One of the many troubling parts in the 2012 “JOBS Act” — a law that weakens IPO standards in order to drive more IPOs — was a provision (Sec. 105b) that makes it legal for analysts to accompany investment bankers who are trying to persuade companies to hire them to help them come public.
We think “Inside the Black Box” raises particularly troubling questions about the objectivity of analysts whose firms are underwriting IPOs. As Ilan mentioned last year in his Senate testimony on the IPO market, there’s a strong likelihood that part of the reason investment banks would bring analysts to sales pitches is to indicate to management that the sell-side analysts will generate favorable “research” on their company.
The fact that 80% of analysts surveyed said their success at generating investment banking revenue was important to their own compensation, and 44% said it was “very important,” appears to call into question whether Wall Street firms are abiding by the spirit of the settlement.
The JOBS Act also required the SEC to study the idea of having small-cap stocks trade in non-penny increments. Doing so may actually turn out to be a good idea if it results in a longer-term focus for investors and management and more capital for companies. But one of the other rationales — raising transaction costs for everyone including ordinary investors in order to juice “trading commissions that formerly helped to fund research analyst coverage” — seems dubious in light of what we now know about the black box of research analyst coverage.
The impossible dream
In “Moneyballing the Financial World,” Motley Fool co-founder David Gardner wrote that he dreamed of a day when every financial source tracks itself publicly and transparently. For David, an analyst’s track record matters a lot to an ordinary investor who might be considering that analyst’s opinion before buying or selling a stock. It’s only common sense to insist on a track record for an analyst’s investing recommendations, once you stop and think about it.
Alas, common sense ain’t all that common, especially on Wall Street. After examining this study, we’ve learned that sell-side analysts are not incentivized to care terribly much about their track records, and are far more focused on pleasing their clients by maintaining good relationships with the management of the companies they cover. That’s fine, of course, but retail investors should keep this in mind the next time they hear a Wall Street analyst increase or decrease a price target on a particular stock.
In the end, we suspect that sell-side analysts won’t be taking up David Gardner’s challenge to track their forecasts and recommendations. Under the current circumstances, why would they bother? We greatly encourage all investors to read “Inside the Black Box.” You’ll never look at a Wall Street analyst quite the same way again.
The article The Shocking Truth About Wall Street Stock Recommendations originally appeared on Fool.com and is written by Ilan Moscovitz.
Ilan Moscovitz has no position in any stocks mentioned. John Reeves owns shares of Apple. The Motley Fool recommends Apple and Goldman Sachs. The Motley Fool owns shares of Apple and JPMorgan Chase & Co (NYSE:JPM).
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