In Part 1 of his peek into the weird world of Wall Street securities analysis, recovering analyst David Smith discussed how supposed reforms may have made things worse for analysts and investors alike. Today, he's probing the strange inner workings of brokerage firms, and exploring why new laws mean less coverage for small companies.
At many investment banking and brokerage firms, the system for rating stocks is deeply flawed and self-serving. It's designed to keep the analysts from crawling too far out on a limb, while maintaining the goodwill of the company being rated. As such, a simple "buy" or "sell" rating can quickly become complicated by a wall of confusing analyst-speak.
For instance, a stock may be rated a short-term hold, but a long-term buy. Honestly, what does that really mean? If the stock is considered attractive in the long run, isn't now a good time to begin buying it? Then there's the notion of confidence levels, in which analysts may be asked to specify just how strongly they believe in their own opinions. Huh?
The analysts' circle of life
Successful analysts must cultivate a series of key relationships, most importantly with the companies they cover. That rapport can vary substantially from company to company, depending on the analysts' own knowledge of the industry involved, and the importance the company places on its investor relations department -- typically the first corporate area the analyst encounters.
The differences between companies in their dealings with analysts can be amazing. In the energy services area, I found my coverage of Baker Hughes
Later, as a media analyst, I found cable operator Comcast
But a good investor relations department isn't enough, though too many companies seem to stop there when dealing with analysts. For truly complete coverage, analysts need to get to know the company's CEO and CFO, and as many operating executives as possible.
The importance of communication
In firms of all sizes, analysts' relationship with their in-house sales force also is crucial. That relationship will benefit from the confidence that analysts generate in their industry knowledge, and their ability to provide original and value-added research that goes well beyond a "me too" peddling of preexisting common knowledge. To that end, analysts need to communicate knowledgeably and effectively with their firms and their clients alike.
Unfortunately, firms too often fail to appreciate the importance of communication. Most firms hold a meeting each morning at the crack of dawn, in which analysts present news or ratings changes on the companies they follow. As soon as those meetings are completed, the sales force begins "smiling and dialing" to the firm's most important institutional clients (mutual funds, pension funds, hedge funds, and insurance companies), hoping to reach them before representatives of other firms are able to impart similar information.
For that reason, firms' morning meetings stay on a tight schedule. Frequently, even analysts with important news about their companies are left off the agenda. In one firm where I followed media companies, those who did get a spot on the morning docket had a minute or less to speak. Try explaining complex company or industry information, and related financial conclusions, in 60 seconds or less. To get the word out, then, analysts need to go directly to their firm's institutional clients.
At large firms, virtually all of the analyst's attention to sales is directed (somewhat by necessity) to the institutional types. However, I always attempted to get to know my firm's top "retail" brokers, the folks working with individual investors. I generally found them far more diverse and interesting than their institutional counterparts. All too often, however, retail brokers only get presentations from their analysts at annual gatherings of firms' top-tier brokers. It's little wonder, then, that the best research from the major brokerage firms frequently does not reach -- or is improperly used by -- the retail clientele.
The analyst-banker duet
Last but hardly least, there are analysts' relationships with the firm's investment bankers. There's a lot of teamwork involved here; for example, energy analysts partner with specialized energy bankers attempting to lure corporate finance business from energy companies into the firm.
Those relationships, and the tendency for some analysts to skirt the edges of ethical conduct, attracted the attention of Eliot Spitzer, then New York's attorney general. Spitzer's forays into the world of analysts and their investment banking colleagues have radically changed analysts' function and compensation forever -- and not necessarily for the best. For one thing, analysts can no longer get paid directly for the investment banking business they help attract to their firms -- business that once meant big money for analysts. As a result, far fewer analysts now receive seven-figure compensation packages.
But another group has also been hurt by now-Governor Spitzer's efforts: small corporations. The new economics of coverage dictate that most of an analyst's compensation must now come from the profits made through the trading of covered companies -- a pool that's also shrinking as commission fees decline. This new edict has made it cost-ineffective for firms to cover many smaller corporations, increasingly depriving investors of high-quality coverage on many companies in the early stages of public ownership.
What does all this mean for investing Fools? It's a complex question, but it has a relatively simple answer. While research opinions can still be useful when selecting an investment, now more than ever, there's no substitute for doing your own Foolish due diligence.
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Fool contributor David Lee Smith does not own shares in any of the companies mentioned. He welcomes your questions or comments -- or both.