Scroll to the bottom of this Guidepost for an easy way
to ask for clarification on questions as they arise!

Greetings, fellow Pro-fundity team members -
4-19-02 Background music:

A visitor to the office this week posed a question about using research reports provided by market analysts. Since our approach here has always been to do our own research, it will be relevant to discuss this issue in this week’s Guidepost. The big question; Can analysts be trusted? Let’s take a look!

1. What is a market analyst? What is the difference between an analyst and a broker?
   • Analyst (Financial, Research) - A person with expertise in evaluating financial investments. Financial analysts, who serve as investment advisors and portfolio managers, use their training and experience to investigate risk and return characteristics of securities.

   • Broker - A person or a firm that brings together buyers and sellers but does not take a position in the asset to be exchanged. Some observers believe a broker provides an unbiased opinion on a security since there is little self-interest involved in the transaction.

   • Broker-dealer - A firm that functions as a broker by bringing buyers and sellers together and as a dealer by taking positions of its own in selected securities. Many firms that are called brokers or brokerage firms are actually broker-dealers.

2. A broker may do his own research, but that does not make him a research analyst. His advice is not reported in the financial press as having “downgraded” or “upgraded” a stock. Whereas, research analysts are the folks who work for brokerages, who do the enlightening, in-depth research on a company’s business and/or industry.

3. Before we address the question, lets understand another distinction; On which side of the market do the analysts play, sell-side or buy-side.
   • Sell-side: That portion of the securities business in which orders are transacted. The sell side includes retail brokers, institutional brokers and traders, and research departments. They are sellers, we are buyers.

   • Buy-side: The portion of the securities business in which institutional orders originate. In most cases, the buy side is limited to institutional buyers such as pension-fund portfolio managers. Individual investors are usually excluded from the buy side. If an institutional portfolio manager changes jobs and becomes a registered representative, they have moved from the buy side to the sell side. We don’t usually participate on this side, other than taking advantage of the rich research and information provided by the buy-side analysts.

4. Buy-side analysts usually work for firms like hedge funds, mutual fund companies, or investment advisors. Their goal is singular: make money off their research. They sell the research and advice to clients of their firm. When they make the right call, they prosper. That’s the goal, to make money. These firms and their analysts are well paid for their objective analysis.

5. Sell-side analysts, known as the Wall Street analysts, work for investment banks with brokerage divisions. They are usually specialized in some market sector, such as airlines or semiconductors, and evaluate companies within their specialty. Their supposed understanding of the inner workings of these companies and elaborate financial models provide earnings estimates and arguments for valuation, e.g. “buy,” “sell,” and “hold.”

6. The main difference between these two sides is motivation. Think about it, what is the prime motivator in the financial markets? You guessed it, money! Buy-siders are single-minded in purpose, to make money based on research. They are motivated to be objective. Sell-siders, however, struggle with a profound conflict of interest. They are torn between honestly evaluating companies and bringing in new business. In order to bring in the business, they must give the client confidence their company will be positively rated. That is exactly why you rarely see “Sell” ratings for any company from these sell-siders!

7. Yet, the influence analysts have on market behavior is truly profound. A simple down-grade rating, say from “Buy” to “Hold” (never to sell…) can cause a stock price to plummet. And the power wielded by the analysts was heightened by information provided by company executives about forthcoming earnings reports. With this advanced information, analysts were in the drivers seat to inform other select clientele. Quite a powerful position, the market analysts.

8. The sell-side analysts have drifted to more pure quantitative analysis, looking only at numbers with almost no concern for the underlying business. While fundamental analysis requires some degree of number crunching, the primary concern is always the underlying business. What about things like management’s expertise, the competitive environment, the market potential for new products, etc. Quantitative analysts view these issues as too subjective and instead focus on objective data that can be analyzed (numbers).

9. Even Benjamin Graham (Warren Buffett’s mentor) was also one of the original proponents of this trend. Graham exhorted his analysts to never talk to management when analyzing a company and focus completely on the numbers, as management could always lead one astray. Today, with the cheap power of computers available, sell-siders will only buy and sell companies on a purely quantitative basis, without regard to the actual business or the current valuation. This is a radical departure from fundamental analysis.

10. This issue of the abuse of “sell-sider power” became such an issue in market politics that the Securites and Exchange Commission (SEC) initiated a new Fair Disclosure (FD) rule to help level the playing field in October, 2000. Financial disclosure was made available to the general public on a real-time basis. We can participate today in analyst calls and presentations, now fully available to the public through the web and conference call access.

