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When buy means hold
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October 31, 2000: 10:54 a.m. ET
As more investors own stock, more Americans have to read between the lines
By Staff Writer Alex Frew McMillan
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New York (CNNfn) - What does an analyst's recommendation mean? That's a good question, stock experts say, as investment banking fees have come to dominate big brokerages' profits. A positive call or opinion on a company may not always be what it seems.
One thing's for sure. Sell-side analysts so called because they research and issue reports for the retail arms of brokerages hardly ever say sell. In fact, Wall Street's top cop, Securities and Exchange Chairman Arthur Levitt, likes to joke that a sell recommendation is about as rare as a Barbra Streisand concert.
Sell recommendations less than 1 percent
He has a point, according to earnings tracker First Call. Analysts are remarkably bullish in their overt recommendations.
First Call tracked 28,000 analyst recommendations on U.S. companies at the start of October. Less than 1 percent of them were sells or strong sells.
Just under three-quarters 73.4 percent were either buys or strong buys. The rest of the recommendations were holds. (Though brokerages give different, often-confusing names to their recommendations, First Call forces them into a five-point system, from a 1 or 'strong buy' to a 5 or 'strong sell.')
 There are currently a few more buy recommendations 37.6 percent of all calls than normal, and fewer holds.
But the breakdown has been roughly one-third strong buys, one-third buys and one-third holds ever since First Call started tracking the information that way a half-decade ago.
"Analysts have always been biased. It's in their nature to be partial," said Joe Cooper, a First Call research analyst. "They're covering an industry because they believe in that industry, and they're covering the stocks that are the best in the industry."
Unwilling to break bad news
As Wall Street weathers a tough 2000, some investment banks are putting a premium on analysts who are willing to 'go negative,' analyst watchers say. But the vast majority of calls are still positive.
That's the result of a sort of inflation. There's a code, investment-industry insiders say. Everyone knows a hold is really a sell, a buy is really a hold, and a strong buy is really a buy.
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They're clearly providing a service and a marketing function to the investment-banking side of the business.
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Mike Thompson
BulldogResearch.com |
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Analysts tend to be unwilling to downgrade companies that might turn to their brokerage for future investment banking. Over the years, trading commissions which analysts produced by developing a following with an institution like a mutual fund -- have become less important than highly lucrative investment banking. Mergers and initial public offerings rack up big bucks.
And increasingly, analysts are part of the investment-banking package. They go on 'road shows' to review IPO prospects. Companies may favor a bank that has an analyst that carries clout and 'understands' the company. Analysts' bonuses may stem from the banking business they help bring in.
"They're clearly providing a service and a marketing function to the investment-banking side of the business," said Mike Thompson, co-president of analyst tracker BulldogResearch.com. "You're not going to win a lot of business by saying 'When you come out, I'm going to take a swat at you and make you look like garbage.' "
Once a company is public, analysts may feel pressure not to undermine the stock if their bank underwrote it. After all, their own company's brokers were touting the stock to its clients.
"Anyone who thought analysts are totally objective gets what they deserve," said Mark Hulbert, editor of the The Hulbert Financial Digest, which tracks newsletter writers. "Everyone knows it's going on."
Does everyone know the code?
So muted praise is not really praise at all. Silence from an underwriter's analyst speaks volumes. At worst, rather than giving a poor rating on a hopeless stock, brokerages will just drop coverage instead.
Well enough, albeit highly cynical, if you understand that. But Susan Wyderko, director of the Office of Investor Education at the Securities and Exchange Commission, said small investors don't always know the code.
She recently spoke with a fairly experienced, 70-year-old investor who was unhappy with his investments. He had followed the advice of a few stock pickers, he said, but seen his holdings drop. He was particularly disappointed because he had only invested in stocks rated 'strong buy,' 'buy' or 'hold.'
"I said, 'Oh my goodness,' " Wyderko recalled. When she told the investor that sell recommendations were in fact highly unusual, he was amazed. The investor was crestfallen to hear that his stock pickers weren't as bullish on his stocks as he'd thought.
Other signals from analysts are even tougher to read.
"You don't keep customers by insulting them or downgrading them," said Bill Burnham, a former analyst with Hambrecht & Quist and now a venture capitalist with Softbank. "When you're in a meeting with buy-side clients, you say 'This is an investment banking client.' It's a code word for 'I'm not going to be harsh on this client,' or 'You need to read between the lines.' "
A hint of trouble or a cagey comment is normally enough. So when an analyst is very positive about a stock his company underwrote, they may in fact only be mildly positive, Burnham explained. An analyst who is slightly negative may well be highly negative.
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I think as more and more Americans invest in the stock market, there needs to be better communication of the entanglements analysts have when they're making recommendations.
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Susan Wyderko
Securities and Exchange Commission |
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But the situation can still be confusing. Burnham often used to field calls from institutions asking what he 'really felt' about a company. Lay investors are more likely to take what analysts say at face value. They have less access to the clues and guidance a mutual-fund manager might get.
"I think as more and more Americans invest in the stock market, there needs to be better communication of the entanglements analysts have when they're making recommendations," Wyderko at the SEC said.
Though brokerages are required to declare certain trading and banking relationships including underwriting -- in print, analysts don't typically make the same disclosures on television. The SEC is exploring whether to require similar disclosures on TV.
Directional change means more than the call
And sometimes the code or a boilerplate disclosure isn't enough. Intel's announcement in September that its revenues would disappoint was greeted with a slew of analysts downgrades. But almost all the analysts also reiterated their 'strong buy' and 'buy' ratings.
Ashok Kumar at U.S. Bancorp Piper Jaffray was viewed as prescient for downgrading Intel from a strong buy to a buy prior to its earnings problem. But he still had a bullish call on the company. Factor in the occasional downgrade from the 27 or so other analysts that cover Intel (INTC: Research, Estimates), and the average call was still a 'buy.' Yet the stock tanked.
"I'm sitting there trying to figure that one out," said Thompson at BulldogResearch.com. "I guess it really doesn't matter any more, the actual rating, it's the directional change."
Overall, analysts tend to be lagging indicators rather than leading indictors, Thompson said. They rely on trends to predict future results, and so they tend to go with the current direction of a company and the market in general.
So when an analyst changes direction, "it's a big deal," Thompson said. Besides an analyst's past history, Thompson and others say it's also key to know an analyst's reputation when interpreting their remarks.
Prominent analysts such as Rick Sherlund, a software analyst with Goldman Sachs, have the clout to say what they want without fear of repercussion, Thompson said. They tend to be more candid as a result Junior analysts face more pressure to censor themselves.
A changing role?
Thompson thinks the role of analysts will shift now that the SEC's Regulation FD, or Fair Disclosure, has gone into effect. Analysts have placed a great emphasis on forecasting earnings accurately, and relying on guidance from the companies they cover to do so.
But Regulation FD, which bars selective disclosure, prevents companies from giving analysts a 'heads up' on their results, unless they release the information to the public at the same time. So analysts will prove themselves with their stock picking, he believes.
Reg FD went into effect in October. But most companies were already complying, for the third quarter.
BulldogResearch says that compliance has already had an effect, as reflected in the company's accuracy ratings.
In September, 28 percent of the companies reporting earnings had multiple winners for BulldogResearch's "most-accurate analyst" prize for anticipating their earnings. That's up from 20 percent in June, the prior quarter.
Thompson said that reflected less favoritism by companies relaying information to analysts. The most accurate analysts used to be the ones that had the best relationship with management, he said. They got better guidance.
Now more are able to come to the right conclusion on earnings, because more have the fullest information possible. "We're basically going to see how accurate a company is at predicting its own earnings," Thompson said. 
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