Analyzing Analyst Recommendations

Research analysts study publicly traded companies and make recommendations on the securities of those companies. Most specialize in a particular industry or sector of the economy. They exert considerable influence in today's marketplace. Analysts' recommendations or reports can influence the price of a company's stock—especially when the recommendations are widely disseminated through television appearances or through other electronic and print media. The mere mention of a company by a popular analyst can temporarily cause its stock to rise or fall—even when nothing about the company's prospects or fundamentals has recently changed.

Analysts often use a variety of terms—buy, strong buy, near-term or long-term accumulate, near-term or long-term over-perform or under-perform, neutral, hold—to describe their recommendations. But the meanings of these terms can differ from firm to firm. Rather than make assumptions, investors should carefully read the definitions of all ratings used in each research report. They should also consider the firm's disclosures regarding what percentage of all ratings fall into either "buy," "hold/neutral," and "sell" categories.

While analysts provide an important source of information in today's markets, investors should understand the potential conflicts of interest analysts might face. For example, some analysts work for firms that underwrite or own the securities of the companies the analysts cover. Analysts themselves sometimes own stocks in the companies they cover—either directly or indirectly, such as through employee stock-purchase pools in which they and their colleagues participate.

As a general matter, investors should not rely solely on an analyst's recommendation when deciding whether to buy, hold, or sell a stock. Instead, they should also do their own research—such as reading the prospectus for new companies or for public companies, the quarterly and annual reports filed with the SEC—to confirm whether a particular investment is appropriate for them in light of their individual financial circumstances. This alert discusses the potential conflicts of interest analysts face, describes the New York Stock Exchange (NYSE) and FINRA rules concerning analyst recommendations, and provides tips for researching investments.

Who Analysts Are and Who They Work for

Analysts historically have served an important role, promoting the efficiency of our markets by ferreting out facts and offering valuable insights on companies and industry trends. Analysts generally fall into one of three categories:

Sell-side analysts typically work for full-service broker-dealers and make recommendations on the securities they cover. Many of the more popular sell-side analysts work for prominent brokerage firms that also provide investment banking services for corporate clients—including companies whose securities the analysts cover.

Buy-side analysts typically work for institutional money managers—such as mutual funds, hedge funds, or investment advisers—that purchase securities for their own accounts. They counsel their employers on which securities to buy, hold, or sell and stand to make money when they make good calls.

Independent analysts typically aren't associated with firms that underwrite the securities they cover. They often sell their research reports on a subscription or other basis. Some firms that have discontinued their investment banking operations now market themselves as more independent than multi-service firms, emphasizing their lack of conflicts of interest.

Potential Conflicts of Interest

Many analysts work in a world with built-in conflicts of interest and competing pressures. On the one hand, sell-side firms want their individual investor clients to be successful over time because satisfied long-term investors are a key to a firm's long-term reputation and success. A well-respected investment research team is an important service to customers.

At the same time, however, several factors can create pressure on an analyst's independence and objectivity. The existence of these factors does not necessarily mean that the research analyst is biased. But investors should take them into account before making an investment decision. Some of these factors include:

• Investment Banking Relationships—When companies issue new securities, they hire investment bankers for advice on structuring the deal and for help with the actual offering. Underwriting a company's securities offerings and providing other investment banking services can bring in more money for firms than revenues from brokerage operations or research reports. Here's what an investment banking relationship may mean:
   
  1. The analyst's firm may be underwriting the offering—If so, the firm has a substantial interest—both financial and with respect to its reputation—in assuring that the offering is successful. Analysts are often an integral part of the investment banking team for initial public offerings—assisting with "due diligence" research into the company, participating in investor road shows, and helping to shape the deal. Upbeat research reports and positive recommendations published after the offering is completed may "support" new stock issued by a firm's investment banking clients.
      
