Getting to Know Your Analysts

If you watch any of the financial news cable television stations, you’ve probably seen numerous industry analysts touting certain stocks and panning others. Do you know who those analysts represent? Do you know whether they’re independent analysts, buy‐side analysts, or sell‐side analysts? Before deciding whether to follow analysts’ recommendations, be sure that you understand who pays their salary and what’s in it for them.

Buy‐side analysts: You won’t see them

You rarely come in contact with a buy‐side analyst because they work primarily for large institutional investment firms that manage mutual funds or private accounts. Their primary role is analyzing stocks that are bought by the firm for which they work and not necessarily the ones bought by individual investors. Their research is rarely available outside the firm that hired them. Buy‐side analysts focus on whether an investment that’s under consideration is a good match for the firm’s investment strategy and portfolio. In fact, buy‐side analysts frequently include information from sell‐side analysts as part of their overall research on an investment. You’re most likely to hear from a buy‐side analyst if you listen to analyst conference calls. They tend to be much harsher on the company officials.

Sell‐side analysts: Watch for conflicts

When you read stock analyses from brokerage houses, you’re more than likely reading information from sell‐side analysts. These analysts work primarily for brokerage houses and other financial distribution sources where salespeople sell securities based on the analysts’ recommendations.

The primary purpose of sell‐side analysts is providing brokerage salespeople with information to help make sales. As long as the interests of the investor, the broker, and the brokerage house are the same, sell‐side analysts’ reports can be useful sources of information. A conflict arises, however, when sell‐side analysts also are responsible for helping their brokerage houses win investment‐banking business.

New York State Attorney General Spitzer exposed why this conflict is a primary reason for all the scandals you’ve read about regarding star analysts, such as Henry Blodget of Merrill Lynch, whose emails privately called stocks dogs, toast, or junk at the same time he and his team were publicly recommending that their customers buy the same stocks. Why do this? Well, according to Spitzer’s charges, Blodget’s recommendations brought in $115 million in investment banking fees for Merrill Lynch, and Blodget took home $12 million in compensation.

Merrill Lynch was only the first to be exposed. Similar charges were raised against many other firms, including Morgan Stanley and Credit Suisse. Few firms that sell stocks and have an investment banking division avoided the scandal. These companies didn’t learn much from the scandals. Merrill Lynch was taken over by Bank of America because of errors made during the mortgage crisis. At one time in the distant past, analysts were separated from investment banks by what companies called a Chinese Wall. Analysts’ work supposedly was kept completely separate from deals that were being generated in a company’s investment‐banking business. At some point, the lines between the two broke down, and analysts were included in the process of generating deals for mergers, acquisitions, and new stock offerings. By writing glowing reports, analysts helped their companies sign more lucrative investment banking deals, all the while putting their small investors at great risk of losing all their money by buying the recommended stocks. When the market bubble burst in 2000, many of the stocks that were recommended because of these deals (particularly in the Internet, telecommunications, and other high‐tech industries) dropped to being worthless, and investors lost billions.

Ratings companies, such as Standard & Poor’s and Moody’s, were exposed for similar weaknesses when the subprime mortgage crises imploded in 2008. Rather than protect the investors of mortgage securities, the ratings companies put making money first. They failed to warn investors of the dangers of these mortgage securities and instead gave these securities top ratings. They later proved to be junk.

The U.S. Securities and Exchange Commission (SEC) finally stepped into the fray in April 2002 and announced it was broadening the investigation into analysts’ roles and was developing new regulations regarding analyst disclosure. The SEC ultimately endorsed rulemaking changes recommended by the New York Stock Exchange and the Financial Industry Regulatory Authority (FINRA), including the following:

