This is what a well known professor explains in the below lines, so do check it out and write your comments.
An analyst’s pessimistic outlook is more to be trusted than an optimistic view — Bijoy Ghosh.
D. Murali
With coverage of the stock markets expanding sharply, ‘analyst’ reports and recommendations are now widely available to every lay investor. But should investors take these sound bytes at face value?
Maybe not, observes Mr Siva Nathan, Associate Professor in the School of Accountancy of Robinson College of Business, Georgia State University, US. He feels that full service brokerage firms (firms that offer complete advice) have transported their US model to India and this brings with it several problems.
“The sell-side analysts working for these firms in India have the same conflict of interest problem that they had in the US before the regulations,” he cautions, during the course of an e-mail interaction with Business Line. “They are overly optimistic on the firms they cover.”
Mr Nathan — a commerce graduate from the University of Bombay, an MBA from the University of Rochester, and a Ph.D from the State University of New York at Buffalo — co-authored in 1995 a paper titled ‘The Effect of Investment Banking Relationships on Financial Analysts’ Earnings Forecasts and Investment Recommendations.’“The Indian stock market has been booming, but I am afraid much of this may be due to the over-optimism of these analysts,” fears Mr Nathan.
Mr Siva Nathan, Associate Professor, Robinson College of Business, Georgia State University, US.
A lot of the blame for the collapse of the Internet firms in the US was traced to the over-optimism of the sell-side analysts, he says.
Excerpts from the interview.
You have done research on US financial analysts. What were the important findings that your work yielded? Has much changed since then?
In the US, most sell-side analysts work for full-service brokerage firms (FSBFs) such as Merrill Lynch, Goldman Sachs, Morgan Stanley, etc. These firms have three major departments:
The research department, where the analyst works.
The investment banking (IB) department, which does the IPOs (initial public offers), bond issues, seasoned equity offerings (firm is already public but is issuing more shares), and M&A (merger and acquisition).
This department is very profitable and the dollars involved are huge.
The trading department, which buys and sells shares on behalf of the brokerage firm’s customers and earns brokerage commission.
My research focused primarily on the relationship between the research department and the investment banking department of the firm.
I found that sell-side analysts working for the firm were more optimistic about a company (relative to other analysts following the same company) both in terms of earnings forecasts and investment recommendations when their brokerage firm had an investment banking relationship with that company.
The analysts were optimistic because they were rewarded based on getting investment banking business for their firm.
The companies the analysts are following will give such business to that firm only if that firm’s analyst is optimistic about that company.
A lot of the blame for the collapse of the Internet firms in the US was traced to the over-optimism of the sell-side analysts working for brokerage firms.
In 2002, regulation was passed in the US prohibiting analysts from being compensated based on anything other than their performance with respect to earnings forecasts and investment recommendations.
In other words, they cannot be compensated based on bringing in investment banking business for their IB department or generating brokerage commission for their trading department.
Since this regulation was passed, sell-side analysts of the FSBF have become less optimistic and they are now issuing more sell recommendations. So I would say the US regulation has been effective.
What are the top traps we need to be cautious about?
In addition to the conflict of interest problem, in the US there was another problem pertaining to analysts. The management of a firm had its favourite analysts.
They would give private information to them (most of these analysts worked for the FSBF).
These analysts would pass on this information to their favourite clients, who would then trade on these stocks and make money. Management, of course, would release the same information publicly a few days later.
In 2000, the SEC passed ‘Reg FD’ (Regulation Fair Disclosure), which required that if management had information to disseminate, it will have to disclose it publicly to everyone at the same time.
sIn other words, releasing information privately to selected analysts beforehand is now prohibited. Again, research has shown that Reg FD has been very effective in curbing insider trading.
In India, I am sure management has its own ‘chela’ analysts to whom it gives private information. So this problem also needs to be fixed, again by SEBI.
Are there clear drivers behind any undue optimism on the part of the analyst?
Overall, an analyst has incentive to be optimistic for three reasons:
First, being optimistic keeps an analyst in the good books of management. Why would management talk to an analyst who is negative about the company?
Second, issuing buy recommendations generates more trading commission for the brokerage firm than sell recommendations.
Third, being optimistic generates investment banking (IB) business for the brokerage firm.
What are the implications for investors?
Investors need to read the research reports of multiple analysts for the same company. They need to find out whether the analyst’s brokerage firm has an IB relationship with the company.
You need to be very careful about the optimism of analysts.
An analyst’s pessimistic outlook is more trustworthy than his/her optimistic outlook.
Also, an individual investor should not try to trade based on information that has just been released, because it is too late.
That information has already been released privately and the market has probably adjusted before the individual investor can trade.
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