The Sell-side Just can’t Bear it

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New York – A short article written by Douglas McIntyre of 24/7 Wall Street, recaps a Financial Times article that indicates that sell side analysts are still too bullish, despite markets that have fallen between 20 and 30 percent so far this year. The article points to the proportion of sell recommendations to overall recommendations being 6.7 per cent: hard to believe.

The author points out that perhaps this reticence of analysts to issue sell ratings is related to their concern that if they are not positive on a company’s stock, they may lose access to management. We note that in the Institutional Investor survey of best analysts (October 08), access to management is number 4 on a list of 12 attributes that institutional investors feel they receive from their sell side research providers (see table below). However, there are two reasons why this may not be the main reason. First, the II review’s third strongest attribute is analyst integrity, which would seem to trump access to management in the eye of the investor. Second, reg FD, while having leveled the playing field for the average investor has, both put management opinion in the hands of many-thereby diluting its value-and made management less willing to share important information. In either case there is not enough rationale here to explain the lack of sell recommendations.

Rank Sell-Side Research Attribute
1 Industry Knowledge
2 Analyst Accessibility/Responsiveness
3 Analyst Integrity/Professionalism
4 Access to Management
5 Special Services
6 Written Research Reports
7 Idea Generation
8 Useful and Timely Calls and Visits
9 Financial Models
10 Earnings Estimates
11 Research Delivery
12 Stock Selection
Source: Institutional Investor, October 2008

A far more cogent explanation may be fear of market impact. Let’s look at the current situation in the banking sector. Suppose that a banker indicates to the press that he is concerned that his bank may be overleveraged, or have an insufficient deposit base. These statements could create a run on deposits that would result in the failure of the bank: analogous to what happened to Bear Stearns. Bear probably had stronger capital ratios that most other bulge bracket firms when it was taken down: primarily by rumor and innuendo.

While understanding the motivation does not excuse the behavior, it would seem prudent to completely disregard sell-side analyst research in bear markets. So what should we be looking at for guidance in a bear market? The naturals are the forensics, the quants, the techs and independent fundamental analysts that have no stake in the market. Additionally, there is a much greater need for investors to find their own course. As such, primary research would be a benefit in refining or testing investment hypotheses.

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  1. Probably has more to do with the fact that analysts, and the managers of the companies being analysed, tend to focus on company specifics rather than macro themes.
    Company managers are usually very good at managing their businesses – they know their company, their staff, their products, their market and their competitors. But very few have any significant comprehension of the macro events shaping the political, economic and social environment within which they operate. It would probably also not be unreasonable to suggest that business managers tend to put forward a positive interpretation of events to analysts. How many directors of UK house-builders, retailers (or banks, for that matter) stood up in 2006, or even 2007, and said that evolving macro issues suggested there was a real possibility that their company, and many others in the same industry, would be experiencing extreme difficulties in 2008-9, with a real prospect of insolvency? Zippo.
    A similar argument can be applied to most analysts, who, collectively, are good at ranking companies in order of attractiveness within their respective industries – but who have limited understanding of the impact of macro themes on the sector itself, and who, by and large, pay limited attention to such considerations in their recommendations.
    The regulatory constraints on the dissemination and – more importantly – the use of price sensitive corporate information means that stock specific analysis cannot consistently add significant investment value. For fund managers/ institutional investors, the identification and interpretation of ‘macro-themes’ is, overwhelmingly, a much more significant contributor to performance differentials – as recent years have so powerfully illustrated.

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