Overall, the study found that buy-side clients valued sell-side analysts’ views more when analysts had direct contact with management. The study didn’t go into detail about whether clients were primarily after hints of short-term market-moving information, or whether they were seeking more insight into company results. But Sharp told us he suspects analysts’ institutional clients believe the most valuable insights are those that come directly from management.
Given the importance of providing their clients with access to corporate management, it only makes sense that sell-side analysts would want to maintain good relations with management. Sharp told us that “analysts are a lot more worried about maintaining their relationship with management than whether or not they’re doing a good job, so-to-speak, for smaller investors.” Maintaining strong relationships with management of the companies they follow is seen by analysts as central to their career success.
All of this appears to call into question the objectivity of the analysts. One analyst even mentioned that he saw himself as a “megaphone” for management. In our interview, Sharp raised the question, “are analysts really supposed to be merely broadcasting what management tells them?”
Because maintaining good relationships with management is so crucial, being cut off from management would be devastating. According to Sharp and Call, it would hurt their relationship with buy-side clients who expect them to provide access to management, and losing that access would also get them into trouble with the sales and marketing folks at their own firms. One analyst told them:
When a company cuts you off, not only do you lose the information value of that [access], but you actually lose revenue. The company won’t come to your conference; therefore, your conference is going to be less important. Clients pay a boat load for that access.
Another analyst said that, “there are a lot of constituencies that analysts have to answer to, and none of them likes an underperform [rating on a stock].”
In addition to the pressure to remain in good graces with the management of the firms they cover, analysts often receive pressure to make positive recommendations from their own firms.
According to the study, 23.9% of the analysts surveyed specifically say they are pressured to “issue stock recommendations that are more favorable than their research would support.” And Sharp told us that number is probably a floor, since analysts may have been reluctant to share such knowledge with outside parties. He added that it’d be a “fantasy” to believe that sell-side analysts are not influenced by the effect their recommendations might have on the profitability of their own firms.
In short, analysts provide management with a “megaphone” in exchange for access, which they are then able to sell to hedge funds, mutual funds, and other institutional investors.
The next pets.com
In the 1990s, gushing Wall Street “research” that awarded every half-baked business idea with a “strong buy” recommendation was a major cause of the $5 trillion dot-com bubble. Even stocks that analysts privately believed to be “dogs” and “pieces of [expletive]” received buy recommendations.
Eliot Spitzer, who prosecuted the investment banks, recalls that:
At that time, the investment banks’ defenses were as astonishing as they were revealing. First, they claimed “everybody knew” that analysts’ recommendations were worthless because of the enormous hidden conflicts — admitting that no rational, knowing person would rely on the advice investment banks were sending to tens of millions of small investors.
As part of a $1.4 billion settlement for charges ranging from failing to disclose conflict of interest payments, to issuing unsound research reports, to “inappropriate spinning of ‘hot’ IPOs,” to producing fraudulent reports, Credit Suisse Group AG (ADR) (NYSE:CS), Merrill Lynch, Bear Stearns, Deutsche Bank AG (USA) (NYSE:DB), Goldman Sachs Group, Inc. (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), Lehman Brothers, Solomon Smith Barney, Morgan Stanley (NYSE:MS), and UBS AG (USA) (NYSE:UBS) agreed in 2003 to take a number of steps “to ensure that stock recommendations are not tainted by efforts to obtain investment banking fees.”
