Are Analysts Worthless?

Last year, a now-infamous email from an HSBC global equity research executive triggered heated debate over whether equity analysts are "worthless." In the email, the executive questioned the worth of HSBC's "sell-side" analyst research, in terms of its quality and ability to make thoughtful, independent recommendations.

Is that a valid concern? How does it compare with the worth of analysts on the "buy side"? Does either side have any merit to its research? Let's take a look.

The sell side
A sell-sider generally works as an analyst for the brokerage division of a Wall Street firm such as Bear Stearns (NYSE: BSC  ) , Lehman Brothers (NYSE: LEH  ) , or Cowen Group (Nasdaq: COWN  ) , or for a regional player such as AG Edwards (NYSE: AGE  ) . The sell side is primarily responsible for following securities and making recommendations, mainly for the benefit of the underlying firm's brokerage customers. Sell-side research also assists other customers who may place trades with a brokerage firm or work with that firm in another capacity.

Customers have traditionally paid for research via "soft dollars," as part of the commission paid for making trades. But they now increasingly prefer to pay for research separately, in order to better track their actual costs when trading shares through a broker.

The buy side
Most other analysts generally work for the buy side. Their research is intended for internal investment purposes, so it's not usually widely published. Buy-side analysts work for mutual funds, money managers, pension funds, or any institution that runs its own funds for the benefit of underlying investors. They seek profitable investments, aiming to help their employers outperform a certain market index. (The degree to which they outperform is called "alpha" in investment-speak.) Traditional money managers such as Federated Investors (NYSE: FII  ) and Janus (NYSE: JNS  ) command large armies of buy-side analysts. Hedge funds are also considered buy-side, and their popularity and potential seven-figure salaries have enticed numerous former sell-siders to migrate in their direction.

Sell-siders' bad reputation
Analysts are jumping ship because the sell side isn't what it used to be. Historically, it's been much more controversial; a 2001 Motley Fool article discusses many investors' animosity toward sell-side analysts, given those analysts' arguable conflicts of interest when making stock picks during the Internet boom and subsequent bust. Sell-siders were closely linked with the investment-banking side of Wall Street firms, and while that conflict has been regulated away, the demise of soft-dollar arrangements has made research a more explicit cost center for the brokers. That could be one reason why salaries have stagnated, driving analysts over to hedge funds and the buy side.

Certain sell-side analysts definitely acted unethically during the dot-com days, inflating stock prices and subsequent banking and trading commissions. But for the most part, I would characterize sell-side research as a helpful tool to keep investors aware of the key issues driving companies' and investments' performance. Sure, sell-siders tend to focus only on the next 12 to 18 months, but that's one of the primary reasons the market is largely considered efficient over this time frame. If a company is unable to keep its promises regarding quarterly or annual numbers, the sell side will call them on it, and newly informed investors will likely punish the stock. Fair or not, it keeps companies honest.

On the buy side, it's easier to tell which analysts are adding positive alpha and finding profitable stock ideas. Mutual funds, hedge funds, and money managers with track records of beating the market tend to attract the lion's share of investable assets. That's clearly not always the case -- outperformance is only one of many key investment screens -- but it is an easy way to separate the winners from the losers.

There are good and bad apples in any profession, but collectively, analysts do their jobs quite well. They arguably play a crucial role in keeping the market pragmatically efficient -- making it very difficult, but not impossible, for very intelligent and diligent individuals to outperform the market.

Analysts' true worth
I think both the buy side and sell side are useful and vital components in investment research -- as long as investors know the differences between the two, and understand why they make recommendations and promote their business.

Of course, the buy and sell sides aren't the only options for investment research. Individual investors can perform their own equity analysis as well. The Motley Fool is designed to help individual investors make and track their own investment decisions. Check out our key steps to investing Foolishly to learn how to take control of your own financial future. Analysts are a key input, but they're only one of the many resources for locating potentially lucrative investment opportunities.

For related Foolishness:

This article was originally published on Oct. 3, 2006. It has been updated.

Federated Investors is a Motley Fool Income Investor recommendation. For even more great investing ideas, try out any of our newsletter services free for 30 days.

Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.


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