sell-side analysts are real people like you and me who happen to have very well-paying jobs. You can’t blame them for wanting to hold onto those jobs. Their employers, mostly brokerages, derive much of their profits from investment banking, that is, working with companies when they issue more stock, make acquisitions, borrow money, and so forth. How much money is involved? Say an investment banker brings a new company public by underwriting its IPO. The underwriting fee is negotiable of course, but think 7 percent. So a deal is worth 7 percent of $150 million, or $10.5 million, if the new company issues 10 million shares at an initial offering price of $15. When one company acquires another, both firms hire investment bankers to advise them on the transaction, involving fees running into tens of millions of dollars.

With that much money involved, the competition among investment banks to land these juicy contracts is intense. Naturally, the client, say a new company going public, picks the bank it believes will do the best job, meaning the one that will get the most shares sold at the highest price, and equally important, keep the share price up after the IPO. The latter is important because company insiders personally own tons of shares they will eventually want to sell. That’s where the analyst comes into the picture. A highly regarded analyst’s strong buy recommendation can make a big difference in a stock’s trading price.

According to a January 29, 2001, Wall Street Journal story, analysts receive “bonuses of several hundred thousand dollars for helping their firms win big underwriting deals.” You can connect the remaining dots on your own. Most public corporations represent potential investment banking business of some sort. Executives at these companies usually have incentives to keep their firm’s share price up. They may be on bonus plans tied to the share price, have stock options, or own shares outright. It’s understandable that most take it personally when an analysts’ sell recommendation tanks their company’s stock price. Since they’re in a position to get even by diverting investment banking business to another firm, analysts get the picture, and most don’t see anything to gain by advising selling a stock.

Consequently, most analysts don’t issue sell ratings. Instead they say, hold, neutral, or market perform, and the pros know that means sell. On occasion, analysts do want to advise selling, but some brokerages don’t allow sell ratings. So, the policy of the analyst’s brokerage house determines whether a stock will be rated hold or sell, not the analyst’s view of the stock’s prospects. As a rule of thumb, interpret hold, sell, and strong sell ratings as sell.

Analysts use terms such as buy, accumulate, long-term buy, outperform, and the like, to specify ratings between strong buy and sell. These ratings mean that the analyst isn’t sure which way the stock is headed, at least in the near future.

Note: Standard & Poor’s analysts are the exception to the hold means sell rule. S&P does issue sell ratings, and a hold recommendation means exactly that; don’t sell if you own it, but don’t buy it either.