Sell side analysts choose peer comparison for show, paid-for analysis legit


Photo courtesy of reynermedia on Flickr

Photo courtesy of reynermedia on Flickr

Rob Swystun, Pristine Advisers

We all have biases. Nobody is completely objective and a new study shows that sell-side analysts use their bias to make their own recommendations look better.

How they do this, it turns out, is by comparing stocks they’re researching to companies in the same industry whose stocks are already expensively-priced. This makes the stock they’re researching (and potentially recommending) look like a better deal by comparison, as reported by

Choosing a “peer” company for comparison purposes, it turns out, is a highly strategic maneuver meant to make an analyst’s recommendation look more credible, according to the study from the University of Toronto‘s Rotman School of Management.

But, lest you think this study is pointing fingers at anybody, it also says that the majority of analysts do use reasonable criteria when they choose a peer company for comparison purposes.

“We believe these analysts fulfill an important function in the market,” said Prof. Ole-Kristian Hope, Deloitte Professor of Accounting at the Rotman School. “That doesn’t mean they’re perfect.”

Not surprisingly, the study also found that analysts show a greater tendency to choose high valuation peer firms when their own brokerages have investment-banking affiliations with the companies they are researching.

The effect is less evident among analysts with an established reputation for skilled analyses.

Previous research has shown that reports by sell-side analysts tend to be optimistic. But this is the first large-scale academic study to examine what goes into those reports and how sell-side analysts decide which peer companies to use for their comparisons.

The study is forthcoming in the Review of Accounting Studies.

Gus De Franco, an associate professor of accounting at the Rotman School, and Stephannie Larocque, a Rotman PhD graduate who is now an assistant professor of accounting at the University of Notre Dame co-wrote the study with Hope.

Paid-for research the same as regular sell side analysis

In other stock analysis news, another study published in The Accounting Review, found that paid-for research doesn’t differ drastically from regular sell side analysis.

Paid-for research is akin to auditors and credit-rating firms, reports Michael Cohn in Accounting Today.

In the study “Worth the Hype? The Relevance of Paid-For Analyst Research for the Buy-and-Hold Investor,” researchers Bruce K. Billings of Florida State University, William L. Buslepp of Texas Tech University and G. Ryan Huston of the University of South Florida analyzed 247 paid-for reports and found “the recommendations and forecasts supplied by paid-for research firms provide value-relevant information for the buy-and-hold investor and [that] they affirm the SEC Advisory Committee recommendations supportive of paid-for research as a means of filling the void left by declining sell-side analyst coverage.”

The researchers said they could not find significant differences in quality between the paid-for research and sell-side analyst research “in terms of bias, accuracy, or ability to distinguish favorable from unfavorable future performance.”

Paid-for research, the team said, offers potential benefits to investors in small- and mid-cap equity markets.

They did make sure to distinguish between paid-for research and investor relations reports in their study, saying that the latter, while they make look like genuine research documents, count more as PR or marketing.

The team specified paid-for research as that done by outfits that are legitimately independent.

“In that way they are like credit-rating agencies, which are paid by companies to evaluate their debt, or auditors, who are paid by companies to certify their financial reports.”

To keep their objectivity in check, the paid-for research firms often have rules stating that their clients cannot prevent the publication of an unfavorable report, or cancel the research before the agreement is up. Some have rules against holding or trading in their clients’ stock to avoid conflicts of interest and some take lump sum payments up front to ensure they’ll get paid for the work even if that work turns out to be unfavorable for the client.

And while the paid-for research firms will typically allow a client to review a report for proofreading purposes, they will hold back their analyst recommendations and forecasts from these preview documents.

How they did it

The researchers analyzed 247 paid-for reports and compared them with an equal number of matching reports from sell-side firms. The matching was based on criteria like:

  • firm size,
  • age,
  • earnings volatility,
  • book-to-market ratio,
  • high-tech status,
  • R&D intensity, and
  • percentage of shares held by institutions.

They then assessed the reports for bias and accuracy of earnings forecasts for up to two years. They also took into account how analyst recommendations compared to stock performance over various periods ranging from one day after the report release up to one year following the report release.

For one and two-year forecasts, the researchers did not see any significant optimism or pessimism bias from paid-for reports.

The accuracy of forecasts were also quite similar, with the paid-for results actually having a slight edge in the two-year forecasts while the quality of recommendations was pretty much even.

Researcher William Buslepp, for one, didn’t expect that paid-for research would be comparable to sell-side research.

“I thought that it would turn out to be — to put it bluntly — garbage. That it didn’t turn out that way was a pleasant surprise.”


One response to “Sell side analysts choose peer comparison for show, paid-for analysis legit

  1. Pingback: 4 Reasons to pre-record your earnings call introduction |·

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