Wall Street equity research analysts are often cited as the primary voice of insight when it comes to predicting the stock market. These analysts routinely pen in-depth reports on individual stocks that include buy/sell/hold ratings, price targets, earnings forecasts and other potentially useful information for investors and clients.
However, the average investor reading summaries of these reports in the news or listening to analyst commentary and recommendations on financial TV networks may not realize that some analysts may not have an objective opinion on the stocks they discuss.
Access, not analysis. A Wall Street Journal report earlier this year revealed that the true value many of these analysts provide for their firms is not their ability to predict where a stock is headed in the future. Instead, their true value comes from providing investors access to the high-level executives working for the companies analysts covers.
[See: 7 Questions Investors Should Ask About Stock Earnings Estimates.]
Equity research firms were paid roughly $2 billion by clients in 2016 for access to meetings with company executives and insiders. Of course, those companies are under no obligation to grant this type of special access, which is where the company’s relationship with analysts comes into play. If the analyst is on good terms with company insiders and has a positive relationship with the company, the company may grant a handful of the research firm’s largest clients a meeting with the company’s vice president.
If the analyst is not on good terms with company management, that meeting may not take place. It doesn’t take a genius to see that the fastest way for an analyst to sour a relationship with company management is to slap a “sell” rating on the company’s stock.
A company like retail giant Coach (NYSE: COH) gets thousands of requests per year from analysts for clients to attend private company events with high-level executives. Coach says spots at these events are reserved for “brand ambassadors,” and analysts who have sell ratings on Coach stock don’t make the cut.
This you-scratch-my-back-I’ll-scratch-yours unwritten rule between research forms and public companies has major implications on the approach analysts take to their work. In December 2016, the Economist conducted a study off all the equity analyst ratings for the 500 or so stocks in the Standard and Poor’s 500 index. The study found that 49 percent of the total ratings on those stocks were “buy/outperform” ratings, 45 percent were “hold/neutral ratings” and only 6 percent of total ratings were “sell/underperform” ratings.
Roughly half of S&P 500 stocks underperformed the overall index in 2016, and about 30 percent of the stocks generated negative overall returns on the year.
Behind the bias. Some onlookers chalk up these skewed numbers to poor performance by analysts.
“The first thing that I have to say is that no one truly knows what is going to happen, and if they did, they would not tell anyone,” says TD Ameritrade chief strategist JJ Kinahan.
He attributes some of the bullish bias to analysts’ tunnel vision related to the specific stocks and sectors they cover.
“I believe that this phenomenon may be that different analysts cover different sectors creating a small bullish bias per sector that compounds into a more pronounced anomaly when put together,” Kinahan says.
Brad McMillan, chief investment officer for Commonwealth Financial Network, says the sampling of analyst ratings isn’t necessarily random.
[See: 9 Ways to Invest in America With Bond Funds.]
“When you spend your professional life looking at companies to buy, you naturally tend to focus on those that look like the best opportunities — which makes it even easier to decide that recommending a buy is the right decision,” McMillan says. “Nothing sinister here, just the natural tendencies of business and natural focus on opportunity.”
In other words, research firms and analysts aren’t responsible for rating every stock in the market. Instead, they often hand-select stocks to rate that they see as particularly well-positioned. Those well-positioned stocks tend to be buy-rated stocks.
The bias is real. While there may be circumstantial evidence that analysts feel pressured to give stocks bullish ratings, a 2016 study by the University of Miami, the University of Mannheim and the University of Michigan found statistical evidence of analyst bias when it comes to earnings estimates.
The study found evidence of a specific type of analyst bias called in-group bias. Analyst tended to overestimate earnings of companies headed by CEOs sharing their same gender, ethnicity and political attitudes. Since 80 percent of Wall Street analysts are male, the vast majority are American and 48.1 percent identify as Republican (compared to 41.1 percent as Democrat), companies headed by female, foreign and/or Democrat CEOs are more likely to deliver upside earnings surprises, the study found.
“There’s some merit in paying closer attention to the characteristics of CEOs for an edge over those just focused on the math,” says Jessica Rabe, research associate at Convergex, a global brokerage company based in New York.
While it may seem strange for investors to expect better numbers from CEOs of companies based on these superficial traits, it’s not the traits themselves that allow the companies to top Wall Street expectations. Instead, it’s the biases of the analysts that are setting the expectations to begin with.
Wall Street analysts are human beings and are subject to many of the same biases as the rest of us. Some of these biases may be the result of the nature of the equity research business, while others are simply the result of shortcomings in the way the human brain perceives the world.
[See: 7 of the Best Stocks to Buy for 2017.]
Investors place a lot of trust in market analysts because of their intimate knowledge of particular stocks and the companies behind them. That level of expertise can certainly be helpful to an investor when learning about a company and making investing decisions. But there may be a lot more behind those “buy” recommendation than meets the eye.
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Stock Analysts Are More Biased Than You Think originally appeared on usnews.com
