NASD Advises How to Understand Stock Analyst Recommendations
he National Association of Securities Dealers (NASD) has published helpful guidance for investors who may consider relying upon stock analyst recommendations. The publication is located at http://www.nasdr.com/analyst_brochure.htm.
This is timely advice. According to the NASD, "there is a din of data for investors to sift through today", and "quantity is no guarantee of quality." Complicating the problem for investors, the NASD states that stock analysts' ratings are neither clear nor standardized. And there is a problem with the potential conflicts of interest of stock analysts. The NASD publication focuses upon these two topics.
Let's review why analysts' ratings are neither clear not standardized. Every brokerage firm has its own rating system. To illustrate, the NASD publication provides the following table:
FIRM A
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FIRM B
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FIRM C
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Buy
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Strong Buy
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Recommended List
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Outperform
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Buy
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Trading Buy
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Neutral
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Hold
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Market Outperformer
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Underperform
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Sell
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Market Perform
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Avoid
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Underperformer
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As one can see, investors will have a difficult time in comparing these rating scales! Furthermore, investors who consult the "consensus" ratings, such as First Call or I/B/E/S, must understand that those providers use their own rating scales after they have applied numerical formulas to map the brokerage firms' ratings. In response to all of this confusion, the NASD offers the following advice.
First, investors should know that a "Buy" rating may not mean that they should buy a stock, just as a "Sell" rating may not mean that they should sell a stock. That is because an investor's own, individualized investment needs and objectives are what matter.
Second, the NASD advises that investors not rely only on a stock analyst's rating. Instead, read the entire analyst research report, and conduct other research. That would include determining how other stock analysts view the company. That also would include researching the company's SEC filings, speaking to one's broker or adviser and reviewing news reports.
Third, and perhaps most important, is the NASD's caution that there has been a "proliferation of euphemistic ratings" - such as "Hold", "Retain", "Market Perform" - about which many investors are unaware. As a result:
Clear "Sell" ratings have grown rare. Some firms no longer even use "Sell" or any word obviously like it. Frequently, a "Hold" rating in effect means "Sell".
Investors must beware of this "ratings inflation", which the NASD observes is as "unhealthy in our markets as grade inflation in our schools."
Now let's review the potential conflicts of interest of stock analysts. Although the SEC's Global Research Analyst Settlement put a spotlight on such conflicts of interests, they bear repeating. Fundamentally, the NASD cautions investors that a large number of research analysts may not work for investors, but instead "are employed by institutions whose financial stake in their recommendations may go well beyond their accuracy." The NASD publication outlines five types of conflicts:
First, investment banking relationships may present conflicts. Here, the stock analyst "may feel an incentive not to say or write things that could jeopardize existing or potential client relationships for their investment banking colleagues", who have or may develop IPO underwriting, or merger and acquisition business.
Second, the manner in which brokerage firms compensate analysts may present conflicts. According to the NASD, many analysts are paid "at least partly and indirectly" on the basis of the firm's investment banking profits. As a result, stock analysts may be reluctant to report in any manner besides positively regarding a stock, so as not to affect the analyst's own compensation.
Third, the NASD cautions that analyst reports can generate more buying and selling, and hence more brokerage firm commission revenue.
Fourth, the SEC describes "Buy-Side Pressures" as a possible conflict of interest. For example, this relates to a situation where a large mutual fund may hold a large position in a particular company stock. That mutual fund has "little desire to see an analyst put out a 'Sell' recommendation on that security and possibly contribute to a sharp decline in its price."
The fifth possible conflict of interest occurs when the stock analyst, other employees or the brokerage firm itself owns stock in the company that the stock analyst is rating. Note that the analyst (and other employees) may own company stock directly or indirectly through employee stock-purchase pools.
In conclusion, the NASD advises, "Before you invest, investigate." That's good advice!
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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