Understanding Securities Analyst Recommendations
Investors considering stocks have a din of data to sift through today.
Unfortunately, quantity is no guarantee of quality: It has never been harder for small investors to assess which information they should rely upon to make decisions. As a result, some investors have depended too heavily on the one-word recommendations of just a few analysts—without understanding the particular context in which such recommendations often are generated, and the particular ways in which they often must be read.
Analysts play a useful role in our capital markets. For example, by doing in-depth research for their large institutional clients and employers, analysts can help substantial sums of capital be directed to more productive uses in our economy.
This article explains what analysts do and places it in perspective, so investors can learn what other information they need for managing their portfolios.
The two key takeaways are: 1) analysts' ratings do not have clear, standardized meanings; and 2) analysts might have potential conflicts of interest that you, as an investor, should be aware of in assessing the usefulness to you of any particular analyst recommendation.
Same Word, Different Meanings
Analysts usually summarize their research reports with a brief recommendation. Every firm uses its own rating system. Here are examples from three firms:
As you can see, comparing these ratings scales is not easy. The same term might mean one thing for one firm and something else for another firm:
Even providers of so-called "consensus" ratings, such as I/B/E/S and First Call, use their own rating scales. These organizations apply numerical formulas to map several analysts' different ratings scales to their own rating conventions. They then average their standardized recommendations to create a "consensus" rating for a particular security.
For all these reasons, it can be potentially damaging to your portfolio to automatically accept an analyst recommendation. Before you act on a recommendation, keep the following in mind:
Conflicts of Interest
Research analysts study companies and draw on a wealth of industry, economic, and business trend information to help their clients make better investment decisions. Retail investors may believe that most analysts' primary obligation is to the investing public. In fact, the full story is much more complicated.
Some analysts are unaffiliated: they sell their independent research to financial or investing institutions, banks, insurance companies or private investors on a project or subscription basis. But a large number of analysts are employed by institutions whose financial stake in their recommendations may go well beyond their accuracy.
For example, many analysts work for large financial firms that underwrite securities. An underwriter acts as an intermediary between the company publicly offering securities and investors buying the new stock. Even after the initial public offering, or IPO, it may have an ongoing relationship with the company or own a significant amount of the company's stock. And it will often stand to benefit from analyst recommendations that would tend to support the price of, or encourage trading in, that security.
Other analysts work for institutional money managers, such as mutual funds, hedge funds or investment advisers. They may provide research and advice for institutional clients whose investment decisions can differ significantly from those faced by ordinary investors. A mutual fund that relied on its analyst's earlier positive recommendation in acquiring the stock of a company might be harmed by any revised recommendation that would tend to lower the market value of the security.
Just by thinking about these kinds of employment arrangements, you can begin to imagine the kinds of conflicts that analysts may face as they develop and offer their opinions in research reports. For example:
These economic realities certainly do not mean that analysts are corrupt or even biased. But because analysts are called upon to make so many judgments that are not black and white, any of the above factors can put pressure on their objectivity—no matter how honest or competent they may be. So you should bear these realities in mind before making an investment decision.
Making Your Investment Decision
The fact that analysts or their firms may have conflicts of interest does not mean that their recommendations are without value. Often research reports will contain quantifiable measures—such as earnings predictions or comparisons to other companies in an industry sector—that you may decide provide useful insight even if you do not take the analyst's rating at face value. In any case, you should take all potential conflicts into consideration in assessing how much weight you should give the recommendation.
The important thing to remember is that you should never rely solely on an analyst recommendation when making an investment decision. There are many other important sources of information and factors you may wish to consider. For example:
In short, whatever a given analyst recommendation may say, always consider whether a particular investment is right for you in light of your own financial circumstances. Remember, you are the boss, it's your money, and your situation and goals that matter.
For additional information, see FINRA's Glossary of Analyst Research Report Terms.