Book Review: Wall Street Research
Wall Street Research: Past, Present, and Future. 2013. Boris Groysberg and Paul M. Healy.
Sell-side research is often seen as a competition among analysts for top rankings in surveys of investors. From time to time, scandals cause the profession to be viewed through the prism of ethical standards. Even the celebrity culture now colors perceptions of the analytical profession. In Wall Street Research: Past, Present, and Future, Boris Groysberg and Paul M. Healy of the Harvard Business School adopt the market for sell-side research as their framework. Oddly, this perspective is rarely used by brokerage industry types, who are otherwise thoroughly immersed in markets.
Brokerage houses tend not to think of research as a service bought and sold in a market because their ambition is to sell securities, not security analysis. The firms must nevertheless recover the costs of producing research. Prior to the US SEC’s abolition of fixed commission rates on 1 May 1975, broker/dealers paid for their teams of industry-specialized security analysts by bundling research with execution services. That worked well under pre–“May Day” commissions of 20–30 cents a share but proved unviable when those rates declined precipitously in the late 1970s.
The solution was to make analysts pay their way by supporting investment banking activities. Corporate issuers directed underwriting business to firms with highly regarded analysts who, they believed, could help generate interest in their stocks. The star analysts reaped sharply increased compensation packages, but along with the high pay came intense pressure to issue only favorable recommendations on their firms’ investment banking clients. A 1998 study by Zacks Investment Research found that of analysts’ recommendations on 6,000 companies, only 1.4% were sells. Such conclusions could not be taken seriously since, by definition, 50% of the issues were destined to underperform the median stock.
This colossal conflict of interest culminated in the industry’s 2003 Global Research Analyst Settlement with the New York State Attorney General’s office. The major investment banks paid fines of more than $1.4 billion. They agreed to end investment banking influence over analysts’ compensation, which would henceforth be determined, at least to a significant extent, by objective measures of research quality and accuracy. Investment bank funding of research plummeted, as did both the number and the compensation of sell-side analysts.
Groysberg and Healy bring this history up to the present with illuminating accounts of recent innovations in the production and distribution of research. They also present original research to argue that the highly publicized misdeeds of a few prominent analysts were not representative of the value of Wall Street research as a whole. By one criterion, sell-siders performed better than their buy-side counterparts, who presumably were less conflicted. To wit, the Wall Streeters were more accurate in their earnings estimates and less biased toward optimism.
The ultimate objective of research, however, is not to issue accurate earnings estimates but, rather, to pick stocks that beat the averages. But Groysberg and Healy report that in Institutional Investor’s 1998 rankings of sell-side analysts, buy-siders rated stock recommendations second in importance behind industry knowledge. The media may be obsessed with the lowdown on the star analysts’ favorite stocks, but institutional money managers do not appear to put much faith in those opinions. Groysberg and Healy offer no evidence that the performance of top-ranked analysts’ recommendations is superior to a random walk.
Investors clearly cared, however, when celebrated bank analyst Meredith Whitney downgraded Citigroup on 1 November 2007. Not only did the stock immediately drop by 6.1%, but Whitney also reportedly received death threats. Roger K. Loh and René Stulz noted that the content of Whitney’s Citigroup report differed little from that published in earlier reports by other analysts. Loh and Stulz inferred that some factor other than content must explain why the recommendations of some analysts are influential. One such factor, Loh and Stulz found, is that a recommendation change by an analyst who is highly ranked in Institutional Investor’s All-America Research Team survey is more likely to affect a stock’s price than one made by a lesser-ranked analyst.
We might conclude from these facts that certain analysts acquire the power to move the market for a stock over the very short run not because they can identify outperformers but because they earn high Institutional Investor rankings by demonstrating industry knowledge. In the days before email, fast-money portfolio managers vied to be the first call of their brokerage house salespeople following the in-house morning research meetings in which recommendation changes were announced. They could then buy the upgraded stocks before most investors heard the news, ride them up for a point or two, and sell for a quick profit.
The massive, simultaneous dissemination of information made possible by today’s technology eliminates any chance of gaining an edge in the old manner. Buy-siders, however, may not have given up trying to profit from the announcement effect of recommendation changes. In January 2014, BlackRock agreed to terminate its survey of sell-side analysts, which ostensibly involved previously disclosed information about the management, competition, and earnings of companies in their coverage areas. The New York Attorney General’s office had determined that the survey enabled BlackRock to obtain advance word of coming recommendation changes. Neither admitting nor denying the Attorney General’s findings, BlackRock paid $400,000 to cover the costs of the investigation.
Although this picture of the market for research differs somewhat from that which Groysberg and Healy portray, they provide valuable insight by applying economic models in novel ways. Particularly interesting is the comment of one expert on sell-side practices in emerging markets: “The majority of investors in China, including fund managers, don’t really pay attention to the fundamentals. Instead, there’s a lot of trading and buying based on privileged information, bordering on insider trading.”
The story of sell-side security analysis is still unfolding, but for an account up to this point, Wall Street Research serves the reader extremely well.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.