Research under the microscope

Global Finance, Jun 2003 by Field, Graham

Analysts are coming under analysis, and it can be a disconcerting experience.

The equity analysts' job has become a great deal ougher in the past three years. A sustained bear narket has meant pressures from all sides: within investment banks it has been a story of remorseless cost cutting, redundancies and slashed bonuses. From outside, disgruntled investors and zealous regulators have been gunning (sometimes quite literally) for the analysts. Now comes another-at times unwelcome-pressure: the scrutiny of research by third parties.

In the past, analysts were seldom held accountable for their forecasts and recommendations. Now, it is standard practice for all research distributed in the US to carry charts showing the history of an analyst's recommendations and the corresponding movements in the share price. A central database is to be set up in the US to track these as part of the 'global' research settlement initiated by New York Attorney Eliot Spitzer's investigations.

Private companies are already providing some of this service. London-based AQ (Accuracy Quotient) has been tracking analysts' earnings per share (eps) forecasts since 1998, using raw data from Thomson Financial, the biggest provider of earnings estimate data. The ability to predict company eps accurately is, we have maintained, one sign of an analyst's understanding of a company's fundamentals.

For investors, however, an analyst's ability to pinpoint an eps number to the third decimal place is not always as useful as knowing whether a buy, hold or sell recommendation was right or not. Spitzer's investigations revealed a clear bias toward positive recommendations-a pattern that UK regulator the Financial Services Authority argues is mirrored in the market it oversees. That's pushed analysts' recommendations to center stage in the quest for independent research. In order to meet that demand AQ has now moved into the monitoring of recommendations in a new report, RQ. First published in May this year RQ tracks analysts' recommendations against the performance of the stocks they choose. Of course, we're not the only ones who have recognized the importance of this service.

In the US, the scrutiny of recommendations has been led by San Fransicso-based Starmine, which ranks individual analysts and highlights those with 5-Star performance. In Europe, the Swiss Association of Financial Analysts has created a computer program, the Information Standard for Analysts (ISFA), that allows users to determine whether analysts' recommendations add value or not.

Analysts will also find themselves being monitored more closely from within their own firms. Heads of research have tools at their fingertips that enable them to see which of their analysts' recommendations have performed best-and worst. They are, in many cases, combining this with new systems designed to eliminate the bias in research by forcing analysts to match the number of buy and sell recommendations. This was a method that HSBC pioneered in the UK under Mark Brown, who has now returned to ABN AMRO as European head of research. Other houses-such as France's Aurel Leven-are forcing analysts to come off the fence by abolishing the hold recommendation (often seen as nothing more than a parking lot for neglected stocks).

For analysts who 'fall in love' with their stocks or who go in fear of the wrath of a company (or their own corporate finance department) when marking a stock down from a buy to a sell, these will be hard times. But for the companies monitoring the process-and for the ultimate investors-there are promising times ahead.

Graham Field is managing editor of AO Publications.