Cannot promise favorable research: Analysts are prohibited from offering a favorable rating or specific price target to encourage investment‐banking business from companies. Firms also must abide by a quiet period, meaning they can’t issue a report on a company within 40 days after an initial public offering (IPO) or within 10 days after a secondary offering if the firm acted as manager or co‐manager of that offering. IPOs are offerings made for a company selling its first shares to the public. Secondary offerings are for companies that already have stock sold on the open market but are issuing new stock.
Limitations on relationships and communications: Research analysts can’t be supervised by the investment banking department. Investment‐banking personnel are even prohibited from discussing research reports with analysts prior to distribution, unless staff for the legal or compliance department is present. Analysts also are prohibited from sharing drafts of their research reports with companies that they are writing about unless they’re just checking facts.
Analyst compensation: Analysts’ compensation can no longer be tied to a specific investment‐banking transaction. If analysts’ compensation is based on general investment‐banking revenues, that must be disclosed in the firm’s research reports. You can review these disclosures and determine how much weight you want to give an analyst’s recommendations.
Restrictions on personal trading by analysts: Analysts and members of their households can’t invest in a company’s securities prior to the IPO if the company is in the business sector the analyst covers. They also can’t trade securities in the companies they follow for 30 days before and 5 days after they issue a research report about a company.
Disclosures of financial interests in covered companies: Analysts must disclose if they own shares in recommended companies. Firms must also disclose if they own 1 percent or more of a company’s securities. You can determine whether the analyst or his or her company stand to gain from the reports they issue.
Disclosures about ratings given: Firms must clearly explain in their research reports the meaning of any ratings given. They must also provide the percentage of each type of rating given, such as buy, sell, or hold. You can assess how reliable their ratings are. For example, if a firm gives a very high percentage of buy or sell recommendations, you may want to more carefully compare its ratings to others or ignore it completely.
Disclosures during public appearances: If you’ve seen analysts on TV or heard them on the radio recently, you may notice that they disclose whether their firm is an investment‐banking client of (or has any other direct connection to) the firm they’re discussing. This too is a new rule that was implemented in 2002.

These rule changes helped investors identify conflicts of interest that can compromise the objectivity of the sell‐side analyst’s report. Pay close attention to the disclosures and the relationships between the brokerage houses and the companies that their analysts’ reports cover. Take these connections into consideration when including their buy or sell recommendations in your plans for future stock transactions.

Independent analysts: Where are they?

You’re probably wondering where independent analysts — people who you can trust who don’t have investment banking connections — really are. Although they do exist, most work for wealthy individuals or institutional investors and provide research for people who manage portfolios of much more than a million dollars and pay fees of at least $25,000 per year.

No one really knows exactly how many independent analysts are out there. Estimates range from 100 to several hundred, but their ranks may grow now that independent research is a required part of selling to individual investors.

In addition to independent research that you probably see distributed by your brokerage house, as a small investor you can turn to some of the major investment research firms such as Morningstar (www.morningstar.com) and Standard & Poor’s (www.standardandpoors.com). They offer services to individual investors through their publications and Internet sites at more reasonable fees than many of the small independent analyst firms. Nevertheless, you need to bear in mind that even these analysts are answering to the companies or wealthy individuals that pay the greatest share of their costs.

The Importance of Analysts

No matter which analyst’s report you’re reading, you must remember that the analyst’s primary income is coming either from the brokerage house or the large institutional clients that he or she serves. Analysts rate stocks on whether you should consider purchasing them, but no standardized rating system exists. The three most common breakdowns that you can expect to see are shown in Table 7‐1.

TABLE 7‐1 Common Stock Recommendations from Analysts

Analysis by Company A	Analysis by Company B	Analysis by Company C
Buy	Strong buy	Recommended list
Outperform	Buy	Trading buy
Neutral	Hold	Market outperformer
Underperform	Sell	Market perform
Avoid		Market underperformer

You can see from this table that you must understand how a company’s analysts rate stocks for that company’s recommendations to have any value. Company A’s Buy recommendation is its highest, but Company B uses Strong buy for its highest rating, and Company C uses Recommended list for its top choice. Merely seeing that a stock is recommended as a Buy by a particular analyst means little if you don’t know which rating system the analyst is using.

