The Shocking Truth About Wall Street Stock Recommendations

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It is difficult to get a man to understand something, when his salary depends on his not understanding it.
-- Upton Sinclair

When Apple announced its second-quarter earnings on April 23, a flurry of news reports cited Wall Street analyst forecasts to help explain the company's results. This is how the bottom lines of companies and stocks are ordinarily explained to the public.

An analyst from Goldman Sachs (NYSE: GS  ) noted that the March quarter was better than expected, but the June quarter guidance was "far worse than feared." He ultimately lowered his price target to $500 from $575, while maintaining a "buy" recommendation on the stock.

An analyst from JPMorgan (NYSE: JPM  ) also lowered his target price, in this case to $480 from $575, and advised he expected "AAPL to remain range-bound" until there was more visibility into new product launches. More bullishly, the analyst from Piper Jaffray felt Apple might trade higher in late 2013, and maintained his $688 price target and "overweight" rating.

Analyst opinions such as these routinely drive coverage of the stock market. But a new study, "Inside the 'Black Box' of Sell-Side Financial Analysts," by professors Lawrence Brown (Temple University), Andrew Call (Arizona State University), Michael Clement (University of Texas), and Nathan Sharp (Texas A&M), suggests that ordinary investors should look elsewhere for insights into their favorite companies.

Sharp and Call, who we interviewed about their findings, told us they wanted to understand what went on behind closed doors when analysts were putting together their research. The professors received completed surveys from 365 sell-side analysts, and later followed up with 18 of them to better understand their decision-making processes. "Sell-side" analysts produce research that's purchased by their firms' "buy-side" clients. They're the group that's often cited in stories about "Wall Street analysts."

Countless studies have shown that the forecasts and stock recommendations of sell-side analysts are of questionable value to investors. As it turns out, Wall Street sell-side analysts aren't primarily interested in making accurate stock picks and earnings forecasts. Despite the attention lavished on their forecasts and recommendations, predictive accuracy just isn't their main job.

Analysts are not that into you
Any time you want to really understand the financial industry, it's helpful to first look at what people are actually paid to do.

The survey found that "accurate earnings forecasts and profitable stock recommendations have relatively little direct impact on their compensation." Instead, industry knowledge and connections are what count.

The chart below ranks the main factors that play into analyst compensation:

Sharp and Call told us that ordinary investors, who may be relying on analysts' stock recommendations to make decisions, need to know that accuracy in these areas is "not a priority." One analyst told the researchers:

The part to me that's shocking about the industry is that I came into the industry thinking [success] would be based on how well my stock picks do. But a lot of it ends up being "What are your broker votes?"

A "broker vote" is an internal process whereby clients of the sell-side analysts' firms assess the value of their research and decide which firms' services they wish to buy. This process is crucial to analysts because good broker votes results in revenue for their firm. One analyst noted that broker votes "directly impact my compensation and directly impact the compensation of my firm."

So who are these clients that analysts are paid to cater to? Mainly hedge funds and mutual funds. Individual -- aka "retail" -- investors are the least important:

Congratulations on another great quarter, Mr. CEO
So if forecasts and stock picks aren't important, what exactly are these valuable institutional clients after?

Sharp and Call told us that institutional clients value analysts' access to the management of the companies they cover more than anything else. One analyst admitted that "one of the biggest things the buy-side compensates sell-side research firms for is corporate access: road shows, meetings, access to management teams." Another said:

As an analyst, if I call up a money manager, a hedge fund, whoever, and I've got a call to make on a stock, and I'm able to say, 'Hey, by the way, we were able to spend 20-30 minutes talking to senior management,' boom! Their ears are just straight up.

Overall, the study found that buy-side clients valued sell-side analysts' views more when analysts had direct contact with management. The study didn't go into detail about whether clients were primarily after hints of short-term market-moving information, or whether they were seeking more insight into company results. But Sharp told us he suspects analysts' institutional clients believe the most valuable insights are those that come directly from management.

Given the importance of providing their clients with access to corporate management, it only makes sense that sell-side analysts would want to maintain good relations with management. Sharp told us that "analysts are a lot more worried about maintaining their relationship with management than whether or not they're doing a good job, so-to-speak, for smaller investors." Maintaining strong relationships with management of the companies they follow is seen by analysts as central to their career success.

