Security Analysts and Conflicts of Interest

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Security Analysts and Conflicts of Interest

• Jay R. Ritter
• Cordell Professor of Finance
• University of Florida

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Security analysts who work for brokerage firms
that do investment banking, trade stocks
(brokerage), and provide research on these stocks
are known as sell-side analystsI will focus
exclusively on equity analysts
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What do security analysts do?

• Public pronouncements
• Buy/sell recommendations
• Target prices
• Earnings forecasts
• Written reports

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What do security analysts do?

• Private (telephone calls)
• Summarizing information
• Passing along private (inside) information

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• Sell-side security analysts are like professors
• We dont make money by selling our research
  papers to PBFJ and other journals
• We get paid indirectly through a higher salary if
  we publish influential research papers

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• Security analysts are paid indirectly if they
  attract
• - investment banking deals
• - trading commissions that include soft dollars
• Soft dollars are investor commissions paid for
  services in excess of pure trade execution.

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Conflicts of interest

• Need to get information from management
• Need to appease investors long in stock
• Need to attract banking mandates

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What do practitioners think?

• If an analyst is negative on you, you are not
  going to hand their bank a significant role in
  your stock issuance, thats for sure. That person
  becomes the mouthpiece to the investment
  community for your firm.
• Amylin Pharmaceuticals CFO Mark Foletta,
• as quoted in Investment Dealers Digest.

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These conflicts create an incentive to issue
optimistic recommendationsDuring the TMT (Tech,
Media, and Telecom) bubble of the late 1990s,
these conflicts of interest became severe
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Where were the regulators?
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• Recent years have seen major changes
• The commissions per share paid by
  institutional investors in the US have collapsed
  in the last seven years from an average of about
  4.5 cents per share to about 1.5 cents per share
• This is a weighted average of ECNs, crossing
  networks, and full-service brokers

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Proportion of buy, hold, and sell recommendations
from U.S. sell-side analysts, 2000-2004.
Source Reuters Estimates
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The Financial Services Authority (FSA) in the UK
has encouraged unbundling
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The salaries of sell-side analysts have been
fallingMany sell-side analysts have moved to
the buy-sideIn Europe and North America, junior
analyst jobs have been outsourced to IndiaMore
research is being offered on Asian stocks
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What are the most important qualities of a good
analyst?

• a) Accurate earnings forecasts
• b) Timely buy and sell recommendations
• c) Insightful written reports
• d) Setting up meetings with management
• e) Accessibility/responsiveness of phone calls
• f) Industry knowledge

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Private value of information

• Investors are willing to pay for information only
  when it is valuable
• Value can be measured as the ability to generate
  positive abnormal returns

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• The private value of public information is
  zero
• The private value of private information can
  be considerable
• This distinction is at the heart of the
  conflicts of interest problem

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Academic researchGrossman and Stiglitz (1980
AER) The Impossibility of Informationally
Efficient Markets --There is an equilibrium
degree of inefficiency
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Underwriters

• Affiliated Managing syndicate members
• Lead underwriter(s)
• Co-managers
• Unaffiliated
• Non-managing syndicate members
• All others

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Are conflicts of interest different for
affiliated and unaffiliated analysts?

• Incumbents advantage
• Currying favor
• Bradley, Jordan, and Ritter (2008 RFS)
  Analyst Behavior Following IPOs The Bubble
  Period Evidence

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Academic research focuses on public, measurable
info like EPS forecastsInstitutional investors
dont care about this infoBut are these
measurable variables correlated with useful
telephone calls?
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A good book

• Confessions of a Wall Street Analyst (2006)
• by Dan Reingold with Jennifer Reingold
• Dan Reingold was an II all-star analyst
• who covered telecoms from 1984-2003

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Summary

• Analyst conflicts are difficult to regulate
  because of the economics of information
• Information has different public and private
  value, so there is an externality
• Academics are able to measure the public
  pronouncements, which institutional investors
  dont care about