Unfortunately, when it comes to stock analysts, if the information is free, it’s probably no better than that free lunch you’re always looking to find. Someone has to pay the analyst, and if it isn’t you, you must find out who is footing the bill before you use that advice to make decisions.

The best way to use analysts’ reports is to think of them as just one tool in your bucket of trading tools. Analysts are one good way to find out about an industry or a stock, but they’re not the final word about what you need to do. Only your own research using fundamental and technical analysis can help you make your investment decisions. We discuss fundamental analysis tools in Chapters 5 and 6 and technical analysis tools in Part 3.

Tracking how a company’s doing

Analysts are good resources for finding historical data about how a company or industry is doing. Their reports usually summarize at least five years of data and frequently provide a historical perspective for the industry and the company that goes back many more years. In addition, analysts make projections about the earnings potential of the company they’re analyzing and indicate why they believe those projections by including information about new products being developed or currently being tested at various stages of market development.

These reports help you track how a company is doing so you can find the gems that may indicate when to expect a company to break out of a current trading trend. For example, if an analyst covering a pharmaceutical company mentions that a new drug is under consideration by the Food and Drug Administration, you may look for news stories about the status of that drug and monitor the stock for indications that drug approval may soon be announced. Watching the technical charts may help you jump in at just the right time and catch the upward trend as positive news is announced. Stocks usually start to move in advance of news.

Providing access to analyst calls

In addition to reading reports, you can track companies by listening in on analyst calls. Some calls are sponsored by the companies themselves to review annual or quarterly results, and others are sponsored by independent analysts.

Company‐sponsored calls

Analyst calls sponsored by companies more often are earnings conference calls primarily for institutional investors and Wall Street analysts. They occur on either a quarterly, semiannual, or annual basis and can be the richest sources of information concerning a company’s fundamentals and future prospects.

Senior management, which usually includes the chief executive officer (CEO), president, and chief financial officer (CFO), talks about their financial reports and then answers questions during these calls. The calls sometimes are scheduled to coincide with announcements of major changes in a company’s leadership or other breaking news about the company. After a formal statement, senior management answers questions from analysts. That’s when you usually can get the most up‐to‐date information about the company and how management views its financial performance and projections. We discuss how to read between these lines and get the most out of these calls in the next section.

Access to these calls used to be limited to professional analysts and institutional investors, but today more than 97 percent of companies that sponsor analyst calls open them to the media and individual investors, according to a survey conducted by the National Investor Relations Institute. This change primarily is credited to the SEC’s Fair Disclosure (FD) Regulation, which requires companies to make public all major announcements that can impact the value of the stock within 24 hours of informing any company outsiders. This rule helps level the information playing field for individual investors.

Analysts no longer can count on getting two or three days of lead time on major announcements, which heretofore helped them inform major investors about company news. Often that amount of lead time enabled analysts to recommend buy or sell decisions to their key clients, but that same practice hurt small investors and traders who weren’t privy to the news. Some complain this new rule actually hurt the flow of information because companies clammed up in private conversations with analysts, making it harder for the analysts to write their investigative reports. Since the regulation first took effect in 2000, the fair disclosure rule has helped to level the information playing field.

Independent analyst–sponsored calls

Firms that provide independent analysis also sponsor calls primarily for their wealthy and institutional clients. During these calls, analysts often discuss breaking news about a company or an industry that they follow. Doing so gives their clients an opportunity to discuss key concerns directly with the analysts. Unless you’re a client, opportunities for listening in on these calls are rare.

SEEKING INSIDER INFORMATION

Investors began seeking insider information about companies long before the scandals that you now read about almost daily. In fact, one of the first stories ever told about trading on insider information involved the startup of one of today’s leading financial information services — Reuters. Julius Reuter started his news service in response to the desire investors had for insider information and how it could impact stock prices. In 1849, Reuter used trained homing pigeons to fly information about closing stock prices from Europe’s mainland across the English Channel to England, thus giving his subscribers a jump on news about a stock so they’d be able to react before other, less‐informed investors received the information. This story highlights a simple but powerful secret of investing: Information is power. Investors with privileged access to information hold a distinct advantage over other investors who don’t have the same access.

