Practical analysis for investment professionals
20 November 2013

Tougher Times for Securities Analysts

Increased scrutiny of securities analysts has repeatedly followed widespread financial turbulence. Since the global financial crisis, regulators have levied punitive fines and penalties on both individual analysts and their employers, for example the $550m fine on Goldman Sachs’ mortgage-related activities. This backlash follows almost the same script as after the tech bubble in 2000, when celebrity analysts were fined and ten investment banks funded a $1.4 billion enforcement agreement known as the “Global Settlement.” It’s hard not to conclude that damage has been done to the professional standing of all analysts, good and bad.

Such a regulatory backlash is one example of a diseconomy of scale in the financial services industry. When any industry attains a size large enough to adversely impact society as a whole and disrupt or threaten capitalist democracies, then host societies may well feel a duty to intervene.

Writing in the Journal of Economic Perspectives recently, John H. Cochrane of the University of Chicago Booth School of Business explores whether the financial sector is simply too big from a welfare analysis perspective. Some studies even suggest that the financial sector is about twice as big in the United States as it should actually be. Such a market distortion might point to the need for sterner regulation. Cochrane also questions the reasons for the persistence of high fees in asset management, a perennially contentious subject.

In another recent study, Robin Greenwood and David Scharfstein, both of Harvard University, evaluate the last 30 years of financial sector development and explore both the social benefits and social costs of financial sector growth. Much of that growth in the financial sector is associated with two activities: asset management and the provision of household credit. For asset management, the benefits to society lie in the expansion of financial market participation and improved opportunities for portfolio diversification. The social costs of asset management include high fees and economic rents extracted by the industry unnecessarily. A related study investigates whether similar conclusions about the development of financial services professions within the United States apply to other economies.

Perhaps regulators will be motivated to take advantage of new technologies to manage risks. One new study proposes a tool for mapping financial stability and visualizing possible sources of systemic risk. This tool can then be used as an early warning alarm.

Looking on the bright side, innovative tools and techniques are available to help investors and analysts deal better with uncertainty in their valuations. At a recent CFA Institute Conference in Singapore, Aswath Damodaran, professor of finance at the Stern School of Business at New York University, argued that uncertainty is embedded in valuations to measurable degrees. Damodaran categorizes uncertainties in valuation into three groups, each of which requires a unique response from skilled analysts.

Nonetheless, valuation errors by analysts regularly exist and are exploitable according to one study by Eric So of the Massachusetts Institute of Technology exploring sell-side analysts’ forecasts. The author finds that predictable errors in the forecasts exist but that investors just don’t spot them, relying more on less successful analyst forecasts. In another analyst study, evidence is produced of correlations between analyst coverage, institutional ownership, and innovation as measured by patents and citations. Depressingly, the authors determine that analyst coverage is not conducive to firm innovation in the long term.

Whether arguing in favor of sophisticated valuation techniques, marketing their latest research, or defending their corner against criticism or regulatory attack, any analyst would benefit from knowing how to give a killer presentation. This summary offers sound advice on delivering talks that keep audiences entertained and informed.

These recent CFA Digest summaries and related resources of interest to securities analysts are summarized below:

  • Finance: Function Matters, Not Size: The author explores whether the financial sector is too large from a welfare analysis perspective, which requires determining whether the given resource allocation is efficient. Economics is meant to explain behavior; the author revisits a number of puzzling aspects of the world for which real-life behavior does not appear to follow economist predictions.
  • An International Look at the Growth of Modern Finance: The long-run evolution of modern financial services in the United States can be evaluated alongside the sector in other economies with similar levels of development. The authors investigate whether conclusions regarding the development of the profession within the United States hold for the other economies in their study.
  • The Growth of Finance: During the last 30 years, the financial services sector has grown enormously. An analysis of how the financial sector has changed reveals both social benefits and costs of financial sector growth.
  • Mapping the State of Financial Stability: The “Self-Organizing Financial Stability Map” (SOFSM) can be a valuable tool for mapping the state of financial stability and visualizing possible sources of systemic risk. Beyond its visualization capabilities, the SOFSM can be used as an early warning model that can be adjusted to accommodate policymakers’ preferences so they do not miss a systemic financial crisis or issue a false warning.
  • The Dark Side of Analyst Coverage: The Case of Innovation: Financial analysts have been thought to reduce information asymmetry, but the authors offer evidence of a previously underexplored outcome of analyst coverage. They examine the correlation between analyst coverage, institutional ownership, and innovation (as measured in patents and citations) within firms, and argue that analyst coverage does more harm than good to firm innovation in the long term.
  • A New Approach to Predicting Analyst Forecast Errors: Do Investors Overweight Analyst Forecasts?: The author explores sell-side analysts’ forecasts of company earnings and compares them with unbiased forecasts of company earnings derived from company characteristics. He finds there are predictable errors in the analyst forecasts but that investors fail to fully take them into account, relying more heavily on less-accurate analyst forecasts. These valuation errors can be successfully exploited.
  • How to Give a Killer Presentation: The author offers advice on delivering presentations that keep audiences engaged, and emphasizes that there are some key steps and considerations — and more than one way — to give a “killer presentation.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/akindo

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, is director of journal publications at CFA Institute, where he supports a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

1 thought on “Tougher Times for Securities Analysts”

  1. Great post Mark. You may also want to take a look at findings from Rick Johnston of Rice University in “Crowdsourcing Forecasts: Competition for Sell-Side Analysts” where he looks at the relative accuracy between the sell side and buy side (as represented by the Estimize data set).

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2333671

    Also the paper from Vinesh Jha and myself titled “Generating Abnormal Returns Using Crowdsourced Earnings Forecasts from Estimize” where we look at a similar outcome of the buy side better representing the true expectation of the market vs the conflicted sell side.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2333671

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