Are Analysts Worthless?

Several months have passed since a now-infamous email from an HSBC (NYSE: HBC  ) global equity research executive made its way through the press, setting off a 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 quality and ability to make thoughtful, independent recommendations.

So, is that a valid concern, and how does that 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 Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , or Merrill Lynch (NYSE: MER  ) , but the list also includes regional players such as Raymond James (NYSE: RJF  ) . The sell-side is primarily responsible for following securities and making recommendations, primarily for the benefit of the underlying firm's brokerage customers. Sell-side research is also disseminated to other customers who may place trades with a brokerage firm or work with a firm in another capacity.

Customers have traditionally paid for research via "soft dollars," or as part of the commission paid for making trades. But lately, the trend has been to separate the two and pay for research via hard-dollar payments so as to better track the flows and avoid any gray area regarding what is actually being paid for when shares are traded through the broker.

The buy-side
Most other analysts are considered to work for the buy-side. Their research is not usually widely published; it is intended for internal investment purposes. 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. Basically, their raison d'etre is to find profitable investments and help their employers outperform a certain market index, also referred to as alpha in investment-speak. Companies such as Legg Mason (NYSE: LM  ) and Waddell & Reed (NYSE: WDR  ) are traditional money managers with large armies of buy-side analysts. Hedge funds are also considered buy-side, and their popularity and potential seven-figure salaries have caused numerous former sell-siders to migrate to where the action is.

Reputation and research
That's because the sell-side isn't what it used to be. This side of the analyst coin has historically been much more controversial; a perusal of a 2001 Motley Fool article will give you a flavor for the animosity most investors held against certain sell-side analysts and their arguable conflict of interests when making stock picks back during the Internet boom and subsequent bust. That's because sell-siders were closely linked with the investment-banking side of Wall Street firms. That conflict has been regulated away, but the demise of soft-dollar arrangements has made research a more explicit cost center for the brokers and could be part of the reason salaries have stagnated and analysts have moved over to the buy-side and to hedge funds.

There's no question that certain sell-side analysts acted unethically during the dot-com days to inflate stock prices and subsequent banking and trading commissions, but for the most part, I would characterize this type of research as a major factor in keeping investors aware of the key issues driving company and investment performance. Sure, they tend to focus on only the next 12 to 18 months, but that is one of the primary reasons the market is largely considered efficient over this time frame. In other words, if a company is unable to keep its promise on making quarterly or annual numbers, then the sell-side will be all over them and investors will likely punish the stock after they become aware of the problems. Fair or not, it keeps companies honest.

On the buy-side, it's easier to tell which analyst or team of analysts is 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, because outperformance is only one of many key investment screens, but it is an easy way to separate the winners from the losers.

So back to the matter of whether analysts are worthless. There are good and bad apples in any profession, and we have certain stereotypes to overcome before we can make a conclusion. But collectively, analysts do their jobs and perform them quite well. In fact, they do such a good job, it is arguable that analysts play a very large part in keeping the market pragmatically efficient, meaning that while it is very difficult to outperform the market, it is not impossible. That's because there are thousands of very intelligent individuals keeping tabs on most companies and industries out there.

Foolish conclusion
Overall, I would characterize both the buy-side and sell-side as useful and vital components in investment research as long as investors know the differences between the two and their underlying motivation for making recommendations and promoting their business.

There is another major side to investment research I haven't mentioned yet: equity analysis by individual investors. That's what The Motley Fool is all about -- providing individual investors the means to make and track their own investment decisions. For a starting point, 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 for those interested in doing their own tire-kicking, analysts should be relied on as only one of the many resources to locating potentially lucrative investment opportunities.

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. The Fool has an ironclad disclosure policy.


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