Just to give you an idea of how analysts used insider information more recently, here are a couple of examples.

In February 1999, during a tour of the headquarters of Compaq Computer Corporation, the company’s treasurer told a group of big‐time investors that he was concerned about softness in the software industry. Compaq shares dropped 14 percent before most individual investors ever discovered such a concern existed.
In September 1999, executives at Apple Computer, Inc., called analysts to alert them that an earthquake in Taiwan disrupted the production of iBook and Powerbook notebook computers. The Apple execs wanted to warn analysts that the company would not meet its numbers for the quarter. The stock fell 7 percent in four days, and again, by the time most investors found out, it was too late.

The SEC fair disclosure rule prevents this kind of favored treatment for insiders.

Pointers for Listening to Analyst Calls

Most company conference calls start with a welcome to all call participants, followed by a discussion of the financial results being released or the purpose the company has designated for the call. After the CEO, president, and CFO make their statements, other key managers may comment on the results before the call is opened to questions from the listening audience.

The question‐and‐answer portion of the call usually is the most revealing and enables you to judge just how confident senior managers are with their reporting. The Q&A period is when you’re most likely to hear information that hasn’t been revealed in press releases or formal annual or quarterly reports. Analysts and institutional investors are usually given the first shot at asking questions, meaning before other listeners, the press, or individual investors get their turn. Not all companies permit individual investors to ask questions. Even when you can’t ask any questions, listening to responses to the questions posed by analysts, institutional investors, and the media is still worthwhile.

Be sure to listen closely to how the company’s senior managers answer those questions. Chances are good that any question you may have will be answered during the Q&A period. If not, you can always write or call the company’s investor‐relations division to get an answer to your specific question.

Analyst conference calls are best used as a research tool and not for taking an immediate action based solely on the information you gather from them. You need to consider them as just one more way of gaining knowledge about a stock that you’re thinking about buying, or of tracking stocks after you’ve already bought them. Day traders and swing traders sometimes use the information from analyst calls to trade after hours, but such trades can be highly risky. We talk more about these two trading strategies in Chapters 17 and 18.

Understanding the analysts’ language

Before ever listening to your first call, you must familiarize yourself with the language used during calls. Most of the common terminology is discussed in Chapter 6, including earnings per share (EPS), EPS growth, net income, cash, and cash equivalents, but other terms that are unique to the analyst call world include the following:

Hockey stick: When company officials say their revenues come in like a hockey stick, they’re not exactly talking about getting hit with a puck. Instead, they’re talking about the shape of a hockey stick. What they mean is that because most of their revenues are booked in the final days of the quarter, revenue charts take on the appearance of a hockey stick. Most companies, in fact, book revenues this way, because sales incentives are designed to encourage the sales force to close their contracts before the end of a quarter. Salespeople have to meet their quotas, and companies that are planning purchases frequently delay those decisions until near the end of a quarter so they can negotiate the best deals when the salespeople are most desperate to make a deal. You’ve probably done the same thing yourself when buying a car or other major item.
Lumpy: Nope, the CEO isn’t talking about poorly cooked oatmeal whenever he or she says revenues or orders were lumpy. This term means that sales were uneven during the quarter, with some weeks having low order rates and others having high order rates. The key is finding out why sales were lumpy and whether lumpy sales are normal for the company.
Run‐rate: Don’t worry, you won’t be asked how fast you can run a race. The run‐rate is the way senior management talks about how its current performance can be projected over a period of time. For example, if the current quarter’s revenues show a $1 million monthly run‐rate, then you can expect annual revenues to total close to $12 million. This concept may work for companies with steady earnings but not for companies whose products primarily are seasonal. For example, if a retail company reports a run‐rate of $1 million per month during the fourth quarter, which of course includes holiday sales, you won’t expect that performance to be indicative of a full 12‐month performance. You must be certain that you understand a company’s revenue picture before counting on run‐rate numbers.

