Do affiliated analysts mean what they say?

Financial Management (Financial Management Association), Winter, 2007 by Michael T. Cliff

Many investors were upset with the losses they experienced by following the recommendations of stock analysts during the recent market downturn. Allegations that these recommendations were often tainted by investment banking relationships fueled their anger. This study examines the investment performance of stock recommendations made by analysts employed by lead underwriters as compared to analysts independent of investment banking. The results indicate that during the 1994-2005 time period, Buy or Hold recommendations from affiliated analysts underperform stocks recommended by independent analysts. On the other hand, shorting their Sells earns significant abnormal returns. Announcement period returns suggest that the market over-reacts to Buys from affiliated analysts, but under-reacts to their Holds or Sells. Further analysis indicates that affiliated analyst recommendations are viewed as more credible following recent regulatory reforms.

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Considerable attention has been paid in recent years to "independent" stock analysts--that is, those analysts that are not affiliated with investment banks. It is widely assumed (at least by much of the media and regulatory community) that the conflict of interest between the investment banking and research arms of financial services firms causes the investment performance of stock recommendations from affiliated analysts to lag behind that of independent analysts. However, evidence on the comparative performance of independent stock research is mixed. This paper provides comprehensive evidence on the investment performance of stock recommendations from affiliated and independent analysts.

The profession of stock analyst has traveled a meteoric path the past decade. Before the mid-1990's, stock analysts were largely unknown to the general public. During the spectacular run-up of the late 1990's, many analysts achieved celebrity status. The best-known analysts generally worked at Wall Street's leading investment banks and leveraged their stature by landing lucrative banking deals for their firms and multi-million dollar pay packages for themselves. However, the public's love affair with these financial superstars faded quickly as share prices tumbled. From the market peak in 2000 to the end of 2002, investors in U.S. equities lost over $7 trillion, or about 40% of their value at the peak. Despite stratospheric valuation levels near the market peak, analysts were generally bullish and remained so as stocks plummeted.

In the wake of such devastating losses, why did the recommendations serve investors so poorly? New York State Attorney General Eliot Spitzer was a prominent figure in the quest to find an answer (see Spitzer, 2002). A series of well-publicized episodes of alleged misconduct served as the impetus for the $1.4 billion Global Settlement in April 2003 between ten leading Wall Street firms and a collection of regulators. A total of $450 million of this is earmarked for "independent research." Each bank is required to fund research by at least three government-approved independent firms and distribute reports from these firms along with their own research reports. The settlement and related regulations such as NASD rule 2711 and NYSE rule 472 also include other provisions about disclosing conflicts, providing recommendations histories, and severing the links between the research and investment banking groups within the banks.

A basic premise of the settlement is that the conflicts of interest between investment banking and research cause analysts to issue misleading recommendations. In other words, what these analysts said was hot necessarily what they meant. Sophisticated investors may be aware of this conflict and interpret the recommendations accordingly. In support of this view, Boni and Womack (2002) report that 87% of the buy-side professionals they survey believe that banking conflicts are an important motivation for analysts to provide optimistic recommendations and that 79% interpret a Hold to mean Sell. However, the focus of the settlement is on retail investors who may be unable to decode the recommendations on their own. In the words of Spitzer, his probe "... has been about one thing. It has been about ensuring that retail investors get a fair shake" (Spitzer, 2002). This paper examines whether access to independent research may help these investors make better decisions.

Spitzer's critics question whether investors are likely to benefit from these independent recommendations. The literature does hot provide a clear answer to this question. A number of papers (e.g., Dugar and Nathan, 1995; Lin and McNichols, 1998; Iskoz, 2003; and Agrawal and Chen, 2005b) find insignificant differences between the investment performance of recommendations from affiliated and unaffiliated analysts. Though the papers differ in sample periods and several methodological details, there are three common elements that may explain their results.

One critical issue is the definition of the unaffiliated benchmark. None of these papers uses a control group that is free from investment banking conflicts. In most cases, the control group consists of underwriters who were not lead managers for the covered firm. Of course those banks may have an interest in becoming the lead underwriter on future banking deals. Agrawal and Chen (2005b) do not include the banking relationship between the broker and covered firm. Instead, they use the fraction of each broker's revenues derived from banking as a proxy for the conflict of interest. This implicitly assumes that a given bank faces an identical conflict with each firm it covers.