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Foundational Principles

Breaking the Wall Street Code

By Mark Biller and Austin Pryor
Sound Mind Investing

CBN.comIt can cause your local broker to call you, pitching a stock you've never heard of. It can cause one of your holdings to swing 10 percent in a day when no news is announced. Its availability may even cause you to choose one brokerage over another. "It" is the infamous analyst research report.

Analyst research drives many of the investment decisions individual investors make, even when they aren't aware of it. In addition to being constantly featured in the financial media, brokers rely on their firm's research reports when seeking ideas for their clients. But deciphering analyst research can be tricky, and misinterpreting can be disastrous.

Who are these analysts? Analysts are simply brokerage employees who study companies within a certain industry and make buy/sell recommendations on those stocks. Their opinions carry a lot of weight with the brokers in their firm, who then pass them along to customers like you. When enough customers hurry to take action in response, there can be a dramatic change in a company's stock price.

Analyst recommendations are hard to interpret, partly because firms are free to use different rating systems and terms. Some brokers use a four-step scale for their recommendations (Raymond James uses Strong Buy, Outperform, Market Perform, and Underperform). Others, like Merrill Lynch, soon to be part of Bank of America, use a three-step scale (Buy, Neutral, and Sell). The only constant is the inconsistency — different graduated systems, using different terminology, with different shades of meaning. In addition to the terms being confusing, the scale is deceptive because the bottom rung of the ratings ladder is rarely used.

As a result of this lopsided field, the terms themselves are of little value. If an analyst says hold, that really means sell right away. In fact, Donald Cassidy, a senior analyst with Lipper Analytical Services, says in his book It's When You Sell That Counts, that all of the following analyst buzzwords should actually be interpreted as negative: hold, accumulate, long-term buy, market perform, and market weight. He lists several others, but you get the idea — anything sounding like faint praise is probably just the opposite.

Why the bias toward positive recommendations? Bluntly said, brokerages care a lot more about their investment banking business than they do their retail investing clients. The reason is simple. Investment banking, which is when a brokerage helps a company bring a new stock or bond offering to the market, brings in the big dollars. And today's analysts play a big role in landing investment banking business. Indeed, analyst compensation is often directly tied to the number of investment banking deals the analyst is involved in. In an investment banking deal, the analyst's role is to "support" the company with favorable research, helping create investor demand for the newly available stock or bonds. Naturally, it would look bad to slap a sell recommendation on a stock they've recently hyped for an IPO.

As a result, some analysts seem unwilling to ever say sell. For example, following the dotcom bust, one of prominent analyst Mary Meeker's favorite stocks, Yahoo!, plummeted from $237 to below $20. Yet she maintained an outperform rating the entire time, even predicting it would recover and rise to new highs (which, of course, it never has). More recently, when Bear Sterns collapsed virtually overnight, only one of the 16 analysts following the stock had it rated underperform, and none put a sell out on it. Thanks for nothing, Wall Street.

Even when analysts cover a company with whom they have no investment banking ties, there's always the prospect of lucrative future business. So it just doesn't pay to irritate the management of prospective clients with negative research reports or recommendations. Plus, there's a chance that in angering company management with a negative recommendation, an analyst could find himself or herself "out of the loop" on important future business revelations. Worth the risk? Not when your bosses would prefer you not ruffle any feathers to begin with.

Is analyst research useless then? Not necessarily. Analysts are typically smart professionals who know the industry they cover very well, and their research often provides valuable clues for those who actually dig in and read it. While the buy/sell recommendation itself probably is useless, a change in recommendation can be helpful. An analyst upgrade can be a bullish signal for a stock. And although downgrades are usually late, when they do occur it often signals further declines.

Analyst research can be a helpful source of ideas, as long as you or your broker read the detail of the report and find solid reasons to like the stock beyond the fact that it's been upgraded. If you remember that the analysts back at headquarters don't necessarily have your best interests at heart, you'll not be unduly swayed by their glowing recommendations.

Sound Mind Investing exists to help individuals understand and apply biblically-based principles for making spending and investing decisions in order that their future financial security would be strengthened, and their giving to worldwide missionary efforts for the cause of Christ would accelerate. In other words, we want to help you have more so that you can give more.

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