If you hear other terminology that you don’t understand, write it down so you can research it and understand it the next time you hear it.

Developing your listening skills

In addition to what senior management is saying, you also need to listen to how they’re saying it. If management is happy with the results, they’ll probably be upbeat and talking about a rosy future for the company. On the other hand, if management isn’t so happy with the results, the mood probably will be downbeat and apologetic as they try to explain why the company didn’t perform as expected and, of course, make excuses for their failure to meet expectations.

Learn to listen and read between the company lines. Try to listen in on every earnings call. The first one you hear may not mean much unless you know how the results differ from previous reports and projections. Before that first call, you need to read analysts’ reports and become as familiar as possible with the company’s earnings history. After you’ve followed a certain company’s calls for a while, the information presented will mean much more to you. Among the many indicators that may help you determine your trading activity are signs relating to earnings expectations, revenue growth, analysts’ moods, company facts, future projections, and employee satisfaction.

Earnings expectations

Whether a company is meeting its own projections and analysts’ expectations is the most important clue about how a company is doing and how the stock market will react to its periodic reports. If the company fails to meet expectations, the market will likely punish the stock by driving the price down, and that can point to a good trading opportunity. If you believe the setback is temporary and the company’s long‐term prospects look good, you may want to wait for the stock to bottom out before buying it. If you think failing periodic expectations is a sign of long‐term bad news, and you hold a position in the stock, you may want to sell it as soon as possible. If you don’t own it, you may want to consider shorting the stock. We discuss shorting a stock at length in Chapter 15.

Revenue growth

Listen for information that indicates whether revenue growth kept pace with earnings growth. This factor becomes even more critical whenever the economy slows down because a company may play with or manipulate the numbers in a practice that’s known as window dressing, or making sure that earnings meet expectations. However, manipulating revenues is much more difficult. Growth in revenues is the key to continued earnings growth in the future.

Although manipulating earnings may be difficult, we’ve seen companies do it successfully for at least a few quarters and, in some cases, a few years. A number of companies caught in recent Wall Street scandals successfully manipulated these numbers with creative methods of booking revenue. One account that you may want to watch for signs of revenue manipulation is accounts receivable. If receivables rise dramatically above historical balances, one of two things are likely — the company is having a hard time collecting on its accounts or the company is booking fictitious revenue. Manipulation may also be detected when a company reports revenue for items sold that is actually greater than the company has the capacity to produce.

You may notice analysts questioning revenue‐growth figures in great detail. This examination by analysts can be a sign that they may suspect problems with the numbers. Detecting any of these signs while listening to a call can be a sign of possible trouble ahead, and you need to take a closer look before buying the stock or holding what you already have.

Analysts’ moods

You can find out a great deal about how analysts are responding to a company’s report by merely listening to the tone of their questions. By listening to how analysts are asking questions and what questions they’re asking, you can judge whether the analysts are downbeat on company prospects, especially if they’re asking increasingly probing questions. On the other hand, you may notice that analysts are upbeat and encourage senior management to talk even more positively about their results and future plans. When you’ve followed the analysts’ calls for a company during several quarters, recognizing whether the mood has changed isn’t difficult. When analysts receive news positively, they often start their questions with some kind of congratulatory remark.

Be sure to jot down the names of analysts, especially the ones making positive remarks. The positive remarks from analysts with sell‐side orientation may not be as good a sign as the positive remarks from buy‐side analysts. If you don’t know what type of analyst is commenting, research his or her affiliations and leanings after the call.

Buy‐side analysts carry the most weight whenever they’re indicating a positive reaction to the company’s financial news. Many buy‐side analysts who attend analyst calls already have a stake in the company, so they have a vested interest in putting a positive spin on the news. If they’re positive, they’ll likely revise their earnings estimates upward, which can be the first indication that they’ll recommend additional buys, and the stock may be getting ready to enter an upward trend. This positive spin can give you the first sign of a good trading opportunity, so watch your technical analysis for any signals of a potential breakout. We discuss more about breakouts in Chapter 10.

