Sell-side analysts more accurate than buy-side: Study

Investors rarely have access to the buy-side analyst reports of institutional investors, and according to a new study by a trio of Harvard Business School researchers, they likely aren’t missing much. The study finds buy-side analysts are more optimistic and less accurate than their sell-side counterparts, who freely distribute their recommendations.

Buy-side analysts work for institutional investors like hedge and pension funds, and, for the most part, their research is internal only. Boris Gorysberg, Paul Healy and Craig Chapman — all researchers affiliated with Harvard Business School — were given access to the forecast reports of an unnamed buy-side firm that, they say, is one of the 10 largest in the U.S. Over the period studied, they compared the quality of research from the buy-side firm to that of freely disseminated sell-side reports.

The resulting study, which is published in the latest issue of the CFA Institute’s Financial Analysts Journal, found that between 1997 and 2004, sell-side analysts who tend to work for large brokerage firms put out much more accurate forecasts than the closely guarded reports of buy-side firms.

The study estimates that for a typical firm with earnings per share of $2, the mean difference between buy- and sell-side absolute forecast errors is $0.21 for a zero- to three-month investment horizon, $0.18 for a 10- to 12-month horizon, and $0.30 per share for a horizon of more than 18 months. That results in a mean difference of accuracy that ranges from 11% to 15% of actual earnings.

The study’s authors don’t offer a definitive reason for the discrepancy, but they do have some guesses. One of the key differences is resources. The authors note that even though the buy-side firm they studied was a top 10 firm, it had only about 20 to 30 analysts whereas the average sell-side firm has upward of 186 senior analysts.

The result is that a sell-side analyst can spend much more time covering a specific security or sector. In fact, the study found that the typical buy-side reports at the sample firm were only two pages long and were far less comprehensive than those of typical sell-side analysts.

During the earlier portion of the study period, sell-side analysts also had an information advantage, since the firms they represent tend to function as the underwriters of new security issuances and debt of the companies they cover. It was widely believed that sell-side firms had additional sources of info over the buy-side, including larger sales forces and traders that may have intimate knowledge of certain markets, a relationship with the managers of the companies they are underwriting and the ability to solicit feedback from their institutional clients.

The study notes that with the U.S. Securities Exchange Commission’s adoption of Regulation Fair Disclosure rules in 2000, buy-side analysts were able to reduce their margin of error. The authors stress, though, that buy-side analysts were already starting to reduce their margin of error by 1999. In addition, the period between 2000 and 2004 was a period of significant market turbulence, so other factors may have come into play to explain a change in forecasting.

The authors also suspect that benchmarking on the sell-side may also play a role in their better accuracy. During the sample period, the study found no attempt by the buy-side firm to benchmark its analysts to its sell-side peers, whereas sell-side analysts are benchmarked to other sell-side analysts. How a sell-side analyst’s standings compare to others’ does affect their compensation.

Chartered financial analyst Paul Gardner, who is also a partner and portfolio manager with Toronto-based Avenue Investment Management, says in his experience, sell-side analysts do outperform but only on those securities they actually bother to cover.

“Sell-side analysts are certainly allowed to write more over the last two years and make a lot more recommendations than are sell/hold. They are also much quicker to change their opinion because of potential liability,” he says. “In my opinion, the buy-side would be certainly more objective. If a company doesn’t issue debt or new issues directly, they are generally not going to get covered by the [sell-side analysts representing] the underlying brokerage firms.”

Therefore, Gardner, who works on the buy-side, implies it’s a trade-off: investors will get a more comprehensive view of the markets with buy-side research but maybe not the best individual analysis of each security.

“I’m at a small firm, and I do research myself, so technically I’m a buy-side analyst, but I’m also a portfolio manager, a compliance officer, a marketer and an administrator. How much time do I have to look at stock like Telus? Maybe 20 minutes a year,” he says.

However, Gardner says because he doesn’t have to worry about generating underwriting fees, he is likely to give better insight on under-researched securities of the market.

“If you want to know the small stories and the sell-side doesn’t have a relationship with the company, then they are no good,” he says. “Leon’s Furniture is a good example. It’s a small-cap stock that nobody covers. It’s probably one of the best retail stories out there, but nobody covers it because they don’t issue equity and they don’t issue debt. So, no one covers it.”

In fact, the study does highlight that a lesser quality of forecasts did not hinder the buy-side from performing well. When the authors computed the firm’s average Morningstar ratings for all equity funds that the firm offered, the sample firm’s average rating exceeded the average ratings for other top 10 firms for the one-, three- and five-year horizons, although not for the 10-year horizon.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/22/08)

Mark Noble