Analysts are often rewarded for their ability to attract and maintain investment banking business. They're often under pressure from the companies they cover, big institutional investors, and their own employers to maintain positive ratings. These are conflicts that may never be resolved. But there are some steps that could alleviate the pressures that prevent analysts from telling the truth.
First, education is paramount. "Investors need to realize that the free research they're getting is often just a marketing tool," says Kent Womack, a professor at Dartmouth College's Amos Tuck School of Business. Better disclosure also could help. It should be mandatory that reports prominently disclose a firm's specific investment banking relationship with the company it's covering.
And an overhaul of the language of ratings would be helpful as well. In normal English, most ratings sound like variations on "we think this is a decent stock that you should own." In ratings land, terms such as "accumulate" and "hold" are part of an elaborate web of euphemisms in which "neutral" means "dump this loser, and run for your life." And it would make sense if all analysts used the same terms.
To help restore analysts' integrity, their compensation should not be dependent on investment banking fees earned from the companies they cover. At the least, that conflict should be disclosed. Two prominent securities-industry trade groups have recommended that analysts be paid on stock-picking and earnings-estimate prowess, a practice some firms are adopting. Some groups have already barred analysts from owning stocks that they cover.
The SEC may soon approve some of these changes. Still, even the best regulation can't make analysts completely unbiased. A healthy skepticism and a willingness to look beyond retail analysis when choosing stocks may be the best bet of all. Says James Grant, publisher of Grant's Interest Rate Observer: "These days, the newsstands are thick with publications that are more inclined to search rather than cheer." Otherwise, to quote Gekko, "you're walking around blind without a cane, pal."