When an analyst at a large investment bank downgrades or upgrades a stock, it can often have a large impact on shares of even the largest companies.

Analyst upgrades and downgrades (and some of the issues that have gone along with them) have long been a part of the stock market. But few investors  know that there is a whole cottage industry of analysts that explicitly rate companies' shares "buy," "sell," or "hold" in exchange for thousands of dollars from the companies whose stock they are rating.

How pay-for-analyst research works
Typically, what we call sell-side analysts come from financial institutions like Merrill Lynch or Goldman Sachs. The issue their opinions on stocks because they know some investors value their research (plus, it can be a good way to get investors to park their cash with the company's brokerage or wealth-management divisions).

There is also an entirely different group of analysts issuing research reports on companies. These research shops, often dubbed "pay-for-analysis" firms, issue their analyst opinions mostly after the companies that they research pay them cash.

Most pay-for-analysis shops say their buy and sell research recommendations are completely independent of the large sums they receive from the companies they rate. Still, it's hard not to take a cynical approach toward pay-for-analysis firms like Dutton Associates, Taglich Brothers, RJ Falkner, or companies that have used them for research -- like Apex Silver Mines (AMEX:SIL) or Harbin Electric (NASDAQ:HRBN).

Presumably, many companies use these pay-for-analysis research firms to help disseminate publicity about their business and stock. A company like Williams Controls (NASDAQ:WMCO) or National Coal (NASDAQ:NCOC) has virtually no sell-side analysts covering it. Using a pay-for-analysis shop can be one way to get more analyst exposure, if a company desires it  -- albeit through a questionable use of shareholder cash.

Looking at pay-for-analyst performance
Dutton Associates and Taglich Brothers are two of the more well-known and prolific pay-for-analyst shops. You can often catch their announcements of a new analyst rating via a press release on Yahoo! Finance or elsewhere.

Here is a chart showing the performance of active stock picks -- which refers to any stocks that Dutton or Taglich have any sort of buy rating on -- since these two pay-for-analysis shops started rating them a buy.

 

Number of Actively Rated Stocks*

Number of Active Buy Recommendations

Average Return on All Active Picks With a Buy Recommendation**

Dutton Associates

92

78

(26%)

Taglich Brothers

33

24

6.7%

*Includes all buy, sell, and neutral recommendations (or their equivalents) as of Aug. 20, 2008.
**Returns at the close of Aug. 20, 2008, per Yahoo! Finance and Pink Sheets.

It's also worth noting that the majority of Dutton and Taglich's stock picks have produced negative returns for investors. For Dutton, shares of only 14 of its active picks that have a buy rating (out of 78 total stocks), are in the green, and are posting positive returns. While the return from Taglich Brothers may seem reasonable given the current market conditions, only 9 of its active picks that have a buy rating (out of 24) have positive returns.

This chart isn't meant to pick on Dutton or Taglich, but rather to show how companies that seek pay-for-analysis research often underperform. There are also several recommendations of theirs -- like Seabridge Gold (AMEX:SA) for Dutton or Life Partners Holdings (NASDAQ:LPHI) for Taglich -- that have performed spectacularly well.

To be fair to Dutton and Taglich, the performances of some of the people on Wall Street, like mutual fund manager Bill Miller, have been bad in recent times as well. The Motley Fool's CAPS database also has a very useful tool where you can see how well much of Wall Street's stock pickers -- like Jim Cramer, for instance -- have performed.

Usually no gold rush here
It's worth pointing out that Dutton and other pay-for-analysis shops usually do a good job of disclosing the financial relationships they have with the companies they rate, so there is nothing illegal about what they are doing.

Every once in a while a company that pays for promotional stuff like pay-for-analysis research turns out to be a future multibagger. Hidden Gems pick American Oriental Bioengineering (NYSE:AOB) has paid firms like Wall Street Reporter to spread its name, but that hasn't prevented its shares from climbing severalfold since the start of 2005.

The bottom line is that if a company feels that it needs to use a pay-for-analysis research shop, there are often good reasons why it's failed to attract much of a following on its own. This doesn't mean that all publicly traded corporations with little analyst or investor following should be avoided, but investors should tread carefully around companies receiving pay-for-analysis ratings.

American Oriental Bioengineering is an active Hidden Gems pick. Try any of our Foolish newsletters today free for 30 days

Fool contributor Brian Lawler does not own or short shares of any company mentioned in this article. The Fool has an A+ disclosure policy.