  2. Client companies prefer favorable research reports—Unfavorable analyst reports may hurt the firm's efforts to nurture a lucrative, long-term investment banking relationship. An unfavorable report might alienate the firm's client or a potential client and could cause a company to look elsewhere for future investment banking services.
      
  3. Positive reports attract new clients—Firms must compete with one another for investment banking business. Favorable analyst coverage of a company may induce that company to hire the firm to underwrite a securities offering. A company might be unlikely to hire an underwriter to sell its stock if the firm's analyst has a negative view of the stock.
      
• Brokerage Commissions—Brokerage firms usually don't charge for their research reports. But a positive-sounding analyst report can help firms make money indirectly by generating more purchases and sales of covered securities—which, in turn, result in additional brokerage commissions.
   
• Analyst Compensation—Brokerage firms' compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, some firms link compensation and bonuses—directly or indirectly—to the number of investment banking deals the analyst lands or to the profitability of the firm's investment banking division.
   
• Ownership Interests in the Company—An analyst, other employees, and the firm itself may own significant positions in the companies an analyst covers. Analysts may also participate in employee stock-purchase pools that invest in companies they cover. And in a growing trend called "venture investing," an analyst's firm or colleagues may acquire a stake in a start-up by obtaining discounted, pre-IPO shares. These practices allow an analyst, the firm he or she works for, or both to profit, directly or indirectly, from owning securities in companies the analyst covers.

Disclosure and Recent Rule Changes

The rules of the NYSE and FINRA require analysts in some circumstances to disclose certain conflicts of interest when recommending the purchase or sale of a specific security. On May 10, 2002, the SEC approved proposed changes to these rules, strengthening the disclosures that analysts and firms must make. The NYSE and FINRA decided upon an implementation schedule of between 60 and 180 calendar days for the new rules in order to provide reasonable time periods for firms to develop and implement policies, procedures and systems to comply with the new requirements. These rules implement key structural reforms aimed at increasing analysts' independence and further managing conflicts of interest. They also require increased disclosure of conflicts in research reports and public appearances. Key provisions of the rules include the following:

	No Promises of Favorable Research — NYSE and FINRA rules now prohibit analysts from offering a favorable research rating or specific price target to induce investment banking business from companies. The rule changes also impose "quiet periods" that bar a firm that is acting as manager or co-manager of a securities offering from issuing a report on a company within 40 days after an initial public offering or within 10 days after a secondary offering for an inactively traded company. Significance of the Change: Promising research coverage to a company will not be as attractive if the research may not be issued within the initial days following the offering.
	Limitations on Relationships and Communications — The rule changes prohibit research analysts from being supervised by the investment banking department. In addition, investment banking personnel are prohibited from discussing research reports with analysts prior to distribution, unless staff from the firm's legal/compliance department monitor those communications. Analysts are also prohibited from sharing draft research reports with the target companies, other than to check facts after approval from the firm's legal/compliance department. Significance of the Change: These provisions help protect research analysts from influences that could impair their objectivity and independence.
	Analyst Compensation — The rule changes bar securities firms from tying an analyst's compensation to specific investment banking transactions. Furthermore, if an analyst's compensation is based on the firm's general investment banking revenues, that fact must be disclosed in the firm's research reports. Significance of the Change: Prohibiting compensation from specific investment banking transactions significantly curtails a potentially major influence on research analysts' objectivity.
	Firm Compensation — The rule changes require a securities firm to disclose in a research report if it managed or co-managed a public offering of equity securities for the company or if it received any compensation for investment banking services from the company in the past 12 months. A firm also must disclose if it expects to receive or intends to seek compensation for investment banking services from the company during the next 3 months. Significance of the Change: Requiring securities firms to disclose compensation from investment banking clients can alert investors to potential biases in their recommendations.
	Restrictions on Personal Trading by Analysts — The rule changes bar analysts and members of their households from investing in a company's securities prior to its initial public offering if the company is in the business sector that the analyst covers. In addition, the rule changes require "blackout periods" that prohibit analysts from trading securities of the companies they follow for 30 days before and 5 days after they issue a research report about the company, and also prohibits analysts from trading against their most recent recommendations—subject to exceptions for unanticipated significant changes in the personal financial circumstances of the beneficial owner of a research analyst account. Significance of the Change: Prohibiting analysts from trading around the time they issue research reports should reduce conflicts arising from personal financial interests.
	Disclosures of Financial Interests in Covered Companies — The rule changes require analysts to disclose if they own shares of recommended companies. Firms are also required to disclose if they own 1% or more of a company's equity securities as of the previous month end. Significance of the Change: Requiring analysts and securities firms to disclose financial interests can alert investors to potential biases in their recommendations.
	Disclosures in Research Reports Regarding the Firm's Ratings — The rule changes require firms to clearly explain in research reports the meaning of all ratings terms they use, and this terminology must be consistent with its plain meaning. Additionally, firms must provide the percentage of all the ratings that they have assigned to buy / hold / sell categories and the percentage of investment banking clients in each category. Firms are also required to provide a graph or chart that plots the historical price movements of the security and indicates those points at which the firm initiated and changed ratings and price targets for the company. Significance of the Change: These disclosures will assist investors in deciding what value to place on a securities firm's ratings and provide them with better information to assess its research.
	Disclosures During Public Appearances by Analysts — The rule changes require disclosures from analysts during public appearances, such as television or radio interviews. Guest analysts will have disclose if they or their firm have a position in the stock; if the company is an investment banking client of the firm; if the analyst or a member of the analyst's household is an officer, director or advisory board member of the recommended issuer; and other material conflicts. Significance of the Change: This disclosure will inform investors who learn of analyst opinions and ratings through the media — rather than in written research reports — of analyst and firm conflicts.

