COMPLIANCE WATCH: Research Questions Analyst Ratings
Thursday December 11st, 2008 / 13h50
By Suzanne Barlyn
A DOW JONES NEWSWIRES COLUMN
NEW YORK -(Dow Jones)- New academic research raises concerns about the reliability of analyst recommendations and suggests the Federal Trade Commission should require brokerage firms to disclose analysts' performance histories to investors.
William Baker, a marketing professor at San Diego State University, says analyst predictions of stocks comprising the Dow Jones Industrials and the S&P 500 technology sector show that stocks with 'buy' ratings don't outperform those with 'hold' or 'sell' ratings. One analysis he conducted suggests the opposite is true - that technology stocks with negative ratings outperformed the S&P by 8.3%, compared with 4.4% for stocks with buy ratings.
One part of the study tracked 1,046 brokerage analyst ratings of DJIA equities from January 1998 to November 2005, concluding that analysts "were unable to predict stock performance any better than chance." There was no difference between the performance of stocks that were issued buy ratings and sell ratings, according to Baker. A second examination of 3,065 analyst recommendations in the S&P technology sector concluded that stocks with sell and neutral ratings significantly outperformed those with buy ratings.
The FTC has authority to mandate that brokerage firms disclose performance records of their analysts to investors as the recommendations are influential to consumers and potentially deceptive, says Baker, who concluded the study in November, and is seeking a journal for its publication.
Robert A. Korajczyk, a finance professor at Northwestern University's Kellogg School of Management, says FTC regulation is "probably feasible" but that he's not sure if it's warranted. Korajczyk says recent evidence, including a study by professors at Harvard Business School and the University of Chicago School of Business, indicates analysts' ability to add value to investment decisions has deteriorated due to Regulation Fair Disclosure, or Regulation FD, adopted by the Securities and Exchange Commission in 2000. "It seems strange that we would now need more regulation due to previous regulation," he says.
Concerns about analyst ratings have been a source of contention among the industry and regulators for more than a decade. In 2003, 10 Wall Street firms, including Citigroup (C), Goldman Sachs (GS) and Credit Suisse Group (CS), entered a landmark $1.4 billion settlement with the SEC and other regulators in response to allegations that investors purchased stock tainted by overly bullish research. A key piece of the pact required each firm to provide independent stock research, in addition to its own, for five years at a total cost of $432.5 million.
The five-year obligation ends in May, according to an SEC spokesman. A Citigroup spokesman said the decision to provide independent research after that time is up to individual firms.
Kei Kianpoor, chief executive of Investars, a New York-based company that provides research performance measurement tools to investors, says he is concerned about the disclosure that may be available when the settlement term ends. "It leaves investors without access to alternative research - and makes it much harder for them to have access to the track records of analysts," he says.
However, Travis Larson, a spokesman for the Securities Industry and Financial Markets Association, or SIFMA, an industry trade group, says member firms think customer-focused research has improved owing to the settlement's "rigorous standards" and subsequent rules adopted by the former National Association of Securities Dealers and member-regulation arm of the New York Stock Exchange, which merged in 2007 to become the Financial Industry Regulatory Authority.
The numerous modifications, aimed at eliminating potential conflicts of interest between research departments and acquiring investment banking business, included prohibiting investment banking personnel from supervising research reports and offering favorable research to induce investment banking business.
SIFMA's Larson says there's now less research available for certain sectors - particularly small-cap stocks - because of the settlement. Costs to comply with the heightened regulation have disproportionately affected smaller firms, which can no longer afford to continue some of their former sector coverage, he says.
Investar's Kianpoor, a longtime advocate of disclosing analyst performance to investors, says current self-regulatory rules require some disclosure of analyst performance to investors, but allow firms to eliminate references to companies they no longer cover. "It is problematic - but better than not having anything," he says.
(Suzanne Barlyn writes Compliance Watch, a column that focuses on compliance and regulatory issues affecting financial advisors. She can be reached at 201-938-4546 or by email at suzanne.barlyn@dowjones.com)
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