Advisors should be wary of conflicts when reviewing stock ratings

You can’t escape them as an advisor — the endless barrage of stock ratings that come across your screen, with upgrades and downgrades implying action should be taken.

Depending on your firm, you may receive ratings from multiple sources that often conflict with each other. But the ratings may also be conflicted by their nature.

Investment banking conflicts

Investment banking relationships taint sell-side analyst recommendations. It’s a fact supported by the statistics firms provide, but the significance still escapes many advisors who use the research. Banks make their money in capital markets through equity underwriting, corporate loans and advising on M&A. Contrary research could undermine that primary effort.

A generation ago, the tech crash threw a spotlight on analyst bias. One of the outcomes was boilerplate disclosures in research reports that break down the number of buy, hold and sell ratings across each firm, and the number of investment banking relationships at each level.

The problem is that the mandated disclosure is shown in an inconsistent manner and can be easily misinterpreted. (The nitty-gritty detail is explained in an article from seven years ago.) What is not easily divined is how investment banking impacts the proportion of buy ratings at a firm. The chart below reworks the recent disclosure of a Big Six bank to be more relevant to advisors.

At this anonymous firm, the chance of an investment banking (IB) client being rated a buy is 62%, while the likelihood for a non-IB client falls to 53.7%. Further, the chance of an IB client being rated a sell is just 1.2%, but rises to 4.7% for a non-IB client.

The upside here is that the degree of investment banking bias seems to have improved over the years (compared to the stats from the previous article). The downside is that the disclosure at some major Canadian banks and investment firms has declined to the point where it is no longer possible to determine the breakdown of ratings for non-IB clients. While the figures for IB clients is still provided, the degree of bias that exists in favour of the IB group can’t be measured.

Advice to advisors: Read those back-page disclosures to see if individual companies are IB clients, because their ratings and target prices are often materially influenced.

Other conflicts also create bias

Even when an IB relationship does not exist between a research firm and a company, material factors can contribute to bias. Having listened to thousands of earnings conference calls in which sell-side analysts interact with management, it’s apparent that objectivity sometimes takes a back seat to human nature.

Offering congratulations to management for “another great quarter” is commonplace. Sell-side analysts can’t help becoming close to corporate management. They rely on executives to attend non-deal roadshows with institutional buy-side clients, and to speak at investment conferences sponsored by the research firm. Institutional clients will pay up (directly or otherwise) for access to management at these events, which analysts can facilitate by playing nice with executives, and not kicking up a fuss with their research reports and ratings.

Advice to advisors: Some research reports are clearly purposed as a follow-up to roadshows or investment conferences, so recognize them as potentially promotional.

Is that sell really a sell?

Sell ratings may also be conflicted. Advisors are always contending with short-seller reports, but those are relatively honest in advertising their conflicts up front — the writers are shorting a stock and hope you panic-sell in response to their revelations, truthful or not.

A lesser-known conflict is when a research firm issues ongoing sell reports on a company while also shorting the stock in an affiliated hedge fund. There’s often no clear warning on the research reports that the author, firm or its executives might benefit by owning units in the hedge fund.

Advice to advisors: Ask questions when a research firm also manages money, especially a hedge fund.

Mark Rosen, CFA, MBA, CFE, heads ARC Research, providing independent equity research to investment advisors across Canada.

Mark Rosen

Investments

Mark Rosen, CFA, MBA, CFE, heads ARC Research, providing independent equity research to investment advisors across Canada.