What Conflicts May Mean to You

The fact that an analyst—or the analyst's firm—may have a conflict of interest does not mean that his or her recommendation is flawed or unwise. But it's a fact you should know and consider in assessing whether the recommendation is wise for you.

It's up to you to educate yourself to make sure that any investments you choose match your goals and tolerance for risk. Remember that analysts generally do not function as your financial adviser when they make recommendations—they're not providing individually tailored investment advice, and they're not taking your personal circumstances into consideration.

Uncovering Conflicts

In addition to paying close attention to the disclosures that firms and analysts make, here are some steps you can take to assess whether and to what extent analyst conflicts may exist:

Identify the Underwriter

Before you buy, confirm whether the analyst's firm underwrote a recommended company's stock by looking at the prospectus, which is part of the registration statement for the offering. Note that firms are required to disclose in research reports whether they managed or co-managed a public offering. You'll find a list of the lead or managing underwriters on the front cover of both the preliminary and final copies of the prospectus. By convention, the name of the lead underwriter—the firm that stands to make the most money on the deal—will appear first, and any co-managers will generally be listed second in alphabetical order. Other firms participating in the deal will be listed only in the "Underwriting" or "Plan of Distribution" sections of the final supplement to the prospectus. You can search for registration statements using the SEC's EDGAR database at www.sec.gov/edgar.shtml. The final supplement to the prospectus will appear in EDGAR as a "424" filing.

Research Ownership Interests

A company's registration statement and its annual report on Form 10-K will tell you who the beneficial owners of more than five percent of a class of equity securities are. Research reports on a company must disclose whether the securities firm issuing the report (or any of its affiliates) beneficially owns one percent or more of any class of common equity securities of the subject company. The issuer's registration statement will also tell you about private sales of the company's securities during the past three years. In addition to the disclosure requirements in the new rules, you may be able to ascertain ownership by checking the following SEC forms:

	Schedules 13D and 13G—Any person who acquires a beneficial ownership of more than five percent must file a Schedule 13D. Schedule 13G is a much abbreviated version of Schedule 13D that is only available for use by a limited category of "persons," such as banks, broker-dealers, or insurance companies.
	Forms 3, 4, and 5—Officers, directors, and beneficial owners of more than 10 percent must report their holdings—and any changes in their holdings—to the SEC on Forms 3, 4, and 5.
	Form 144—If an analyst or a firm holds "restricted" securities from the company—meaning those acquired in an unregistered, private sale from the issuer or its affiliates—then investors can find out whether the analyst or the firm recently sold the stock by researching their Form 144 filings.