All of this appears to call into question the objectivity of the analysts. One analyst even mentioned that he saw himself as a "megaphone" for management. In our interview, Sharp raised the question, "are analysts really supposed to be merely broadcasting what management tells them?"

Because maintaining good relationships with management is so crucial, being cut off from management would be devastating. According to Sharp and Call, it would hurt their relationship with buy-side clients who expect them to provide access to management, and losing that access would also get them into trouble with the sales and marketing folks at their own firms. One analyst told them:

When a company cuts you off, not only do you lose the information value of that [access], but you actually lose revenue. The company won't come to your conference; therefore, your conference is going to be less important. Clients pay a boat load for that access.

Another analyst said that, "there are a lot of constituencies that analysts have to answer to, and none of them likes an underperform [rating on a stock]."

In addition to the pressure to remain in good graces with the management of the firms they cover, analysts often receive pressure to make positive recommendations from their own firms.

According to the study, 23.9% of the analysts surveyed specifically say they are pressured to "issue stock recommendations that are more favorable than their research would support." And Sharp told us that number is probably a floor, since analysts may have been reluctant to share such knowledge with outside parties. He added that it'd be a "fantasy" to believe that sell-side analysts are not influenced by the effect their recommendations might have on the profitability of their own firms.

In short, analysts provide management with a "megaphone" in exchange for access, which they are then able to sell to hedge funds, mutual funds, and other institutional investors.

The next
In the 1990s, gushing Wall Street "research" that awarded every half-baked business idea with a "strong buy" recommendation was a major cause of the $5 trillion dot-com bubble. Even stocks that analysts privately believed to be "dogs" and "pieces of [expletive]" received buy recommendations.

Eliot Spitzer, who prosecuted the investment banks, recalls that:

At that time, the investment banks' defenses were as astonishing as they were revealing. First, they claimed "everybody knew" that analysts' recommendations were worthless because of the enormous hidden conflicts -- admitting that no rational, knowing person would rely on the advice investment banks were sending to tens of millions of small investors.

As part of a $1.4 billion settlement for charges ranging from failing to disclose conflict of interest payments, to issuing unsound research reports, to "inappropriate spinning of 'hot' IPOs," to producing fraudulent reports, Credit Suisse, Merrill Lynch, Bear Stearns, Deutsche Bank (NYSE: DB  ) , Goldman Sachs, JPMorgan, Lehman Brothers, Solomon Smith Barney, Morgan Stanley (NYSE: MS  ) , and UBS (NYSE: UBS  ) agreed in 2003 to take a number of steps "to ensure that stock recommendations are not tainted by efforts to obtain investment banking fees."

One of the many troubling parts in the 2012 "JOBS Act" -- a law that weakens IPO standards in order to drive more IPOs -- was a provision (Sec. 105b) that makes it legal for analysts to accompany investment bankers who are trying to persuade companies to hire them to help them come public.

We think "Inside the Black Box" raises particularly troubling questions about the objectivity of analysts whose firms are underwriting IPOs. As Ilan mentioned last year in his Senate testimony on the IPO market, there's a strong likelihood that part of the reason investment banks would bring analysts to sales pitches is to indicate to management that the sell-side analysts will generate favorable "research" on their company.

The fact that 80% of analysts surveyed said their success at generating investment banking revenue was important to their own compensation, and 44% said it was "very important," appears to call into question whether Wall Street firms are abiding by the spirit of the settlement.

The JOBS Act also required the SEC to study the idea of having small-cap stocks trade in non-penny increments. Doing so may actually turn out to be a good idea if it results in a longer-term focus for investors and management and more capital for companies. But one of the other rationales -- raising transaction costs for everyone including ordinary investors in order to juice "trading commissions that formerly helped to fund research analyst coverage" -- seems dubious in light of what we now know about the black box of research analyst coverage.

The impossible dream
In "Moneyballing the Financial World," Motley Fool co-founder David Gardner wrote that he dreamed of a day when every financial source tracks itself publicly and transparently. For David, an analyst's track record matters a lot to an ordinary investor who might be considering that analyst's opinion before buying or selling a stock. It's only common sense to insist on a track record for an analyst's investing recommendations, once you stop and think about it.

Alas, common sense ain't all that common, especially on Wall Street. After examining this study, we've learned that sell-side analysts are not incentivized to care terribly much about their track records, and are far more focused on pleasing their clients by maintaining good relationships with the management of the companies they cover. That's fine, of course, but retail investors should keep this in mind the next time they hear a Wall Street analyst increase or decrease a price target on a particular stock.

In the end, we suspect that sell-side analysts won't be taking up David Gardner's challenge to track their forecasts and recommendations. Under the current circumstances, why would they bother? We greatly encourage all investors to read "Inside the Black Box." You'll never look at a Wall Street analyst quite the same way again.


Read/Post Comments (30) | Recommend This Article (160)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 03, 2013, at 12:09 PM, prginww wrote:

    We all know that the analysts work is to aid in manipulating the market. Their facts are only useful to the person who pays them.

  • Report this Comment On June 03, 2013, at 6:06 PM, prginww wrote:

    I enjoyed the article. I believe that track record is an important indicator in stock purchase decision.

  • Report this Comment On June 03, 2013, at 6:13 PM, prginww wrote:

    Great stuff guys, per usual.

  • Report this Comment On June 03, 2013, at 6:52 PM, prginww wrote:

    If I have learned anything since becoming a Fool, it is to completely ignore the analysts. This just supports that conclusion.

  • Report this Comment On June 03, 2013, at 7:51 PM, prginww wrote:

    This is shocking? If yes, you would be shocked to hear that leopards have spots.

    Most of these "analysts" are nothing more than paid shills. Follow them only if you want to lose your money.

  • Report this Comment On June 03, 2013, at 8:01 PM, prginww wrote:

    I appreciate your article. It is still a scandal which maybe cause the next economy meltdown again.

    Sadly our government still protects this corrupt side of Wall street by lending billion dollars of our tax money to them and protecting ludicrous huge compensations in the previous financial crisis.

    Even worse, none of those crooks go to jail for it after millions of individuals lost their hard earn money in this scandal by their stock recommendation.

  • Report this Comment On June 03, 2013, at 9:21 PM, prginww wrote:

    Excellent article. We live in the upside room in Alice in Wonderland. What you thought was professional is actually ridiculous. What seems Foolish may just be of value. Whether we're talking sell-side analysts or fee-based financial advisors or full-service brokers. . . you name it, what you thought professial is actually ridiculous. Thanks, team.

    Tom Gardner

  • Report this Comment On June 03, 2013, at 10:26 PM, prginww wrote:

    When I compare my TMG Stock-Adviser-recommended holdings with the ratings listed automatically on my Charles Schwab brokerage page, my best-performing stocks routinely get "D" or "F" ratings on Schwab.

    I suspect the issues in this article are at lest part of the reason?

  • Report this Comment On June 03, 2013, at 11:32 PM, prginww wrote:

    Anybody who has even a modicum of investing experience realizes in due time that most analysts are shills for the market making interests behind them. Nobody should be shocked at this.

    Trust but verify. As in all things in life, you have to be your own advocate & decision maker...whether it's taking a student loan...buying a house...or taking investment advice from an analyst on wall street or analyst on an online service.

    If you are going to invest, make sure you know the basics about cash flow, balance sheets, interest rates, amortization, dollar cost averaging, index funds, and value that you can properly assess and weigh "expert opinion".

  • Report this Comment On June 04, 2013, at 12:15 AM, prginww wrote:

    "Shocking"? Don't most people already know that these "analysts" just keep BSing the whole time with their price targets? I don't even know why anyone takes them seriously... when the stock goes up and has some momentum, they increase their price targets and hit the buy signal... when they show some weakness, they hit the sell signal. When they hear good guidance, they recommend a buy rating. When they hear bad guidance, they suggest a sell. That's all they do. It's not rocket science. I can also come up with price targets like they do... it's very easy. Just work in one of the big firms and come out with a random number that gels in with sentiment. Like, AAPL will be 2000$ per share. Just don't ask me when. Who knows when...we just need to come up with numbers and don't give them a target date to hold us to account. Simple.

  • Report this Comment On June 04, 2013, at 1:51 AM, prginww wrote:

    This is why i use TipRanks, its the only transparent platform that automatically opens a performance report anytime i come across an analyst while browsing the web. you can see who is worth listening too and who isn't. most of them aren't :)

  • Report this Comment On June 04, 2013, at 3:15 AM, prginww wrote:

    Great article most have their agenda pity as it destroys people's pensions Hope one day there will be honest reporting

  • Report this Comment On June 04, 2013, at 5:15 AM, prginww wrote:

    Gentlemen...........that is simply an outstanding piece of writing on a subject that needs more exposure.

    The very same houses that publish these self-serving opinions are the places of business that drove so many retail investors to the sidelines and many of these once believers out forever.

    Not unlike the poker game analogy: "That's a crooked game you know." ......"Oh I know but it's the only game in town."

    Only one step beneath this deceit are the miscreants who appear on network tv with some stock to sell.At that point one I backing up a frontrunner or buying his firm's "outs" ?

    Another day of reckoning is nearby with the type of behavior outlined in this piece, fast trading programs, any one of a dozen algo schemes,and a repeat of the, yet to be truly explained, "greasy thumb" incident of recent vintage.

    What a cesspool of self-righteous thieves.

  • Report this Comment On June 04, 2013, at 7:48 AM, prginww wrote:

    Analysts are about as useful as weather forecasters. Both have a job where being wrong is normal with no consequences. I have been on this planet nearly 3 decades and have never seen a weatherman predict the weather to the exact degree. Even worse, it sometimes snow when it is supposed to be sunny and it is sometimes hot when it is supposed to be freezing.

    I'm an engineer and if a building I design collapses because an earthquake hits it right after a tornado, it is suddenly my fault because I didn't design it to be able to survive every possible cosmic event imaginable.

  • Report this Comment On June 04, 2013, at 9:59 AM, prginww wrote:

    Thanks for all of the comments, everyone! We really appreciate them.

    Many of you have rightly made the point that investors should have been pretty skeptical of sell-side research all along. That's a great point, of course, and there have definitely been quite a few studies prior to this one that have questioned the value of such research.

    The "Inside the Black Box" study was "shocking", however, in that it shows precisely how and why the analysts are incentivized to focus on other priorities besides the accuracy of their forecasts and stock recommendations. There were quite a few illuminating direct quotes from the sell-side analysts themselves that really helped us to better understand their processes. I highly recommend reading the study in its entirety, if you can make the time for it. It's a fascinating read.


    John Reeves

  • Report this Comment On June 05, 2013, at 7:47 AM, prginww wrote:

    As both a private investor and manager of clients' investment portfolios, I only take notice of analysts views if the aggregated opinion confirms my own thoughts: generally analysts views can show the short term direction of any given stock price; and that is as good as it gets. Do not invest based on what an analyst says: DYOR.

  • Report this Comment On June 05, 2013, at 2:30 PM, prginww wrote:

    A good article but this is not news. I only use analyst recommendations for a place to find potential candidates to research myself.

    Has anyone ever noticed that most buy side commentators in the media tout their own poisitions that have risen in value so that you will buy their funds or at least help to drive up their holdings?

  • Report this Comment On June 07, 2013, at 12:51 PM, prginww wrote:

    Wall Street is about access. Insider information is how any of these people really make their money. I don't even look at these so called recommendations. I imagine 99% of the Wall Street insiders look at retail investors as suckers, plain and simple.

  • Report this Comment On June 07, 2013, at 1:31 PM, prginww wrote:

    I witnessed the audacity of these analysts first hand - I was married to one - she and her fellow employees' offices were filled with plaques and gifts from companies that went public on their recommendations - As mentioned before " Trust but Verify "

  • Report this Comment On June 07, 2013, at 8:13 PM, prginww wrote:

    "Overall, the study found that buy-side clients valued sell-side analysts' views more when analysts had direct contact with management."

    Nice to know... :-)

  • Report this Comment On June 07, 2013, at 8:24 PM, prginww wrote:

    That anyone would want to live in a society where self-serving, misrepresented parasites such as these described above are compensated at all is shocking. What value, in terms of service, do these 'analysts' deliver, anyway?

  • Report this Comment On June 07, 2013, at 8:33 PM, prginww wrote:

    just a new/old fool looking forward to June 19 and learning how to make money with options!!!

  • Report this Comment On June 08, 2013, at 6:15 AM, prginww wrote:

    Again, the business news services fail to expose this conflict of interest and continue to give the analysts a microphone for their faulty analysis. They, at least could track analyst success before putting them on camera.

  • Report this Comment On June 08, 2013, at 8:43 AM, prginww wrote:

    ''Don't follow the herd'' does'nt mean the herd on main street but the heard of oxymorons on Wall street. Access to informations from the CEO count for 5 % and distortions from the biases situations count for 95 % of the recommendations.

    Congradulation to professors Lawrence Brown (Temple University), Andrew Call (Arizona State University), Michael Clement (University of Texas), and Nathan Sharp (Texas A&M) and thank you John Reeves, and Ilan Moscovitz and Motley Fool.

    A real fool from Montreal

  • Report this Comment On June 09, 2013, at 3:20 PM, prginww wrote:

    The first time one of my stocks rose to, for example, $100, and then a week later, the analysts raised their target price to $ 85 or $90, I thought I was a totally ignorant newbie. The second time that scenario occurred, I started asking questions. By the third time, I realized analysts who make calls like that are totally NOT worth reading.

  • Report this Comment On June 10, 2013, at 12:07 AM, prginww wrote:


    The fourth time you might actually begin buying on their recommendations -- just in a contrary way. Analysts are rewarded by their brokerage sales forces. Their recommendations should either be ignored or reversed. The value they provide is in the financial models they present. . which have often been double-checked with company management. It's a funny world. I don't think it'll survive the Internet revolution, though. Too many in the know now. Eventually, their reputations will burn down.

    Great article. We should republish this, with updates, once a year.

    Tom Gardner

  • Report this Comment On June 11, 2013, at 12:57 AM, prginww wrote:

    WOW! Morgan, I think you just got a whole bucket of attaboys.

  • Report this Comment On June 11, 2013, at 11:24 AM, prginww wrote:

    Great article, but confused...if this is true (and I whole heartedly believe it is) then why does the Fool allow/accept that their reporters use the analysts information (earnings estimates) in their articles?? We've tried to integrate our earnings expectations data (based on crowd sourcing) with the Fool community but have been ignored. Don't you think 15 years worth of proven earnings data would be a great addition to your research and a viable alternative to the analysts game?

    Other great articles along this line include "Why You Can't Trust Wall Street's Predictions for 2012" (ETF Guide) and "Why You Shouldn't Buy Those Quarterly Earnings Surprises" (WSJ).

  • Report this Comment On June 11, 2013, at 1:59 PM, prginww wrote:


    I think that’s a fair question to ask. After talking with the authors of this study, we really noticed the insidious effects of sell-side research on the day-to-day coverage of individual stocks in the financial media. Obviously, it’s difficult to be overly prescriptive on how this research should be effectively used by financial writers, but it’s helpful, I think, to be aware of how ubiquitous this research actually is.

    Thanks sharing your thoughts and providing the article recommendations.


    John Reeves

  • Report this Comment On June 12, 2013, at 12:17 PM, prginww wrote:

    Kudos to jds0922 for brtigning that up...if Analysts rec's are so suspect, then why should the Fool give them so much creedence / coverage if you will in their Free articles and paid Newsletter Services?

    Furthermore...what else is new...the game is rigged against the little guy, hedge funds, insiders, politicians, etc have an edge, fair or unfair, against the little we can do is not to play the game their way...

    PS - Per the above article and how unreliable Analyst Rec's and Q'ly / annual earnings Estimates are, did the authors of the study give any insight into how Q'ly earnings estimates are calculated and their 'accuracy' rate?

    FWIW, it seems stock price performance hinges a lot on missing/beating estimates...whether those Estimates are in anyway Credible or nor.


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