Just the facts, ma’am

The best way to judge whether senior managers are confident in their reporting is determining how quickly they respond to questions. If senior managers are confident with their numbers, they respond to questions quickly, taking little time to think their responses through. If senior managers are unsure of their reports, they’re more likely to take a good deal of time checking through their papers to answer even the simplest questions. You definitely need to think twice about buying or holding stock in a company whose management shows a lack of confidence in reporting their numbers.

The future

You’re likely to get a good reading about how senior managers view the company’s future prospects by listening to their vision for the company and whether the results actually demonstrate that they’re fulfilling that vision. When managers are successfully fulfilling their vision, they clearly articulate their view of the company’s future and how they plan to get there. Ask yourself whether management inspires you with its vision. If not, managers most likely are not inspiring their employees, which can be an early sign that the company is heading on a downward trend.

Employee satisfaction

Happy employees are a good sign that a company will be able to meet its future expectations. If, during the call, you hear that the company is having trouble attracting new employees or retaining its existing staff, you may be looking at a sign of trouble on the horizon. High employee turnover is bad for future growth, and so is having trouble finding and recruiting qualified employees.

Identifying Trends in the Stock‐Analyst Community

The regulatory climate in Washington now drives changes in the stock‐analyst community following disclosures of the abuses exposed after the stock bubble that ended in 2000. The Financial Disclosure Regulation of 2001 (Regulation FD) controls the flow of information between companies and analysts and ultimately what information makes its way to you as an outside investor or trader.

Some traders believe that the restrictions that ban selective disclosure to friendly analysts or key investors actually hurt the flow of information to the general public. Regulation FD requires that any information disclosed to analysts or key investors that can affect a company’s value must be disclosed to the general public within 24 hours, even if the information wasn’t part of a planned report.

The preference is for making announcements about material information at the same time for everyone, but sometimes during meetings with an analyst or institutional investor, information is shared inadvertently. For example, if analysts find out information during a company tour, the company then is required to put out a press release disclosing the same information to the general public. Some analysts believe this is making the preparation of their reports much more difficult than it needs to be.

Regulation FD, however, halted some commonplace industry practices, including closed meetings with analysts and institutional investors. Lawyers for many companies warn senior managers to be careful about responding to calls from individual analysts. Some companies require that any contact with analysts first be evaluated and approved through their legal advisors.

Regulations also impact roadshows, which are marketing tours that introduce a company’s new securities offerings. The SEC permits these events but gives clear guidance that they now need to be more like oral offers that are designed to avoid the prohibition against written or broadcast offers made outside the official prospectus of the offering. The SEC believes these roadshows are best conducted in the open to all investors and has voiced objections to having two separate roadshows, one for institutional investors and another, more sanitized version, for retail investors. Some legal experts also advise companies to be careful about whether they include outside analysts, those not employed by the underwriter of the offering, as part of the roadshow. Including outside analysts, some believe, can be viewed as selective disclosure, which violates Regulation FD.

The biggest regulatory changes you’ll see as an individual investor or trader relate to disclosures that must be made in research reports, including a requirement that securities firms must disclose any compensation they receive for investment banking services they provide during the three months following the public offering for a covered company. In addition, firms that are members of the New York Stock Exchange or the National Association of Securities Dealers must disclose when they stop coverage of a public company. Many times this type of news generates unfavorable publicity for the company and can result in a drop in stock prices. In addition to these big disclosures, analysts’ research reports now must include information about the relationships among the analysts, underwriters, and stock issuer.

Operating in this type of fish bowl may make companies and analysts nervous, but it nevertheless leveled the playing field for individual investors. Look carefully for these disclosures as you read analysts’ reports, and take advantage of your newfound access to information by attending analysts’ earnings conferences and being part of the insider pool rather than a passive outsider waiting to be fed information by the financial media or professional analysts.

Listening to Analyst Calls