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Stock analyst recommendations should be taken with a grain of salt

by Wayne Cheveldayoff, 2004-04-15

If a stock analyst makes a buy or sell recommendation on a stock, it’s worth taking notice, as it could be a good idea. But for a couple of good reasons, individual investors shouldn’t blindly follow the advice.

First, things could turn out differently than the analyst expects. For example, a recent U.S. study showed stock analysts were wrong on earnings estimates more than 40 per cent of the time.

Second, despite moves to bring in reforms in the wake of U.S. scandals, there are still enough problems with the work environment for stock analysts that it leaves open the question as to whether analysts can provide independent, honest advice without fear of losing their jobs, missing out on bonuses, or being sued by an offended company.

A French court recently awarded millions of dollars in damages to LVMH SA for what it considered negatively biased research on the company by analysts at Morgan Stanley. Other lawsuits are pending in Europe.

In Canada, businessman Peter Monk has launched a defamation lawsuit in an Ontario court against a New York-based Smith Barney analyst for comments surrounding a sell recommendation on Trizec Properties Inc. in August 2002.

While such lawsuits are a recent phenomenon, companies have used other techniques in the past to apply pressure to analysts whose opinions they don’t like, such as refusing to return phone calls or refusing to take their questions on quarterly analyst conference calls.

Such pressure rarely surfaces in public, so investors usually aren’t aware that it is happening. A recent case where it did come to light involved a Canadian brokerage analyst who publicly stated that the management of Canadian software provider Hummingbird Communications was refusing to talk to him after he published a sell recommendation.

These kinds of tactics recently prompted the U.S.-based Association for Investment Management and Research (AIMR) in cooperation with the National Investor Relations Institute to propose ethical guidelines governing the relationship between corporations and the securities analysts who cover them. AIMR has an important role in that it is responsible for setting ethical standards for analysts and for granting the designation of Chartered Financial Analyst (CFA) to those who pass stringent exams.

The guidelines state that analysts should “remain objective, conduct thorough and diligent research, and never bias their research reports in an effort to make companies happy or to receive better information or access.”

At the same time, say the guidelines, corporations should not discriminate among the analysts who cover them on the basis of past or present recommendations and “should never deny to analysts either information or access to company representatives in an attempt to influence their research, nor exert pressure on analysts through other business relationships, such as investment banking.”

The fact that these guidelines were thought necessary suggests a wider problem than had been previously thought.

Most of the publicity in recent years had focused on how certain brokerage analysts had maintained buy recommendations despite their doubts in order to give their corporate finance colleagues a better chance at winning commission-paying stock and bond underwriting business from the corporations involved.

Some analysts willingly participated in these misrepresentations of opinion knowing that their compensation was tied to the profitability of their firm’s corporate finance operation.

After these conflicts of interest were exposed in a few high-profile cases, some steps were taken to fix the situation.

However, regulators have basically focused only on ensuring that conflicts of interest are properly disclosed. Instead of putting strict rules in place to prohibit such conflicts, they have left it up to the brokerage houses to manage conflicts internally.

Unfortunately, this leaves a cloud of uncertainty. Investors are not absolutely sure that analyst recommendations aren’t still tainted in some way, and analysts themselves may be left wondering about how they should conduct themselves.

Most brokerages have erected walls between analysts and investment bankers, prohibiting the two sides from talking, and are no longer gearing analyst bonuses directly to the success of investment banking. So, analysts are supposed to be free of direct pressure. But they still may worry that a negative recommendation on an important investment-banking client could be a career or compensation-limiting move.

Some have argued that analysts and investment bankers should not be in the same organization. But, while there presently is the odd exception, this is unlikely to catch on because underwriting fees are all-important in the investment business. Brokerages that rely only on secondary trading commissions (that is, no underwriting fees) usually can’t generate enough to pay for a full group of analysts.

Even if analysts are independent of investment banking, this doesn’t automatically remove all conflicts. For example, eResearch, a Canadian research firm with no investment banking business, charges companies at least $15,000 annually to provide analyst coverage. Companies are supposed to pay and take their chances on whether they will be awarded a buy, hold or sell recommendation. At the same time, however, everyone employed by eResearch is aware that companies wouldn’t be interested in paying for research if most of the recommendations were holds or sells.

In the current situation in Canada, the variety of conflicts of interest faced by analysts may be handled well or they may not. Individual analysts may succumb to pressure or they may not. It’s just too uncertain to know for sure.

So, when a stock analyst talks, take it with a grain of salt.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff