• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

D. Murali

A `BUY' recommendation pops up from the financial media, and immediately you call up your broker to say `buy'. You turn the page, and there's a `sell'. And you pick up your mobile to make another call, so as not to lose gains made or stem further losses. But wait. Are you sure that the analysts who tell the world what to do aren't in the game themselves? Or, do they have an axe to grind?

Anup Agrawal and Mark A. Chen, of University of Alabama and University of Maryland respectively, explore this question in a recent research paper titled "Do Analyst Conflicts Matter? Evidence from Stock Recommendations," published in American Law & Economics Association Annual Meetings, and hosted by The Berkeley Electronic Press (http://law.bepress.com). The authors examine "whether conflicts of interest with investment banking and brokerage lead analysts to issue optimistic stock recommendations and whether investors are misled by such biases." A sensitive and serious issue, you'd agree.

The paper opens with what happened in the US about a year ago. "In April 2003, ten of the largest Wall Street firms reached a landmark settlement with state and federal securities regulators on the issue of conflicts of interest faced by stock analysts." Compensation and penalties were a record $1.4 billion, to turn a new leaf after the firms were caught with their pants down in routinely issuing "optimistic stock research and recommendations to win investment banking (IB) business from the companies they followed". No different, one may say, from the bane of `advertorials' that some newspapers indulge in, factoring in advertisement income when putting forth editorial opinion.

For starters, IB is defined narrowly to mean the role played to facilitate M&A or mergers and acquisitions, and broadly to cover "everything from buying and selling bonds, shares and other financial products, to helping clients' raise money to finance a new factory," as http://news.efinancialcareers.com explains.

How does conflict arise in IB? Let's say analyst Whizkid works in BizCo that is into IB business too. Whizkid tracks a few companies and offers recommendations that investors listen to before making their buy and sell decisions. One fine morning, BizCo wants to sell IB services to a company that Whizkid follows. "The company, in turn, would like the analyst to support its stock with an optimistic recommendation. The greater the importance of IB business to an analyst's employer, the more pressure the analyst faces to be bullish in his recommendations," explain Anup and Mark.

Before you kill the analyst!

Let me hurriedly return to the paper because I can see you're so angry that you think all your losses arose from the trust you placed in interested analysts, and therefore, you would like to punish them forthwith. Before you pull the trigger, however, I suggest you pay heed to a question that the authors raise: Is it possible that investors take into account the conflicts faced by analysts and rationally discount their opinions?

If you have kept the loaded pistol aside, you'd concede that it is popular and dramatic to say that investors are naïve victims of biased stock research. But such a view presumes that investors take analyst recommendations at face value, as Anup and Mark point out. They cite a thought of Sanford J. Grossman and Joseph E. Stiglitz that investor rationality and self-interested behaviour imply that stock prices accurately reflect a consensus about the informational quality of public announcements. A `rational discounting hypothesis' to counter the naivety.

The paper goes on to raise three posers: One, what is the relation between stock recommendation levels and magnitudes of conflicts faced by analysts? Two, to what extent do investors discount the opinions of more conflicted analysts? That is, "do reactions of stock prices and trading volumes to recommendation revisions vary systematically according to the degree of conflict faced by analysts?" And three, "is the medium-term (3 to 12 months) performance of recommendation revisions related to the magnitude of conflict severity?"

Methodology

The duo seeks answers to the questions empirically, using "a unique, hand-collected dataset that contains the annual revenue breakdown of 232 public and private analyst employers." With this, they construct quantitative measures of the magnitude of potential conflicts that analysts face with regard to investment banking and brokerage business.

Armed with a huge sample — "1,10,000 stock recommendations issued by about 4,000 analysts during the 1994-2003 time period" — the authors unleash "univariate tests, and cross-sectional regressions that control for individual analysts' experience, resources, workload and reputation."

A `concurrent research' cited in the paper may also be relevant for the avid: that of Malmendier and Shanthikumar who examine "the trading response of small and large investors to recommendations by analysts facing IB conflicts, by classifying firms into underwriters and others".

I'm sure the research-minded among you would love to pore over lines such as "The dummy variable for a large analyst employer is positively related to the market reaction to upgrades and negatively related to the reaction to downgrades" and equations like "t(CAAR _{+1, +12}) = CAAR _{+1, +12} / s(CAAR _{+1, +12})".

Conclusion

"Consistent with the view of the media and regulators, we find that optimism in stock recommendations is positively related to the importance of IB business to an analyst's employer," write Anup and Mark, but hasten to add that "investors are sophisticated enough to adjust for this bias". Which, therefore, makes `aggressive regulation of analyst research' unnecessary, they argue.

What a happy thought for Sunday that investors aren't systematically misled by analyst recommendations! So, shall we let the analyst live, after all?

dmurali@thehindu.co.in

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Ambuja Cement Eastern: Reject

Copyright © 2005, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line