Investment Research: Ignore the Ratings, Read the Reports

Scott Rothbort

Investment research seems to be everywhere -- both online and off -- but what is it? At its core, this investment research is financial analysis performed in order to derive an actionable investment recommendation. These research-based recommendations (issued in formal written reports) constitute the basis of broker solicitation for the buying and selling of securities.

Financial analysts ' actions are well publicized, and as a result, their recommendations can significantly impact security prices and your investment portfolio. So here is The Finance Professor's primer on investment research.

Price Moves

Typically, in the short term, the market's reaction to analyst research tends to be immediate and binary. In other words, if an analyst upgrades his or her opinion of a particular stock, then the stock price will likely rise, and if they downgrade their opinion, then the price will most likely fall. This is akin to the first point in "Five Missteps to Avoid in Earnings Season." As with an earnings report, initially, the market will react (either up or down) to a headline, but once everyone digs into the details, they are able to discern a better investment strategy.

Types of Research

Investment research comes in several different styles. Here are the more popular types of research:

• Fundamental research (see fundamental analysis )
• Technical research (see technical analysis )
• Market strategy: This type of analysis looks at macro-level trends in order to identify investment strategies. Often they will provide asset allocations and identify sectors for opportunistic investment or avoidance. Some companies will have a single market strategist while others will break up those roles into asset classes , such as fixed income , equities and commodities .
• Economic research: Many research teams employ economists that provide economic analysis. They will research and publish opinions on many economic data points that investors keenly focus on, such as gross domestic product, or GDP , non-farm payrolls or consumer price index -- CPI .

All of these various types of research are conducted by primarily two camps: the sell side and the independents.

Sell-Side Research

The "sell side " of the investment world is made of retail brokers that execute security transactions and make investment recommendations to their clients (individual, small investors) (Institutional , large money managers are known as the "buy side .") Research is produced by these brokerage firms that seek to provide value-added services to their brokerage clientele.

Big brokers such as Goldman Sachs (GS Quote), Merrill Lynch (MER Quote), Lehman Brothers (LEH Quote), Morgan Stanley (MS Quote), Bear Stearns (BSC Quote), Deutche Bank and UBS employ large teams of analysts that produce volumes of research across a wide range of investment research disciplines, including fundamental analysis and technical analysis (see Types of Research earlier).

Where do the brokerages find these analysts? Most analysts come from a variety of backgrounds, such as industry, academia and investment banking , while many go directly into financial research after graduating from college.

The 'Chinese Wall' Between Analysts and Brokers

Historically and now legally, a "Chinese Wall" separates the research and brokerage functions of a broker/investment bank from its pure investment banking role. Why? Consider the technology bubble of the late 1990s. During this period, sell-side research analysts began to mislead their firm's clients.

Some of the most nefarious analysts' research caused investors to buy valueless and debt-ridden companies at inflated prices. This was done in order to garner investment banking business and in some instances, for their own personal gains. This entire episode in investment history left an indelible stain on the entire brokerage and research industry. (Charles Gasparino best encapsulated the Wall Street research scandals in his excellent book, Blood on the Street, which is required reading for my undergraduate students.)

As the New York State attorney general at the time, Eliot Spitzer (now governor of New York) worked in concert with the SEC to legally strong-arm the brokers/investment banks, threatening to close them down unless changes were made in the way brokerages conducted their business. As a result, a comprehensive agreement was made between the regulators and the industry, which net civil penalties and important reforms.

These reforms included:

• Enactment of "Regulation AC," which is highlighted by definitions of industry terms such as "research analyst" and "research report," a requirment that analysts certify all research reports, and disclosure for certain analyst compensation arrangements.
• Disclosure of holdings on behalf of the analyst and his or her relatives as well as any other conflicts of interest.
• Strengthening the "Chinese Wall."
• Disclosure of the rating system and pertinent statistics for the analyst's employer.

It is the rating system disclosure that I believe fell short of accomplishing meaningful reform, as it tends to cause a great deal of frustration and confusion on the part of investors.

Ratings: Think Golf

Each research company has its own rating system. Some have simple ratings like "buy," "sell" and "hold." Others use terms like "accumulate," "overweight" and "underweight." What these ratings mean is subject to great variability and subjectivity. There is no industry standard or objective measure.

So here is how I look at ratings and how I teach my students to view them.

In golf, you gauge your performance based on par, which is the amount of strokes that an average golfer is expected to need to complete a round of golf. For stocks, the "par" is an expected return . You can either look at the historical expected return of a broad-based index or the expected return for the next year. Then if your stock is expected to increase by, let's say, 2% of the market's expected return, that stock should be a "hold." If the stock is expected to do better, it's a "buy," and if performance expectations are extremely high, then it's a "strong buy."

On the flip side, if the stock is expected to underperform the expected return by more than 2%, it's a "sell" and if it is expected to dramatically underperform the expected return, it could be considered a short sale . A rating system like that would eliminate the subjectivity and guess work (see benchmark ).

Thus, I strongly suggest you ignore the research rating and, instead, actually read the report. Here are few important parts of the report to look for:

• Price targets: Just because an analyst changes a rating doesn't mean that the price target on the stock has changed. The price target is a fair value assigned by an analyst to a company's stock. The better analysts will provide various scenarios (base case, best case, worst case), all of which have varying price targets. Compare the stock's current price to that of the analyst's price target to determine if the stock is worthy of buying, selling or holding (see "Ask TheStreet: Target Practice" and "What Do EBITDA and Target Estimate Mean?")
• Metrics: Look for more quantitative data points such as EPS estimates, revenue growth, margins (gross and net ) and any relevant costs and sales figures.
• Qualitative commentary: Pay attention to how an analyst covers the actual business, such as the new product offerings, competitive landscape, industry trends and management changes.
• Balance sheet: Never forget the importance of the balance sheet (see "Balance Sheets: The Good, the Bad and the In-Between" ).

What About Independent Research?

The Wall Street analyst scandal and the growth of the Internet in terms of investing and investment research opened up opportunities for third-party independent research to emerge as a viable alternative to sell-side research.

Independent research takes many forms. Here are a few primary examples:

• Web sites: Financial sites that provide commentary and expert advice from buy side market professionals and financial journalists. (While I may be biased, I have to say that TheStreet.com ranks at the top of the list of Web-based independent research and analysis.)
• Independent analysts: Individuals and full firms that provide research similar to that of sell-side analysts, but with the bundled service of brokerage execution and custody. Some independent analysts may charge a fee while others offer their research for free.

  As is the case with many things in life, you get what you pay for. The best and most actionable research tends to be for a fee. That is not to say that free research is not valuable. It is. Also, there are some fee-based services that are not worth a penny, in my opinion. Buyer beware: I suggest to get a no-obligation free trial before you sign up to pay for any service.

• Market data and information services: These can be quite costly and are typically used by professional money managers or high net worth individuals. These services vary by form and function, but as points of reference, a few services that I use are Bloomberg and Thomson Financial.

So, sell side or independent research?

The answer is really up to you. However, here is a set of criteria to help you make your decision:

• Quality: How well has the source of the research performed? Look at the track record or reputation of the analyst or service.
• Cost: At the end of the trading day, is the source "worth it"? Do an old-fashioned cost-benefit analysis.
• Convenience: Can you digitally download the data or use the research to test your own investment theories and trading strategies? You want the research to be made available to you in the most expedient and efficient manner possible. Accessibility, flexibility and speed are paramount.

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