The Glass is Half Full

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New York, NY – In a blog posted yesterday, we noted various studies conducted over the past few years that reveal continued “excessive optimism” from sell-side research analysts.

Some authors see this trend to be a sign that the conflicts of interest that investment banks were accused of that led to the Global Research Analyst Settlement continue to plague the equity research industry.  However, we suspect that the optimism seen in sell-side research could be caused by a few factors inherent to the research process.

Human Nature

The first reason analysts tend to be overly optimistic is actually based on human nature — a phenomenon called “optimism bias“.  The following definition comes from Wikipedia.

“Armor and Taylor review a number of studies that have found optimism bias in different kinds of judgement. These include:

  • Second-year MBA students overestimated the number of jobs they would receive and their starting salary.
  • Students overestimated the scores they would achieve on exams.
  • Almost all the newlyweds in a US study expected their marriage to last a lifetime, even while aware of the divorce statistics.
  • Professional financial analysts consistently overestimated corporate earnings.
  • Most smokers believe they are less at risk of developing smoking-related diseases than others who smoke.

Students in one study rated themselves as much less likely than their peers (students of the same sex at the same college) to experience negative life events such as developing a drinking problem, having a heart attack, being fired from a job or divorcing a few years after getting married.”

This means that equity analysts, regardless of whether they come from the sell-side, buy-side, or from the ranks of independent analysts, need to guard against their own human natures to provide value-added research.

Analyst Familiarity

One reason that analysts tend to be “overly optimistic” about the stocks they cover is familiarity.  Various studies have shown that securities analysts that regularly cover a company often become enamored by the firm’s business model, the management, the firm’s products or services, and the stock.  Ultimately, the optimistic analyst loses his / her professional cynicism and “drinks the company’s cool aid.”

Fear of Management Reprisal

Sell-side analysts make their living, to a great extent, from their ability to gain access to company management.  As a result, most analysts must walk a fine line between providing insightful, objective analysis, and maintaining good communication with senior executives at the publicly traded companies they have under coverage.

Unfortunately, most analysts have heard stories of analysts being cut off from access to company managers because of a negative research note or a bearish recommendation.  Consequently, sell-side analysts are likely to err on the side of optimism rather than risk losing access to company management.

Conflicts of Interest

Of course, another potential reason for optimistic analyst earnings forecasts and BUY / SELL / HOLD recommendations could be the conflicts of interest associated with working for an investment bank.  Historically, investment banks were accused of putting significant pressure on analysts to provide positive ratings on a company in order to increase the liklihood that the firm might win a lucrative banking mandate.

However, the passing of Sarbanes Oxley, the Global Research Analyst Settlement, and other SEC rules have greatly reduced the probability that investment bankers would have the leverage to coerce analysts to give firms overly optimistic ratings that they did not feel was warranted.

Summary

We acknowledge that a wide range of studies reveal that sell-side research remains extremely optimistic (even when the stock market has declined sharply).  However, we are not convinced that this bullish leaning is a result of any nefarious attempt to defraud investors by convincing them to buy stocks of companies they actually believe are poor investments.  Instead, we suspect that much of the optimism currently seen by these studies is a result of issues like human nature, analyst familiarity, or even fear of management reprisals.  Of course, this view could also be overly optimistic.

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  1. Optimism or bias.

    Three other reasons that analysts and individual registered representatives may recommend buying a stock (rather than selling a stock):

    (1) When a client buys a stock the brokerage firm and the registered rep. (RR) can be fairly confident they are going to get the “round-trip” commission. If the recommendation is to sell the stock there is no assurance the cash freed-up will be reinvested with that broker or with RR, it may even be withdrawn from the account.

    (2) Many brokerage firms and registered reps. (RR) find that “making markets” or holding principal positions in stocks can be very profitable (why is that?). Registered representatives are paid a larger commission to sell principal stock (why is that?).

    (3) In brokerage, the chain of “supervision” favors the registered representatives which have the most profitable “production”. If a registered representative wants to curry the favor of his chain of “supervison” that RR should be mindful of (1) and (2) above.

    The chain of “supervison” manages several aspects of the RR’s business. For instance, in ebullent markets the distribution of hot IPO’s is controlled by the chain of “supervison”. You might say it’s Quattroned). And under the frequent conditions of downsizing the chain of supervision decides who has been productive for the company, and how the account of the downsized brokers will be reallocated within the “system”.

    Also to be noted, in retail brokerage the primary point of contact with the client is the RR. Why should anybody be surprised that most retail clients are unaware of independent research.

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