Editor's note: This piece is the first in a three-part series about the state of analyst research. Look for the next two installments on Tuesday and Wednesday.
There was a time when the term securities analyst was unambiguous. It was a man or woman who gathered all sorts of information about particular stocks -- from basic financial data to arcane tidbits about the competition -- and analyzed all these factors to come up with investment advice for brokerage clients.
Analysts spent hours crunching a company's numbers, probing its management team, investigating its customer relationships and the strength of its markets -- generally assessing its prospects. Then they issued a report, usually on paper, explaining why a stock was a buy at a given price or not. Clients of the big brokerage houses got the research as a matter of course as part of the service they expected in return for paying full commissions on their trades.
Today, it's difficult to pinpoint exactly what the function of a Wall Street analyst is. Analysts still perform research. And they still make recommendations. But now analysts have many masters, with diverging interests. Research must help the brokerage's sales force generate orders. It must also guide institutional clients (big mutual fund companies like
). And, increasingly, analysts play a vital role in helping their firms drum up underwriting and mergers-and-acquisitions advisory business. Somewhere in there are the interests of individual investors seeking unbiased investment advice.
The individual investor is decidedly lowest on the totem pole in the hearts -- and wallets -- of analysts because they deliver the fewest bucks to Wall Street firms. The real money comes from fees generated by underwriting new securities offerings, brokering megadeals and high-volume trading activity from institutions. A hundred shares of
-- a sizable transaction to the average investor -- doesn't amount to a hill of beans for a broker or banker at
Morgan Stanley Dean Witter
. And when even big firms like
are going online and cutting commissions to retain customers, there's no margin left to pay for research aimed at the little guy.
"Today, the motivation isn't on trading volume," says Maryann Keller, president of the auto services division of
and formerly a top auto-industry analyst with
. "But rather it's on who's going to do financing or M&A activity and who will generate fee income."
That's important to keep in mind when you read the papers or watch financial news shows on TV. The marquee names like Morgan Stanley's Mary Meeker in Internet stocks or Rick Sherlund, the top analyst on
, may seem to be talking to you, the individual investor. But the message is about something other than what's best for your portfolio. Sherlund's employer,
, offers brokerage service only to high-net-worth investors. Its core businesses are investment banking and trading.
At their most conflicted, research analysts are little more than shills for the investment banking clients of their firms. In the old days, there was a "Chinese Wall" that, in theory if not in practice, separated equities research from banking. That wall is history. Analysts actively participate in the process of bringing in banking business. And they cover primarily companies that have generated big banking fees for their firms. Not surprisingly, the bias is to urge customers to buy, never sell.
That, say veteran analysts, is not how the game was played 10 or 20 years ago. "I can honestly say there was no pressure," says Charles Hill, director of research for earnings forecast aggregator
and a longtime Wall Street analyst. In a 20-year career on Wall Street, Hill worked for a series of brokerages that included
and Kidder Peabody, covering the electronics industry, the forerunner of today's high-tech sector. "I put sell
recommendations on big corporate-finance clients like
," says Hill, of the electronics connector company since acquired by
, and heard "no complaints from Pru management or from Amp."
The dark side of research gets darker still. Analysts often invest for their personal accounts in the same companies they follow. These investments typically are disclosed in the eye-straining print at the bottom of their reports, but the vested interest can't help but taint objectivity.
Worse, Wall Street analysts are often invited to make early-stage investments in companies they may later follow as analysts. Indeed, many private companies feel that by offering prepublic shares to name-brand analysts, the company will improve its odds of being chosen as a client by the star's investment bank. (A spot survey of several top investment brokerages reveals strict rules for disclosure of investments in shares of companies that are investment banking clients. But the rules don't always cover investments in immature companies.)
So, if analysts appear to be such a rotten bunch, what use could they possibly be to the average investor? Quite a lot, actually.
Many analysts are experts in their fields, often individuals who moved to Wall Street after a career in the industry they now analyze. Philip Rueppel, a computer hardware analyst with
Deutsche Banc Alex. Brown
in San Francisco, worked in marketing and product-development positions for six years at
before becoming an analyst. "It's been invaluable to me over the years," says Rueppel, an electrical engineer by training.
He says the industry background helps most in terms of being a "fib detector" on what he's hearing from HP (one of the hardware manufacturers he follows) and others. Chuck Phillips, business software analyst for Morgan Stanley (who came in first in two categories in
Analyst Rankings) ran computer systems for the U.S. Marine Corps before becoming an analyst. He also has an undergraduate degree in computer science, which he terms "critical to understanding the technology." Robert Chaplinsky, now a venture capitalist with
Mohr Davidow Ventures
in Menlo Park, Calif., spent six years at
before following the chip maker for
Hambrecht & Quist
. Because he worked in the investor relations department at Intel, some investors believed Chaplinsky often had a better ability than competing analysts to read the company's body language.
The top analysts in a sector may not be the best stock pickers. But they have deep understanding of the businesses and spend time with top executives, accumulating a treasure trove of information that ordinary investors can't obtain. They may not be adept at assessing whether a stock is a buy or a sell, but they are able to evaluate market opportunities and, occasionally, pick up reasons for investors to be concerned.
Indeed, while the investment-banking link can taint analyst coverage, it has a positive side as well. Analysts at firms that have a banking relationship with a covered company also tend to have unusually good access to senior management at those companies. An analyst who meets with a young company as it prepares to go public, shepherds it through the IPO process, and then supports it in the aftermarket with continuing research coverage likely will be the first to get a return phone call and be in the best position to discern changes in the business plan, for good or ill.
And, analysts say, they also function as a quality-control department for their banks. If a major analyst is skeptical about a company's business plan and indicates that he or she won't be able to support the stock with favorable research post-IPO, the bank may pass on the deal. How often this happens isn't a matter of public record.
In short, a research analyst can be a key resource for the investor. Insights can be more valuable than advice, especially at a time when opinions can be had on the cheap (on the tube and all over the Web) but even investing giants like George Soros and Julian Robertson are confused as to what to make of the environment. This is borne out in our survey results. See our (
So, research is just that -- background material that gives you some understanding of what's going on in a particular sector of the market. It is not, however, a reliable way to pick stocks.