Analysts evaluate companies and issue recommendations to help investors – mostly institutions

Analysts evaluate companies and issue recommendations to help investors – mostly institutions – make informed decisions

May 30, 2024 | 10:38am

Your guide to Wall Street analyst research and how to use it like the investing pros

Analysts evaluate companies and issue recommendations to help investors – mostly institutions – make informed decisions

Wall Street sell-side research is a key part of the financial markets, written by analysts working for brokerage firms, investment banks and other institutions. These analysts evaluate companies and issue recommendations to help investors – mostly institutions – make informed decisions. Buy-side research (by money management firms) is another kettle of fish entirely, produced in-house by institutional investors themselves and not meant to be shared or distributed or otherwise sold, and intended solely for the use of that firm's own money managers. Here is a breakdown of how the sell-side research process works and how to use it to your advantage: Sell-side analysts' role Analysts are financial professionals, oftentimes holding qualifications such as a Chartered Financial Analyst designation, who perform in-depth research on publicly-traded companies. In health care research, it's not unusual to find analysts with medical degrees. Sometimes analysts will come from private industry. The work involves analyzing financial statements, industry trends, management performance, company strategy and macroeconomic factors affecting supply and demand. The goal is to assess a company's future performance and offer investment recommendations to the investment bank's clients, be they institutional investors such as pensions or hedge funds, mutual funds, insurance companies or retail investors. Research reports An analyst's published research report might include a company overview with basic information about a company's business, products and position in the relevant market. This is especially true when an analyst is first initiating research coverage into a particular company or industry. Beyond the basics, the report will explore a company's financial health and analyze income statement, balance sheets and cash flow. That will include the analyst's own financial model and estimates of future years' revenue; profit margins; net income; income adjusted for one-time items; earnings before interest, taxes, depreciation and amortization (EBITDA); cash flow; and a host of secondary yardsticks. That analysis will lead to a discussion of valuation, using methods such as future cash flows discounted back into today's dollars; price-to-earnings ratios based on current results and expected numbers in the future; and other benchmarks to decide on intrinsic value. Against that backdrop, an investment thesis will offer arguments for why a stock is a good or bad investment , and highlight the possible risks to that thesis that could affect a business's performance or the price of its stock on the open market. The culmination of the report is a recommendation to buy, sell or hold a security and to give a target price projected to be realized over a given time, usually the next 12 months although sometimes even longer. Recommendations At the end of the day, what a client wants to know is whether she should consider buying, holding or selling a stock, using the analyst's insight to help guide an investment decision. A "buy" recommendation means an analyst believes a stock is undervalued and is likely to appreciate. Variations include "strong buy" or "outperform" to signal an even higher or lesser degree of confidence, depending on a particular firm's own specific nomenclature, or simply that a stock will do better than others in its industry or the market as a whole. A "hold" recommendation simply means an analyst believes a stock is fairly valued near today's price and offers limited room to advance, such that the advice is to maintain a current position but not to buy more or sell it. Variations on this theme include such ratings as "neutral" or "market perform." The rarest call on the street is "sell," where an analyst is effectively saying a stock is overvalued today or will soon face downside risk. Variations here might include "strong sell" or "underperform," once again signifying more or less confidence, reflecting a firm's own in-house hierarchy, and that a stock will lag its industry or the broad market. Analyst recommendations affect stock prices every day , especially if an analyst or her firm is highly reputable or believed to hold expertise in a particular area. This is also often the result of marketing and salesmanship by an investment bank's brokers and traders who alert a firm's clients of a notably bold call on the part of the research department. As with so much else on Wall Street, sometimes it's simply a matter of trust. A stock might run up after a positive report and a buy recommendation, or decline after a negative report and sell recommendation, simply because many investors trust the analyst's expertise and follow her advice. A wink is as good as a nod Be aware that sell ratings are so scarce on Wall Street that frequently a downgrade of a stock to "hold" from "buy" (or "neutral" from "outperform," etc.) is interpreted as veiled advice to get rid of a holding entirely. In other words, as a "soft sell." It's a diplomatic way for analysts to express a negative view on a stock without appearing overly pessimistic. How can a "hold" become a "sell"? Because of possible conflicts of interest, where an investment bank is holding out to be hired to help a company sell stock or advise on a merger or acquisition, and an analyst issuing a sell opinion could jeopardize that relationship. Or because an existing client, such as a pension or hedge fund, holds a position in that stock and a formal sell recommendation will hurt their portfolio. And because a "sell" recommendation might cut off an analyst from contact with a company's management, or otherwise jeopardize her flow of information from the company. As a result, "hold" recommendations can be a code for "sell," and their use has increased over time as a catch-all category for a stock that an analyst believes investors should avoid, but without the stigma of an outright "sell." Consequently, while perhaps 50% to 60% of all the recommendations on the Street from all analysts are to buy a stock, anywhere from 30% to 40% might be advice to hold and just 5% to 10% are a sell. Contrarian indicators Analyst recommendations can occasionally act as a contrarian indicator , too. In the same way that indicators of investor sentiment can signal a possible top in prices when opinion is overly bullish, and a possible bottom when opinion is too bearish, so too with Wall Street sell-side research. When a significant majority of analysts issue a buy rating on a stock, it might mean that all the potential good news is already priced into the shares, suggesting little upside remains. Or when analysts are largely bearish on a stock and recommend no more than a hold or a sell, it can mean that expectations are low, most or all of the bad news is already reflected in the share price, the stock is potentially undervalued and sentiment can improve. Analysts are also sometimes late to the game. By the time a stock has received a large number of buy recommendations, it may have already run up. Or conversely, by the time a stock attracts many hold or sell recommendations, the price has already slumped. Finally, investors can also treat too many buy ratings as reflecting a desire by analysts to curry favor with the companies they cover, aiding the investment banking side of the business to gain clients and boost business. Regulations, compliance and ethics As a counterweight, analysts and their firms are now subject to myriad regulations aimed at ensuring transparency and reducing conflicts of interest. That was largely a response to the Dot Com Bubble of the late 1990s and its subsequent crash in the early 2000s. At the time, many sell-side analysts were criticized for overly optimistic research reports that were blamed for contributing to the bubble. A wave of regulatory reform, including the Sarbanes-Oxley Act of 2002, followed. Among other provisions, Sarbanes-Oxley requires analysts to disclose any potential conflicts of interest. More formally, the Global Analyst Research Settlement of 2003 grew out of investigations by the Securities and Exchange Commission and state attorneys general into conflicts of interest between the securities research side and the banking side of investment banks. The $1.4 billion settlement ($2.4 billion in 2023 dollars) mandated 10 of the nation's largest investment firms pay hundreds of millions in restitution to harmed investors and hundreds of millions in penalties, as well as agree to reforms in the way they do business to prevent future conflicts. As part of the settlement, Merrill Lynch internet analyst Henry Blodgett agreed to a "letter of acceptance, waiver and consent," that said Merrill for three years "published research reports on two Internet companies that violated antifraud provisions of the federal securities laws, and published research reports on five other Internet companies that expressed views inconsistent with [its] analysts' privately expressed negative views" in violation of National Association of Securities Dealers' advertising rules. "Those rules require that, among other things, published research reports have a reasonable basis, present a fair picture of the investment risks and benefits, and not make exaggerated or unwarranted claims," according to the settlement. Transform your portfolio with expert analyst ratings! Click here to join CNBC Pro .

This story originally appeared on: CNBC - Author:Scott Schnipper