Stock Analyst Recommendations - Should We Trust Them?
Stock analysts do provide important and useful information in today's markets and investors should take that source of information into account since analysts' recommendations may influence the price of a company's stock significantly.
However, as a rule of thumb, investors should not rely solely on those recommendations when making their investment decisions. They should understand that certain conflicts of interest might exist which may create pressure on a stock analyst's objectivity and independence.
The following article will present some of the potential conflicts of interests analysts may face:
Underwriting a company's securities offerings
When companies issue new securities they turn to investment bankers for help with the actual offering. Typically, analysts play a substantial role as a part of the investment banking team; they assist with the due diligence research into the company and help to shape the deal. However, if the analyst's firm is underwriting the offering it has a significant interest in assuring that the offering is successful. Positive recommendations and upbeat research reports may help accomplish that and support the newly issued stock.
Trying to establish long-term investment banking
Naturally client companies would want a favorable research report. Thus, an unfavorable analyst report may make the company search for another firms for future investment banking services and hamper the firm's efforts to establish lucrative, long-term relationship with the company.
Typically brokerage firms don't charge for the research report itself. However, a positive report may generate more purchases and sales of the particular securities and help the firm make more money indirectly - thanks to the additional brokerage commissions.
Some firms bind their compensation and bonuses to the profitability of the investment banking division or to the number of investment banking deals a stock analyst lands. Thus, such compensation arrangements may exert pressure on analysts and make them issue positive reports.
If the analysts, other employees, or the firm itself own significant positions in the covered company stock, they have ownership interest and this may also exert pressure towards issuing a positive analyst research report.
To conclude, the fact that analysts, or their firm, may face a conflict of interest does not necessarily mean that the stock analyst recommendations are flawed or unwise. And yet, don't rely solely on them for your investment decisions. Do your own research, such as reading companies' prospectus, quarterly and annual reports that are filed with the SEC, etc.
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