11. The rule says basically, “Whenever a public company, or any person acting on its behalf, discloses material nonpublic information to certain enumerated persons, the company must simultaneously, in the case of intentional disclosures, or promptly, in the case of unintentional disclosures, make public disclosure of that same information.” Or when you tell one, you gotta tell ‘em all! This is a huge deal. Now, you and I have not only a level playing field but an advantage over the analysts; We don’t have the conflict of interest they do! We can listen to information from news agencies or commentators who have the same information as the analysts, at the same time!

12. What does all this have to do with us, as short-term traders in the market? First and foremost, we cannot depend on sell-side analyst recommendations for objective, helpful guidance. With all the information now available on the net, provided to us at the same rate of speed as the analysts, we can generate our own recommendations. Does that sound strange, when there are so many well paid analysts doing this already? It shouldn’t, knowing what you know now. The financial literature is replete with horror stories where investors have been led down the garden path to their dismay by analyst recommendations.

13. The problem lies in the fact that today’s sell-side analysts are part analyst, part cheerleader, and part dealmaker. When an analyst gets carried away with the cheerleader and dealmaker parts he loses credibility as an analyst. It’s a common experience. Analysts depend way too much on corporate pressures and not enough on true research. So, if you can’t trust the analysts to provide objective company analysis, who can you trust? Recently J.P. Morgan got caught with its pants down when an internal memo directed analysts to get feedback from its corporate clients prior to changing a stock recommendation. There is no mistaking the message: If your analysis could damage our relationship, bury it.

14. So, as we do our homework with the tools and resources available, we first disregard analysts' ratings on stocks, whether "Strong Buy," "Buy," "Accumulate," "Hold," or whatever. These subjective judgments are often skewed by the blatant conflict of interest we’ve discussed. However, we can rely on buy-side analyst reports, recognizing that analysts do know how to evaluate a particular company's prospects for growth. They do it for a living! That does not mean we should trust their “recommendations,” we should use the objective data they gather to help come to our own conclusions. The most important of this data is the estimated earnings per share figures. We can compare analyst’s estimates against the earnings announcements as they come out and see whether business performance is meeting, exceeding, or under-performing expectations. In these analysts reports, future growth projections are at least as important as the company's earnings performance. Those projections are part of every nalyst's report and become the basis of stock valuation as we will see in future GP’s.

15. That said, lets take a look at recent picks to help direct our efforts for greater returns. Following are watchlist-tracking results for Main Picks and Breakouts for a four-week window.
    
    
    Main Picks – 4/12/02
    
    
    Breakouts – 4/12/02
    
    
    Mainpicks – 4/05/02
    
    
    Breakouts – 4/05/02
    
    
    Mainpicks – 3/29/02
    
    
    Breakouts – 3/29/02
    
    
    Mainpicks – 3/22/02
    
    
    Breakouts – 3/22/02

16. Next week we will look at several of the price patterns for winning stocks to review exit strategies. This is critical from the results shown above. For instance, how could we capture the 28% in four weeks in the previous Breakout watchlist? Or the 18% or the 10%? And how about 28% in three weeks, in the 3/29/02 Mainpick watchlist? Notice the returns generally get higher with longer time-in-place. That is the “wind to our back” quality of the picks selected. Stay with me.

    

    
    
    
    
    

    
    If you have thoughts, suggestions, or comments, we would like to hear about them.
    Your e-mail address:
    
    Your comments:
    
    

    
    
    

    [HOME] [SITE MAP] [TUTORIALS] [MEMBERS]
    [THE OFFER] [TOOLS&LINKS] [CONTACT US]

    ---

    COPYRIGHT © 1998-2010 by Pro-fundity (sm). All Rights Reserved. No part of this work may be used or reproduced in any manner whatsoever without the written permission of Pro-fundity(sm). Pro-fundity(sm) is an independent research firm producing research reports based on many sources believed to be reliable. No guarantees are made as to the accuracy and completeness of the information. The information in this report does not constitute an offer nor solicitation to buy or sell securities. Information obtained via the use of this site should be coupled with the individual's personal due diligence in researching individual securities BEFORE purchase and the individual is advised to contact their broker or financial advisor before making any investment decision.

    Linked sites on the Pro-fundity web site, that are not under the control of Pro-fundity, are provided as a convenience only. The inclusion of a link does not imply endorsement of the linked site or its content by Pro-fundity.