Former Sell-Side Analyst Reveals Trade Secrets

Article by Investment U

In my last article I told you why you shouldn’t look too far into analysts “Buy,” “Sell,” or “Hold” ratings. Simply put, there’s just not much incentive for analysts to initiate anything but a “Buy” rating.

That’s why you see many more “Buy” ratings than “Sell” ratings.

To understand this phenomenon better, let’s take a look at the four potential results facing the sell-side analyst.

I rate them from best to worst:

• Bullish and Right – This is the best. You like a stock, you say positive things, you rate it a “Buy” and the stock goes up. You’re a rock star, your clients who agree are making money and everybody thinks you know what you’re doing. You ride the wave of a bull market and you feel like you’re on top of the world, along with everyone else.
• Bearish and Right – Ok, even if nobody listens, if you’re right you can take credit. Being bearish and right means the stock is going down. People don’t openly celebrate when a stock goes down – it’s like the guy betting “Don’t Pass” at a craps table. If the dice are cold and you bet against the shooter, you just take your chips when they come your way. You don’t jump up and down and celebrate in the face of people who are losing money. So, because of this, bearish and right is only slightly better than….
• Bullish and Wrong – You say buy a stock, but it keeps going down. At least you’ll find that misery loves company. You’ll hold investors’ hands as the stock descends below the level you said it wouldn’t go below. You’re wrong, but at least you’re still a red-blood American who believes people can get rich owning the right stocks. So, bullish and wrong is still a heck of a lot better than….
• Bearish and Wrong – You say “Sell,” the stock goes up. You’re lonely. Everyone is having a party but you. You feel like the whole world is a tuxedo, and you are a pair of brown shoes.

Which brings me to the four biggest reasons there are more “Buy” ratings than anything else.

Four Reasons for More Buys Than Sells

The first, as you can see in my points above, is simply that it’s more fun to be bullish!

The second is that when analysts choose the stocks, they’re going to cover stocks you’re more likely to like. This is natural, and in no way misleading. Simply put, analysts choose stocks to cover that they’re more likely to be positive about.

In my last article, I explained that the “Buy” side wants access to management. This means they’ll reward you if you bring a management team into their office to speak to them. This is typically called a “Non-Deal Road Show.” Unlike the recent Facebook road show hoopla, these meetings occur even when there’s no high profile IPO occurring. It’s simply business as usual. And who will these management teams go on the road with? Well, more often than not they would prefer to go on the road with someone who’s positive on the stock. So the third reason why, is it’s easier to get management team access when you rate a company a “Buy.”

Firms still get compensated for investment banking. An analyst can’t be paid directly from particular banking deals, but the analyst also knows that the more positive they are, the more likely an investment banking client may choose them. So, the fourth reason is, investment banking still brings money into the firm.

Basically, the typical analyst wakes up each morning with a pre-disposition to be positive. Not always. But the game is tilted in that direction.

When a firm initiates coverage of a high-profile name like Facebook prior to the IPO, and prior to even knowing the level at which the stock will trade, they’re trying to be interesting…

They’re also trying to fill the information void from the analysts’ firms who are on the IPO, since they’ll be embargoed from publishing research for over a month after the IPO.

And it’s not just the “Buy” ratings you need to be aware of. There’s also pressure to be contrarian and to issue the dreaded “Sell” rating.

Sell Ratings: It’s All in the Semantics..

I know of at lease one sell-side firm that will try to get analysts to go to a “Sell” rating when a company is being acquired. In those cases, the stock essentially goes to the take-out price and the theory is that clients should sell and get into another stock instead.

That’s fine, except when you look at the ratings definition of a “Sell,” which typically state something like “we expect the stock to be at least 15% lower in 12 months” or words to that effect. Downgrading to “Sell” is much more interesting than going to a “Hold.”

Unfortunately, it isn’t consistent with the way the firm defines its ratings. This same firm I’m referring to actually issued a “Sell” rating on a stock after the stock stopped trading.

Sell-side research isn’t inherently evil. It may even be, and frequently is, valuable. I’m merely suggesting you take a “random walk” in the shoes of the typical sell-side analyst, and see how those shoes could affect what they say and how they say it.

Good Investing,

Gary Spivak

Article by Investment U