Question

Question 6

6.1.
Many market participants believe that sell-side analysts are too optimistic in their stock recommendations, and too slow to recommend sells. Critically discuss factors which have been shown to contribute to analysts’ bias.

6.2.
James Alexander works as a sell-side analyst for an investment bank that offers both underwriting and brokerage services. James sends you a highly favourable report on a stock that his investment bank recently helped go public and for which it currently makes the market. What are the potential advantages and disadvantages in relying on his report in deciding whether to buy the stock?

Answer 1

6.1  

Need for access to firms. Sell-side analysts often depend on information from the firm to answer questions about firm performance and strategy not contained in other public information about the firm. This information can make an analyst’s reports more thorough and persuasive to potential investors. Furthermore, higher quality reports can increase revenues for the firm and compensation for the analyst. After a sell recommendation, firms are less likely to be as open and forthcoming with analysts who have recommended a sale. Conversely, a strong recommendation to buy a firm’s share may result in greater access to the firm in the future. Hence, the sell-side analyst could provide optimistic recommendations to help guarantee access to the firms they cover. Potential for investment banking services by the analyst’s firm. Investment banking services can be a significant source of income for brokerage/investment banking firms. Moreover, firms are more likely to use the investment banking services of brokerage/investment banking firms that issue favourable recommendations. A negative recommendation may cause the brokerage/investment banking firm the loss of significant additional revenues from underwriting or investment banking services in the future. As a result, sell-side analysts may be more likely to be optimistic in recommendations about a specific firm. Difficulty of taking advantage of a sell recommendation. It may be more difficult for a brokerage firm’s client to take advantage of a sell recommendation. A much narrower group of clients can take advantage of a sell recommendation. If a client owns the shares, he can sell them outright. If the client does not own the shares, he must find another shareholder to borrow it from in order to short it and take advantage of the recommendation. Furthermore, short sales are typically more expensive than regular share purchases, last only a finite amount of time before expiring, and carry a higher riskfor the investor. Hence, a sell recommendation for a share is less likely to generate the same revenues for the firm as a buy recommendation.

6.2

* Stock prices are observed to follow the recommendations derived from analyst coverage

* Increased analyst coverage typically causes investors to believe that more superior information will be priced into a stock’s prospects and value

* Analyst coverage catches the attention of retail investors and thereby boosts liquidity

* Reductions in the cost of capital are possible through increased analyst coverage

* Analyst coverage adds the most value during volatile economic periods or ‘bad times’

* In emerging markets, weakly distributed information presents a lack of firm-specific information from being incorporated into stock prices

* Smaller companies are in line to benefit the most from analyst coverage off their limited visibilit.

* Losses in analyst coverage increase the likelihood of a company delisting.