Question

The existing literature on sell-side analysts demonstrates that not only analysts err in their forecasts, valuations and investment recommendations, but that they are also biased. Critically discuss the potential causes of errors and biases of sell-side analysts working at: (a) brokerage houses that do not offer any investment banking services to the companies covered by their analysts; (b) large investment banks that offer an entire spectrum of other services to the companies covered by their analysts; and (c) pure research firms that only offer analyst research services.

Answer 1

There have been various scandals and other instances of sell side analysts being either reluctant or negligent to put out propert stock analysis and recommendations. This can be driven by various factors chief being that he analysts are seen as cost centre since the investors especially retail are averse to paying for quality research hence these departments tend to aling themselves with the so called revenue generators/profit centres within their respective firms and this may impact the quality of their recommendations. We look at the 3 categories (as given) and briefly discuss their incentives to err:

(a) Brokerage House without Investment Banking: These firms are driven largely by trading & brokerage revenues and key clients for them would be large institutional clients. The analysts are geared towards providing new attractive innovative ideas to institutional clients and are not so much focussed on retail clientele interests. Additionally once they have an idea which has been bought in by their large clients, they are averse to downgrade their stock (even if there is a case) publicly since it can impact their image. Hence their interests are completely aligned especially in line with retail clients.

(b) Large Investment Banks: These firms earn their revenues by placing securities (debt as well as equity) to institutions and public at large. It is highly unlikely that one arm of the bank is pitching a security to investors and its analysts would be giving a negative report on the same underlying stock. The analysts in these firms would be constrained or atleast be driven by investment banking revenues to not give an outright opposite view to as being pitched by the IB team.

(c) Pure Research Firms: Pure research firms are selling themselves stating that there is no conflict of interest for them. However since their revenues will still have to come from investors, and atleast retail investors are not very happy paying for quality research, they tend to discriminate between high paying institutional / large clients compared to others . Plus they would always be looking for a big idea to get themselves in the eyes of investors, and once they have sold an idea they tend to be prejudiced to go against their own idea in a hurry.

Thus we see that each category has its shortfalls and possible areas for errors & biases.