Chapter 21
In This Chapter
Looking at the various kinds of analysts
Exploring the bond-rating agencies
Understanding stock ratings
Getting key information from analysts
Financial analysts regularly get into the act not by talking companies through their mother issues, but by developing rankings that reflect a company's value.
The way analysts view a company can make or break the value of its stock. If a well-respected analyst writes a negative report after seeing a firm's financial reports, its stock price is guaranteed to drop at least temporarily. Red flags analysts raise help you find crucial details to look for when reading a company's financial reports.
This chapter reviews the types of analysts and the ways a company feeds financial information to them.
Analysts, many of whom have completed a grueling testing process that takes at least three years to get the designation Chartered Financial Analyst, serve different roles for different people:
Reports from bond-rating companies are especially helpful because they focus on any debt problems the company may be facing. You can then check out the financial reports yourself and find the red flags more easily.
You may not realize that several types of analysts master various domains of financial analysis. Regardless of what type of analyst you're dealing with, the one fact you can be sure of as an individual investor is that analysts don't work for you unless you're the one paying them for developing the information. They primarily gear their reports to the needs of the people who do pay them.
This section looks at the various types of analysts and who they primarily serve.
Buy-side analysts work primarily for large institutions and investment firms that manage mutual funds, pension funds, or other types of multimillion-dollar private accounts. Buy-side analysts are responsible for analyzing stocks that portfolio managers are considering for possible purchase and placement in various portfolios their firms manage. In other words, buy-side analysts’ bosses are major institutional buyers of stock. Some buy-side analysts work directly for mutual funds or pension funds; others work for independent analyst firms hired by the mutual funds or pension funds.
Buy-side analysts write reports that help portfolio managers determine whether a stock fits the firm's portfolio-management strategy. But the stock may not fit your portfolio's strategy, so you can't necessarily follow their recommendations. Managers of mutual funds that focus on growth stocks look for stocks that fill that niche. Managers of mutual funds that focus on foreign stocks look for stocks that fit that objective. Sometimes a stock that most analysts pan gets a positive report inside a buy-side analytical shop. For example, if portfolio managers are looking for candidates for a value portfolio made up of stocks currently beaten down by the market but with good potential to rebound, buy-side analysts may recommend buying a stock that has just lost half its value.
As an individual investor, you most likely see reports from sell-side analysts. These analysts work for brokerage houses or other financial institutions that sell stocks to individual investors. You get reports written by these analysts when you ask your broker for research on a particular stock.
You can't take everything you get from sell-side analysts as gospel. Their primary purpose is to help a company's salespeople make sales. As long as your interests match the interests of the broker and brokerage house, the sell-side analytical reports can be helpful. But as scandals after the Internet and technology stock crash of 2000 showed (see the sidebar “Analyzing the analysts”), conflicts of interest can exist between a brokerage house's need to make money by selling stock and an individual investor's need to make money by owning stock that goes up in value.
Many investors lost 50 percent or more of the money they invested in stock during the 1990s and early 2000s before the stock market crashed. Many brokerage houses were more concerned with making money by selling stocks than they were with helping investors put together stock portfolios that met their goals and took into consideration their tolerance for risk. And investors weren't well served by the analysts, who should have been accurately reporting the risks of investing in many of the companies whose financial reports they analyzed for investors.
Brokerage companies used to avoid scandals and conflicts of interest by protecting themselves with what's called a Chinese Wall. Analysts kept their work separate from the investment banking division (which sells new public offerings of stocks or bonds and arranges mergers and acquisitions), and their compensation wasn't dependent on what business they helped to bring in. At some point in the past 20 years, this wall broke down, and sell-side analysts became partners with the investment banking side to help the firm make money. If a company won new investment banking business, it rewarded analysts with fees or commissions.
As an investor, you can quickly determine whether a conflict exists between your interests and the financial interests of a brokerage house or analyst when you see the new disclosures required. You can also look at the brokerage house's historical ratings for a company's stock and see how successful it has been in accurately reporting the stock's value in the past.
You may wonder whether you can depend on any analysts out there. Well, the answer is yes and no. Certainly, some independent analyst groups — ones that aren't paid by a brokerage house or other financial institution but that provide reports for a fee paid by people who want them — report on companies as well. The problem is that independent analyst groups work for people who can afford to pay them, meaning that you must have a portfolio of at least $1 million or be able to pay about $25,000 per year. Few individual investors meet these criteria.
Bond analysts are most concerned with a company's liquidity and the company's ability to make its interest payments, repay its debt principal, and pay its bills. They used to have a reputation of doing things with a more cautious eye, but their close relationship to the investment banking side of the house was exposed during the mortgage crisis beginning in 2007. Many of the mortgage debt instruments they rated proved to be rated incorrectly, leading to huge losses for banks, mutual funds, and pension funds.
Before this fiasco, bond analysts were thought to evaluate financial reports, management quality, the competitive environment, and overall economic conditions more carefully. They tended to err on the side of caution, but now this reputation has been shattered. When it comes to rating corporate bonds, it's worth looking at their view, but always do your own research.
