Strategy

Analysis paralysis

The blatant fraud and conflicts of interests are gone. So why are equity analysts’ track records still so pathetic?

Wall Street analyst Jack Grubman testifies at a hearing of the House Financial Services Committee investigating nearly $4 billion in accounting irregularities. (Photo by Harry Hamburg/NY Daily News Archive via Getty Images)

For most of its history, Research In Motion has provided a great return for its shareholders. Just as the company’s BlackBerry became ubiquitous, so, too, did the stock proliferate inside Canadian investors’ portfolios. But competitors soon arrived to push RIM from its dominant position, and the company’s share price has fallen dramatically in recent years.

The majority of analysts covering RIM maintained their Buy ratings even as the stock dropped. Today, there are 23 Buy recommendations, compared to 21 Holds and nine Sells. The most bullish analysts predict shares will double over the next 12 months to more than $100.

If, as an investor, you had followed the consensus advice over the past two years, you would be regretting it now. RIM shares have plunged 38% since April 2009, while the S&P 500 index has rallied by more than 50%. RIM’s story isn’t over; shares could well rebound. But it’s hard to look at the stock’s performance and not conclude that analysts got it very wrong.

Such optimistic projections are, however, the norm. Last year, McKinsey & Co. charted the results of S&P 500 companies from 1985 to present day against analyst forecasts. On average, analysts overestimated earnings by nearly 100%. Only twice in 25 years did they underestimate returns. This pattern is surprising, the researchers note, because a series of reforms instituted a decade ago were supposed to “improve the quality of the analysts’ long-term earnings forecasts [and] restore investor confidence in them.”

Indeed, the reliability and independence of analyst projections have long been contentious. In theory, those who research equities at the big banks and investment firms (known as sell-side analysts) provide their honest opinions about the companies they track for institutional investor clients (called the buy side). But the corporations under scrutiny may also tap the investment banking services of the analysts’ employers. Both parties potentially benefit when analyst coverage is positive: the corporation sees its share price rise, and may in turn be inclined to reward the bullish analyst’s firm with its investment banking business. “Even though the role between research and investment banking is supposed to be blurred, that’s nonsense,” says Terry Shaunessy, a Calgary-based money manager.

About a decade ago, former New York attorney general Eliot Spitzer went to war with analysts, unearthing evidence that the sell side at major Wall Street firms issued fraudulent or misleading research to drive investment banking revenue. Henry Blodget, a star Internet analyst at Merrill Lynch, was found to be touting companies as good investments to clients while trashing them in private e-mails. The investigation culminated in a US$1.4-billion settlement with 10 Wall Street firms. Blodget and Jack Grubman, another celebrity analyst, were banned for life from the securities industry. Extensive reforms swept Wall Street, aimed at increasing analysts’ independence, and regulators heralded a new era for research. “This agreement will permanently change the way Wall Street operates,” Spitzer promised in a 2002 press release. “Our objective…has been to protect the small investor and restore integrity to the marketplace.”

Though there was never a major scandal of this sort on Bay Street, Spitzer’s investigation made waves in Canada. Regulators tightened rules separating research from investment banking, prohibiting analysts from being compensated on the basis of specific financing deals.

In many respects, the reforms have been positive. There are now more independent firms that provide only research, and the most egregious conflicts of interest have been addressed. But what hasn’t changed much is analysts’ perpetual optimism and propensity for inaccuracy. It’s true the expectations put upon them are unrealistic. Analysts are charged with predicting the future: Will this stock go up or down? By how much? By when? It’s an impossible job to do well consistently. Nevertheless, financial TV shows, newspapers and magazines tout stock picks and target prices with rarely a mention of the prognosticators’ track records, or the fact that analysts continue to face pressure to be upbeat.

Professional investors are well aware of these pitfalls and employ their own analysts to vet investment decisions. Retail investors lack such resources, leaving them vulnerable. “What I worry about,” says Shaunessy, “is that because more and more individuals are trying to manage their own funds, they listen to this bullshit.”

Shaunessy’s assessment, which is unusually harsh, stems from his belief that stock picking is ultimately a fool’s game that few can manage consistently, including analysts. “It’s not because they’re not smart and don’t work hard, but that they can’t predict the future,” he says.

Statistics back him up. The Thomson Reuters StarMine list, an annual ranking of equity analysts based on the returns of their stock recommendations, shows analysts rarely score well for long. The Top 10 is completely different from year to year, and the same is true to a lesser extent for the best analysts in each sector. Bloomberg Markets magazine released its own ranking of the world’s financial sector analysts last fall, and pointed out that “even the best-performing Wall Street firms and individual stock pickers failed to predict the fall and rise of most big financial stocks.” The No. 1 firm, Goldman Sachs, made 30 accurate calls on the price direction of 79 financial stocks—more misses than hits. Meredith Whitney, the former Oppenheimer analyst famous for her dire predictions of U.S. banks’ future, failed to make the list.

