The Boring Invstr - Your Simple, Digestible Weekly Investing & Finance Newsletter

Welcome Back to The Sixteenth Edition of The Boring Invstr!

Hello Boring Invstrs,

If you regularly watch and read top business and investing media outlets, you will often catch revised analyst recommendations along with concurrent price movement charts as the front page and breaking news headlines. Analyst recommendation revisions often mean a lot to regular and institutional investors. Professional athletes in the investing field are analysts.

Like professional athletes, they have the best data and resources to maintain and improve their abilities. It’s why so many investors take their research so seriously, especially if many investors are listed on the report.

Before 2003, the research and investment banking departments were one in investment bank firms. In 2003, the Securities and Exchange Commission (SEC) announced a historical and altering agreement in the investment banking world. The Global Research Analyst Settlement offered insights into potential conflicts of interest among security analysts at the ten largest investment banking firms. The ten firms agreed to pay back over a billion dollars in fees including millions to help fund investor education and independent research. The agreement also mandated the ten investment banks to separate research and banking into two separate departments and include disclosures in their research depending on circumstance.

While still incentivized today, before 2003 analysts were even more incentivized to drive revenue for their firms. Disappointing institutional investors by issuing a downgrade on a held position was not a risk many analysts were willing to take. Generating high returns to persuade new clients one all analysts took. The analysts' reputation and compensation were often based on how much capital they drove to the firm. Unfortunately, this took a turn during and preceding the dot com bubble in the early 2000s prompting the SEC to act.

In concurrence with Trueman et al. (2007), independent research firms are more likely to issue accurate buy recommendations, especially in bear markets likely due to independent research firms having fewer conflicts of interest, unlike analysts of investment banks. Between 1996 and 2003, Trueman et al. (2007) found that independent research firms’ buy recommendations outperform those of the investment banks, earning a daily abnormal return that is significantly larger (3.1 basis points higher, almost 8 percentage points annualized) than that of the buy recommendations of the investment banks.

Independent research firms’ buy recommendations also outperformed investment bank recommendations by 3.1 basis points in a bull market and 6.9 basis points in a bear market. Even as investment banking analysts issued favorable ratings in a favorable market, independent research recommendations still outperformed. This is possible due to investment banking analysts holding favorable ratings for too long to satisfy clients. Independent research firms were solely focused on maximizing their returns on their recommendations leaving any bias at the door. When it was time to get out of a rating, they dropped their rating and moved on.

When it comes to bear markets, the only time analysts at investment banks outperformed those at independent research firms was for hold and/or sell recommendations. Investment bank hold and/or sell recommendations outperform those of the independent research firms by a significant 3.5 basis points per day during the period Trueman et al. (2007) examined likely due to analysts being compensated by clientele. The firm would generate more revenue and be perceived better if it advised its investors to get out of their positions before the stock dropped.

While bias among recommendation revisions from analysts at investment banks has likely dropped since 2003, there is evidence to conclude why the SEC issued the Global Research Analyst Settlement. Investment bank analysts were heavily influenced to make decisions in times to keep their clients happy. Independent research firms likely made better revisions because they didn’t have millions in investment money hanging over their heads.

As cliché as this next comment will be truly take it sincerely. You can’t judge a book by its cover, no matter if it's investment banking analyst recommendations or independent research recommendations. The value of analyst reports is best put this way by Business Week Online, “In the end, stock ratings and target prices are just the skin and bones of analysts’ research. The meat of such reports is in the analysis, detail, and tone.” The SEC warns investors about relying solely on an analyst's recommendation when deciding to buy, hold, or sell a stock. While the meaning of each recommendation can vary between analysts, you can still be blind to analyst bias. So, as the old saying goes, don't judge a book by its cover. And when it comes to analyst recommendations, don't judge a recommendation by its rating.

That’s all for this week! I hope you have a great week and see you next week!

Trey

References:

Altinkilic, R., & Hansen, R. (2009). The determinants of analyst recommendation revisions. Journal of Financial Economics, 93(3), 323-348.

Asquith, P., Mikhailb, M., & Au, B. (2005). The information content of analyst reports. Journal of Accounting Research, 43(2), 277-318.

Barber, B., Lehavy, R., McNichols, M., & Trueman, B. (2001). Can investors profit from the recommendations of security analysts? The Journal of Finance, 56(2), 551-580.

Green, R. (2006). Early access to analyst stock recommendations. Journal of Financial Economics, 79(3), 505-530.

Loh, W.-Y., & Stulz, R. M. (2011). Influential analyst recommendations: The role of information and consensus. The Journal of Finance, 66(6), 2165-2200.

Stickel, S. (1986). The economics of analysts' forecasts. The Journal of Finance, 41(2), 493-510.

U.S. Securities and Exchange Commission. (2003, July). Analyzing analyst recommendations. Investor Bulletin. Retrieved from https://www.sec.gov/about/reports-publications/investor-publications/analyzing-analyst-recommendations