Bond ratings have a great impact on a company's operations and the cost of funding its operations. The quality rating of a company's bonds determines how much interest the firm has to offer to pay in order to sell the bonds on the public bond market. Bonds that are rated with a higher-quality rating are considered less risky, so the interest rates that must be paid to attract individuals or companies to buy those bonds can be lower. Companies that issue bonds with the lowest ratings, which are also known as junk bonds, pay much higher interest rates to attract individuals or companies to buy those bonds.
You should be familiar with the three key rating agencies, where you can find out what bond analysts think:
Each bond-rating company has its own alphabetical coding for rating bonds and other types of credit issues, such as commercial paper (which are shorter-term debt issues than bonds).
Table 21-1 shows how the companies’ bond ratings compare.
Any company bonds rated in the “speculative” category or lower are considered to be junk bonds. Companies in the “best quality” category have the lowest interest rates, and interest rates go up as companies’ ratings drop. A key job of any firm's executive team is to feed bond analysts critical financial data to keep the firm's ratings high. Financial reports are one major component of that information.
Regulations for bond-rating agencies changed after passage of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010. The change became necessary after the failure of bond-rating agencies to properly rate mortgage securities.
Many people see the AAA ratings on bonds that later proved to be junk as a major contributing factor to the crash of 2008 and the collapse of Lehman Brothers. The 2010 legislation imposes new liability exposure on the credit rating agencies. They must improve their internal control requirements. They must also put barriers in place to address conflicts of interest issues. The SEC also now has more oversight responsibility regarding bond-rating companies.
Stock ratings for general public consumption are primarily done by sell-side analysts, who seem to err on the side of optimism. You rarely find a stock with a sell rating (a recommendation to sell the stock). In fact, when analysts testified in Congress after the analyst scandals in the early 2000s (see the sidebar “Analyzing the analysts,” earlier in the chapter), one analyst was heard saying that everybody on Wall Street knows that a hold rating (which is intended to mean you should hold the stock but probably not buy more) really means to sell. Some firms use an accumulate rating, which you may think means to hold on to the stock or maybe even add more shares, but really means to sell in behind-the-scenes circles on Wall Street.
Because various companies’ rankings may differ dramatically, you need to check out ratings from several different firms and research what each firm means by its ratings. A stock that's rated as a “market outperformer” may sound pretty good, but in reality, it's probably not a good investment, which may become clear when you compare rankings of other firms and find that they consider the stock a “neutral” or “hold” stock.
Companies not only send out financial reports to analysts, but also talk with analysts regularly about the reports. Sometimes you can get access to what's said by listening in to analyst calls or reading press releases. You can also get information from road shows, which I briefly describe later in this chapter, but you usually don't have access to them unless you're a major investor.
Each time a company releases a new financial report, it usually schedules a call with analysts to discuss the results. Usually, these calls include the chief executive officer (CEO), president (if not the same as the CEO), and chief financial officer (CFO), as well as other top managers.
Individual investors can listen in on many of these calls between companies and analysts. The calls typically start with a statement from one or more of the company representatives and then are opened up to listener questions. However, as an individual investor, you may not be able to ask any questions. In most cases, only the analysts, and sometimes the financial press, are allowed to ask questions. But even if you can't ask questions, you can learn a lot just by listening.
The biggest advantage of listening to these calls is that analysts ask questions of the executives that help you focus on the areas of concern in the financial reports. Turn to Chapter 22 to find out more about analyst calls.
In the past, calls between analysts and companies were a way for analysts to get insider information about a firm before the news was broadcast to individual investors. The SEC stopped that practice in 2000 with a new rule called Fair Disclosure (Regulation FD). This rule makes it mandatory for companies to inform everyone at the same time about major financial announcements. Sometimes analysts find out information in a conversation with officers or employees of a corporation during a private interview. If analysts receive information that others aren't aware of, the company must release a press release about the information within 24 hours of any company outsider getting the information. Regulation FD has certainly leveled the playing field for individual investors.
Companies often feed information to analysts through press releases. Luckily, individual investors can easily access these press releases on financial websites. But remember that press releases are always going to contain exactly what the company wants you to know. You need to read between the lines and ask questions of the company's investor relations department if something concerns you.
Press reports, which are written after a press release is issued, are probably a more important source of information. Companies put out a lot of press releases, and not every one makes it into the newspaper as a story. In fact, most press releases end up in the garbage because a financial reporter determines the information isn't worth a story.
Some companies now provide mobile applications to communicate with their investors. It's a relatively new phenomenon at the time of this writing, but a leader in developing these is theIRAPP (www.theirapp.com/). You can find out which companies offer these apps at theIRAPP website. I checked the investor sections of companies offering a mobile app, and many had not yet listed the app as available; you may have to do some digging to find these apps.
Companies use road shows (which I discuss in greater detail in Chapter 3) to introduce new securities issues, such as initial stock or bond offerings. Road shows are presentations by the company and its investment bankers to the analyst community and other major investors, in the hope of building interest in the new public offering. As an individual investor, you're not likely to be able to attend these shows; invitations are usually reserved only for people who can put up significant funding.