Like investors, analysts tend to move as a herd, which can blind them to opportunities. John Dorfman, founder of institutional investor firm Thunderstorm Capital in Boston, tracked analysts’ four most loved and hated stocks from 1998 to 2009, and wrote about the results in his Bloomberg column last year. The favourites were flat during those years, while the despised stocks gained 6% annually. How could that be? “Like most human beings,” Dorfman concluded, “analysts extrapolate the recent past as a guide to what comes next.”

Christine Tan, a portfolio manager at Gluskin Sheff Associates in Toronto, has found much the same. “Some of our best performers have been when the analyst is wrong,” she says. That’s partly because there is little incentive for analysts to make a call that challenges the market consensus. If you buck the crowd, and “you’re wrong, you get fired,” Tan says. Even if the call proves correct, Canadian institutional investors are conservative and are unlikely to follow the advice. As a result, Canadian sell-side analysts are more conformist than their U.S. counterparts, Tan finds. A larger investor base and a greater number of independent research shops in the States encourages analysts there to try harder to differentiate themselves with unique viewpoints.

But in both countries, the consensus opinion is invariably bullish. The percentage of U.S. and Canadian companies labelled Sells peaked at 11% in 2003 (the year after Spitzer’s sweep). The portion today is roughly 6%. That’s low, but far better than in 2000, when fewer than 1% of stocks had Sell ratings.

Quentin Broad, head of equity research at CIBC World Markets, says it’s logical that the majority of ratings would be Buys, since analysts are supposed to provide clients with investment opportunities and can choose from a wide variety of companies to cover. “You’re probably going to choose stocks that you think are going to perform better rather than worse,” he says.

The more cynical money managers, however, point to continuing pressures to drive investment banking and trading commissions. Despite tightened regulations, indirect conflicts of interest still exist. For example, when a financial institution conducts a lot of investment banking deals, the bonus pool for all employees—including analysts—grows. Research departments are also under pressure from the management of the companies they cover. If executives take offence at negative reports and Sell ratings, they may stop talking to analysts, depriving them of information they need for in-depth coverage.

These perceptions are inaccurate, analysts say. “Every now and then there’s a company that chooses to stop talking to you, but those are few and far between,” says Rafi Khouri, an international oil and gas analyst at Raymond James. Chris Umiastowski, a former technology analyst at TD Securities who recently left the industry after more than a decade, says he never hesitated to write a negative report. But he adds, “I understand where that criticism is coming from, because you don’t see many reports where an analyst is super critical of a management team or a strategy.”

Analysts will always have to balance the needs of multiple stakeholders. This fact is reflected in the annual Brendan Wood International TopGun Analyst survey, another ranking of the sell side and one that can influence analyst compensation. The firm traditionally polls institutional investors, whose focus is reliable information, about their favourite analysts. For the first time last year, however, Brendan Wood created a separate ranking of analysts based on the opinions of corporate executives, noting in a press release that management teams value analysts who can “make their corporate story relevant to investors” (translation: portray their companies in the best possible light). Twenty of the 47 analysts who scored highly with executives were also singled out by investors, showing it is possible to gain high esteem among both constituencies.

But the fact that the opinions of company management may carry weight in analysts’ minds is just one more reason for investors to be skeptical of their research. “You can meet some very good analysts and learn to trust them,” says billionaire fund manager Stephen Jarislowsky. “But for anybody who buys [securities], it’s the old caveat emptor.”

Despite the inherent flaws in the sell side, there are plenty of reasons why institutional investors continue to pay for analysts’ services. Stock recommendations aren’t at the top of the list. “These people have a lot of useful information,” says Larry Sarbit, founder of Sarbit Advisory Services in Winnipeg. “But their conclusions are something that I put a lot less emphasis on, or none at all.” Insights about industry and company trends are what’s most valuable to professional investors. “Portfolio managers invest across sectors and sometimes own 100 stocks or more,” says Kris Thompson, a technology analyst at National Bank Financial. “They’re tasked with knowing these names well, which would be nearly impossible without the help of specialists.” When doing research for TD, Umiastowski not only spoke to management teams but sought out independent people who knew a given sector well. “An analyst has to build a large network of industry experts that you can talk to and share hypotheses with,” he says.

Portfolio managers don’t have time for such research, but they conduct similar independent analysis before making an investing decision. Listening to the sell side is just one part of that process. Institutional investors also have the luxury of being able to call analysts to further probe their views. Analysts release multiple reports daily, but since they tend to be written for a broad audience encompassing a variety of investing styles, they’re not always useful. Tan at Gluskin Sheff finds it far more informative to meet with analysts. “If you ask the right questions, you can ferret out the risks in their views,” she says. And because analysts are close to the companies they cover, they can connect institutional investors with management teams so they can gather even more information first-hand.

Retail investors, of course, have none of these opportunities. They are left with the public reports, recommendations and target prices, which analysts themselves say should not be relied upon exclusively. “If someone invests just because an analyst said this stock is going from $10 to $20 in the next 12 months, I would say that’s a problem,” says Broad at CIBC.

Choosing to direct one’s own investing is a huge responsibility, and requires a lot of independent research. After all, billionaire money manager Stephen Jarislowsky didn’t get rich on the backs of sell-side analysts. “Have I listened to them very much in my life? The answer is no,” he says. “Whenever I get a report from people like that, I always view it with a grain of salt.”