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Financial Analysts: Potential Sources of Bias

Financial analysts (a.k.a. research analysts, securities analysts, equities analysts) do not exist in a vacuum. They are subject to social pressures, same as everyone else. They may be influenced to give a company a good rating, even if that company does not deserve it. Ergo, a security analyst's recommendations may not always be truthful or fair.

Situations Where a Possible Bias May Exist

There are two situations where a financial analyst may be less than objective about his assessment. They are the following:

  • The research analyst is invested in a company he covers.
  • The research analyst works for a brokerage firm.

When the research analyst has an ownership stake

A financial analyst is almost always an investor. A research analyst assesses publicly traded companies. It only makes sense that he capitalize on the information he gathers. If he is part of an underwriting team, he may also be receiving stocks in new companies as part of his compensation package.

If a securities analyst is invested in a company he covers, it is against his interest to give this company a negative rating. Doing this would devalue his shares and lead to financial losses.

On the other hand, it is in his interest to give this company's competitors a negative rating. Doing this would devalue these competitors' shares, thereby strengthening the market position of the company in which he has an ownership stake.

When the securities analyst works for a brokerage firm

A financial analyst employed by a brokerage firm is called a sell-side analyst. His main task is to assess the securities his employer (the brokerage firm) offers to its investor clients.

Generally, it is in the brokerage firm's interest to ensure that its financial analyst's report is reliable. The more reliable a financial analyst's report, the more confidence the firm's investor clients will have in the firm. Consequently, these investor clients are more likely to stay with the firm. They are also more likely to recommend the brokerage firm to their friends.

However, a brokerage firm has other interests besides keeping investor clients happy. These other interests are potential sources of bias for the financial analysts in their payroll.

Conflicts of interest may exist if a financial analyst works for a brokerage firm that:

  • Earns commissions from sales

    A brokerage firm may frown on negative research reports, thereby inducing its financial analysts into writing only positive reports about the securities they deal in. Positively rated securities are securities that sell. More sales simply mean a greater profit for the brokerage firm.

    Since all brokerage firms earn commissions from transactions, this means that all sell-side financial analysts are subject to this pressure. This doesn't mean all sell-side analysts are biased. This just means they may be, and it's worth your time checking out whether or not such a bias does exist.

  • Has an investment banking division

    Brokerage firms that offer investment banking services help their corporate clients prepare for their public offering. Brokerage firms also help such clients sell their securities to the public. They may even underwrite their clients' securities.

    If a brokerage firm offers investment banking services, the financial analysts in its employ are subject to a conflict of interest.

    On the one hand, the financial analysts have to write reports that investor clients can rely on for their trading decisions. On the other hand, some of the companies they have to asses are their firm's corporate clients.

    If a research analyst gives his firm's corporate client a negative rating, the following are some of the possible consequences:

    • The corporate client may change firms. The firm will lose an important investment banking client.
    • The brokerage firm may have a hard time finding other investment banking clients. Prospective clients may be scared off by the negative rating the firm has given one of its clients.
    • Sales of this client's securities will be slow. The brokerage firm's reputation will suffer. This will make it even harder for the firm to find new investment banking clients.
    • The firm will lose money. If the brokerage firm was also the offering's underwriter, the firm will lose the money used to underwrite the corporate client's securities. The brokerage firm will also lose the money spent setting up the underwriting deal.
    • The brokerage firm will incur opportunity costs. Money used to underwrite the failed offering could have been used to underwrite a much more lucrative offering.

    A brokerage firm has much to lose if its financial analysts give investment banking clients a negative rating. Thus, a brokerage firm may exert influence (subtly or overtly) on the financial analysts who are in charge of assessing its corporate clients.

    Pressure applied on financial analysts to ensure their compliance may be negative - e.g. the financial analyst's job security may be threatened. It may also be positive - e.g. the financial analyst may be given a share of investment banking profits or his salary may grow apace with the brokerage firm's investment banking division.

Protecting Yourself against a Financial Analyst's Potential Biases

Forewarned is forearmed, as they say. If you know that a financial analyst's recommendations may be biased, you can be more careful about verifying his facts and assessment. In the end, you will still follow a securities analyst's recommendations - potentially biased or not it may be - as long as it makes sense.

Note: Just because an analyst is potentially biased doesn't mean he is. You simply need to understand where an analyst is coming from so you can factor that in with his recommendations.

If you are thinking of buying securities based on the positive recommendation of a financial analyst, check whether or not a potential bias exists by doing the following:

  • Check the securities issuer's prospectus (if the company is a new one) to see if the financial analyst's brokerage firm is the underwriter of the deal.
  • Check the securities issuer's prospectus, too, for a lock-up agreement.

    During the lock-up period, venture investors in the company's securities (may include the brokerage firm) as well as these venture investors' employees, affiliates, friends, and relatives are prohibited from selling any shares.

    This means that price fluctuations are possible after the lock-up period ends and the supply of securities increases. This also means that a positive report before a lock-up period's expiry may be intended to boost stock prices before more shares are released into the market.

  • Get a copy of the company's financial statements and SEC filings. Try analyzing a company's financial situation yourself.
  • Read all the disclosures that you can find on a company's prospectus or SEC filings as well as the financial analyst's/brokerage firm's report. These disclosures can alert you to potential biases.
  • Check the company's registration documents to see if the financial analyst (or the financial analyst's brokerage firm) owns a significant chunk of the company's securities.

    A financial analyst's (or his brokerage firm's) ownership interests may also be traced by checking their SEC filings. Of particular interest are SEC forms 3, 4, 5, and144 as well as Schedules 13D and 13G.

  • Get a second opinion from other securities professionals, preferably those who are not affiliated with the firm/securities analyst that released the positive rating.
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