Don't be taken in when an analyst says, "Buy." Even if they believe it, there are other factors and conflicts you should be aware of.
This article published with permission from InvestmentU.com.
In early May, I was intrigued when a few brokerage firms “initiated” coverage of Facebook with “Buy” ratings and price targets in the mid-$40 range — even before the stock was publicly traded. Now, if the stock were to trade near its $38 IPO price, is it still a “Buy” if it’s only going to get to the mid-40s?
Given the disappointing post-IPO performance of the stock and questions about what a particular analyst said or didn’t say to some clients, I thought it would be a good time to look at what makes a sell-side technology equity research analyst tick.
More importantly, how do they generate revenue for their firms?
For the most part, a technology equity analyst (which I have been for the past 14 years) is an honorable, hard-working person trying to make a decent living in a highly competitive environment where trading commissions are declining. But what you need to know is that, in most cases, the analyst isn’t compensated if they make you — John or Jane Q — money on stock picks. From a purely economic standpoint, they simply don’t care.
Saturday Night Live
Billy Crystal used to have a recurring skit when he was a regular on called Fernando’s Hideaway. That’s the one where he coined the phrase “You Look Mahvellous!” In the skit, he would frequently utter the saying, “It is better to look good than to feel good.”
For the typical sell-side analyst, it’s better to look good than to be good. It’s more important to be interesting than it is to be right.
My point is — don’t be taken in when an analyst says, “Buy.” I’m certain they believe it, but there are other factors and conflicts you should be aware of.
“Buy,” “Sell,” or “Hold”
To understand why, let’s review what an analyst does. The analyst works hard to produce a report, sometimes fairly detailed, sometimes with a unique perspective, sometimes merely updating investors on current events, but almost always with a “Buy,” “Hold,” or “Sell” recommendation attached to it.
This report is summarized in “The Morning Meeting,” where the analyst conveys the essence of the message to the sales force. The sales force then may ask questions of the analyst to better understand the message. Ultimately, the salesperson then gets on the phone to their clients to deliver the message — “we say ‘Buy’ XYZ today, and here’s why.”
In many cases, the top clients are the large mutual funds and hedge funds. Why? They’re the ones that pay the most commission dollars. If the portfolio manager at the fund finds the comment interesting, he may place a trade with the brokerage firm issuing the research report. And that is primarily how the cash register rings.
Now, please notice that I said “finds the comment interesting.” I did not say “finds the comment convincing.” Let’s look at why.
When asked what they value in sell-side research, portfolio managers typically point to “idea generation” and “access to management.”
They do not say, “We look for the best stock pickers.” There are two obvious reasons why they don’t say this.
If they admitted that they got their stock picks from listening to a sell-side analyst, they would be failing to justify their own existence.
The sell-side analyst who truly is a great stock picker ends up on the buy side. That’s where the decisions are made, and that’s where a good stock picker is worth the most money.
So, whether it’s self-serving or not, the buy side will admit to paying little attention to whether an analyst has a “Buy” rating or not. They’re looking for the incremental things — is this analyst looking at something differently, have they spoken to somebody I haven’t that may have a particular insight, have they recently spent time with the management team?
Believe it or not, there’s nothing sinister in this. It’s just a natural result of the environment for an analyst. Just remember as an individual investor not to put too much value the next time you see a report stating an analyst rates a stock a “Buy,” “Hold,” or “Sell.”