As of November 4, 2002, all statements of beneficial ownership on Schedules 13D and 13G (including those relating to the securities of foreign private issuers) must be submitted electronically using the SEC's EDGAR system. If you can't find a form on EDGAR, please refer to information on "How to Request Public Documents" at http://www.sec.gov/answers/publicdocs.htm. Or check the "Quotes" section of the Nasdaq Stock Market's website at http://quotes.nasdaq.com/

Unlock the Mystery of "Lock-ups"

If the analyst's firm acquired ownership interests through venture investing, the shares generally will be subject to a "lock-up" agreement during and after the issuer's initial public offering. Lock-up agreements prohibit company insiders—including employees, their friends and family, and venture capitalists—from selling their shares for a set period of time without the underwriter's permission. While the underwriter can choose to end a lock-up period early—whether because of market conditions, the performance of the offering, or other factors—lock-ups generally last for 180 days after the offering's registration statement becomes effective.

After the lock-up period ends, the firm may be able to sell the stock. If you're considering investing in a company that has recently conducted an initial public offering, you'll want to check whether a lock-up agreement is in effect and when it expires or if the underwriter waived any lock-up restrictions. This is important information because a company's stock price may be affected by the prospect of lock-up shares being sold into the market when the lock-up ends. It is also a data point you can consider when assessing research reports issued just before a lock-up period expires—which are sometimes known as "booster shot" reports.

To find out whether a company has a lock-up agreement, check the "Underwriting" or "Plan of Distribution" sections of the prospectus. That's where companies must disclose that information. You can contact the company's shareholder relations department to ask for its prospectus, or use the SEC's EDGAR database if the company has filed its prospectus electronically. If you can't find a form on EDGAR, please refer to information on "How to Request Public Documents" at http://www.sec.gov/answers/publicdocs.htm. There are also commercial websites you can use for free that track when companies' lock-up agreements expire. The SEC does not endorse these websites and makes no representation about any of the information or services contained on these websites.

How You Can Protect Yourself

We advise all investors to do their homework before investing. If you purchase a security solely because an analyst said the company was one of his or her "top picks," you may be doing yourself a disservice. Especially if the company is one you've never heard of, take time to investigate:

	When assessing a firm's research report of a company, be sure to read all of the disclosures about the firm and analysts' conflicts of interest and the types of research recommendations that the firm has made.
	Research the company's financial reports using the SEC's EDGAR database at http://www.sec.gov/edgar.shtml, or call the company for copies. If you can't analyze them on your own, ask a trusted professional for help.
	Find out if a lock-up period is about to expire or whether the underwriter waived it. While that may not necessarily affect your decision to buy, it may put an analyst recommendation in perspective.
	Confirm whether the analyst's firm underwrote one of the company's recent stock offerings—especially its IPO.
	Learn as much as you can about the company by reading independent news reports, commercial databases, and reference books. Your local library may have these and other resources.
	Talk to your broker or financial adviser and ask questions about the company and its prospects. But bear in mind that if your broker's firm issued a positive report on a company, your broker will be hard-pressed to contradict it. Be sure to ask your broker whether a particular investment is suitable for you in light of your financial circumstances.

Above all, always remember that even the soundest recommendation from the most trust-worthy analyst may not be a good choice for you. That's one reason we caution investors never to rely solely on an analyst's recommendation when buying or selling a stock. Before you act, ask yourself whether the decision fits with your goals, your time horizon, and your tolerance for risk. Know what you're buying—or selling—and why.