Security Analysts and Their Recommendations

Stock prices, especially those with high price-earnings ratios, are usually based on future expectations, which often originate from the recommendations of security analysts. A security analyst (aka sell-side analyst) is a person who works for a brokerage, bank, or mutual fund, who studies specific companies, usually within a sector, publishes financial reports on those companies, and makes buy-sell-hold recommendations about the companies' securities. The recommendations consist of 5 categories:

1. strong buy,
2. buy, outperform, overweight
3. hold, equal weight
4. sell, underperform, underweight
5. strong sell.

The designations overweight, equal weight, and underweight are used in regards to portfolio weightings. Hence, a stock with an overweight rating would be a recommendation to weigh the portfolio more heavily with the stock, since the analyst expects it to outperform the market; equal weight would indicate that the stock is expected to perform as well as the market, while an underweighted stock is forecasted to underperform the market.

Security analysts also forecast a target price, based on their expectations of future earnings and revenues.

However, many studies and scandals have shown that analysts' recommendations are not reliable, that there has often been a conflict of interest among analysts and the firms they work for. Analysts tend to inflate their forecasts for specific companies to curry favor with the management so that they can gain inside knowledge or get crucial information before it is distributed to other analysts or to the public. Favorable forecasts also help to increase business for the companies that employed the analysts. Companies were often rated buys so that the investment banks could win their business. In the late 1990's, at the height of the stock market bubble, less than 2% of the companies were designated with sell recommendations.

For instance, Jack Grubman, who worked for Saloman Smith Barney of Citigroup as a top telecommunications analyst, allegedly upgraded his rating of AT&T, so that Saloman would be selected in managing AT&T's large stock sale. He also supported WorldCom, McLeodUSA, Global Crossing, and Rhythms Netconnections — companies that filed for bankruptcy after the tech bubble burst in 2000. In fact, according this New York Times article, Grubman kept his buy rating on WorldCom until a few days before WorldCom announced its accounting irregularities, forcing it to declare bankruptcy shortly thereafter.

In 2003, the SEC secured a settlement from 10 Wall Street firms — including Citigroup, Credit Suisse Group, and Goldman Sachs — of $1.4 billion for potentially misleading investors with their biased recommendations, and coerced the firms to provide independent stock research at a cost of $432.5 million for a 5-year period that ends in May, 2009. The settlement included a prohibition of investment banking members from reviewing or influencing research reports made by the banks' analysts.

William Baker, a marketing professor at San Diego State University, conducted a study of analysts' recommendations for stocks in the Dow Jones Industrial Average (DJIA) and the technology sector of the S&P 500, and found that stocks with buy recommendations performed no better than stocks with hold or sell recommendations, and that technology stocks with hold or sell recommendations outperformed the S&P 500 Index by 8.3% compared to 4.4% for those with buy recommendations.

Another part of the study that examined more than 1,000 analysts' recommendations — issued between January, 1998 and November, 2005 — on stocks in the DJIA found that the recommendations were no more predictive of stock performance than could be attributed to chance.

Still another study has shown that analysts' recommendations are not very valuable themselves, but that upgrades and downgrades were more indicative of future stock prices.

A major recommendation to enhance the reliability of analysts' ratings is to have their record of recommendations available to investors. The public availability of their previous recommendations would motivate analysts to improve their track record to improve their credibility. Some rules by the self-regulatory authorities do require the listing of an analyst's recommendation for companies that they are currently covering, but companies no longer covered by the analysts can be excluded.

A major consideration to keep in mind when reviewing recommendations is that stock analysts are no more able to predict future market conditions than other market participants. (If they could, they would all be enormously wealthy!) Target prices are based on the assumption that the current market conditions will continue.

When large numbers of people are doing something where no skill is involved, some will outperform all the rest due solely to chance. It has also often been said that past performance is no indication of future performance. This adage may well apply to analysts. It would be interesting to see the statistical correlation between the accuracy of analysts early in their career with their accuracy later. If there is little or no correlation, then any rating system would have little utility — it would just select the best dart throwers among the thousands of monkeys.