Chapter 21

Checking Out the Analyst–Corporation Connection

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.

Typecasting the Analysts

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:

• For large investment groups (such as mutual or pension funds): They determine whether a company's stock price accurately reflects the firm's worth and whether the stock fills a particular niche that the group wants to fill in its overall portfolio-management objectives.
• For financial institutions: They analyze a company's debt structure and determine whether the company is bringing in enough money to pay its bills, which helps the institution decide whether to loan the firm money and at what interest rate.
• For brokerage houses: They provide individual investors analysis about the companies they're considering for their portfolio. Their reports are available to anyone who uses the brokerage house for stock transactions. Unless you have a very large portfolio and can pay an analyst, the analyst doesn't work specifically for you, so you need to read and analyze financial reports yourself.
• For bond-rating firms: They review a company's debt structure, financial health, and bill-paying ability to rate the bonds the company issues.

  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

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.

You rarely see this type of analyst's research available on the public market, but much of the information does trickle out in the financial press through statements made by mutual fund managers. Morningstar, which is one of the leading groups that rate mutual funds for individual investors, is a good place to get ideas for possible additions to your stock portfolio. On its website (www.morningstar.com), you can frequently find stories about which stocks mutual fund managers are buying and why they're buying them. Of course, you can't just buy stock based on these stories. You need to read the financial reports and do your own analysis of these reports.

Sell-side analysts

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.

You must take the responsibility yourself to read and analyze reports. You can't depend on an analyst unless you pay that analyst out of your own pocket to do the analysis.

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.

Sell-side analysts’ Chinese Wall was reconstructed to a certain extent after the tech stock scandals (see the sidebar “Analyzing the analysts”). The Securities and Exchange Commission (SEC) finally got involved in April 2002 and ended up endorsing rulemaking changes developed by the New York Stock Exchange and the National Association of Securities Dealers. These new rules do the following:

• Prohibit investment banking divisions from supervising analysts or approving their research reports.
• Ban the practice of tying analysts’ compensation to specific investment banking transactions.
• Prohibit analysts from offering favorable research to bring in investment banking business for a firm.
• Disclose conflicts of interest in research reports and public appearances. Brokerage houses must include information about business relationships with, or ownership interests in, any company that's the subject of an analyst's report.
• Restrict personal trading by analysts in securities of companies they analyze or report on.
• Dictate that a firm disclose data about its historical ratings and a price chart that compares its ratings with closing prices.

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.

When you read a sell-side analyst's report and see that the brokerage firm gets fees for investment banking services from the company that's the subject of the report, realize that the brokerage firm makes more money from its investment banking business than it does from you. Take what you find useful from the report, but be sure to do your own additional research.

Independent analysts

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.

Many independent analysts do sell the reports through financial websites for a per-report fee to individuals who are researching a specific company. Your rule of thumb about independent analysts’ reports must be to take what information you find useful but be sure to do additional research on your own. The report you buy from the independent analyst on a particular company was developed for one of the analyst's clients, not specifically for you.

After reading about analysts, you may think you don't have a chance to get good information from them. Your best place to find research that isn't tainted by the investment banking business of your brokerage firm is the websites of major investment research firms like Morningstar (www.morningstar.com) and Standard & Poor's (www.standardandpoors.com). You have to pay fees to access their confidential services, but they're much more reasonable than the cost of using an independent analyst — they can be as low as $100 per year, depending on what information you need.

Bond analysts

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.

When you're looking to buy stock, pay attention to the warnings of bond analysts. You certainly don't want to invest in a company that can't meet its financial obligations and may go bankrupt. Use bond analysts’ red flags to help you find the critical information when you read and analyze financial reports yourself.

Regarding Bond-Rating Agencies

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.

Bonds are a type of debt for a company. The individual or company that buys a bond is loaning money to the company that it expects to get back. The firm must pay interest on the money that it's borrowing from these bondholders.

You should be familiar with the three key rating agencies, where you can find out what bond analysts think:

• Standard & Poor's: Although S&P is well-known for the S&P 500, which is a collection of 500 stocks that form the basis for a stock market index (a portfolio of stocks for which a change in price is carefully watched), the company is also one of the primary bond raters. You can find more information at www.standardandpoors.com.

• Moody's Investor Service: Moody's specializes in credit ratings, research, and risk analysis, tracking trillions of dollars in debt issued in the U.S. and international markets. In addition to its credit-rating services, Moody's publishes investor-oriented credit research, which you can access at www.moodys.com.
• Fitch Ratings: The youngest of the three major bond-rating services is Fitch Ratings (www.fitchratings.com). John Knowles Fitch founded Fitch Publishing Company in 1913, and the business started as a publisher of financial statistics. In 1924, Fitch introduced the credit-rating scales that are very familiar today: AAA to D. Fitch is best known for its research in the area of complex credit deals and is thought to provide more rigorous surveillance than other rating agencies on such deals.

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.

Standard & Poor's (S&P) makes its bond ratings publicly available with links on its website home page. You can search for information about any company's debt ratings.

Whenever a change occurs in the ratings, the rating services issue a press release with an extensive explanation about why the rating has changed. These press releases can be an excellent source of information if you're looking for opinions on the numbers you see in the financial reports. You can find these press releases on the bond-rating companies’ websites, as well as in news links on financial websites.

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.

Delving into Stock Rating

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.

Just like with bond ratings, each firm has its own vocabulary when rating stocks. A strong buy from one firm may be called a buy in another firm and may be on the recommended list in a third firm. You can never know which company is right, but after following a firm's stock ratings for a while, you can understand how its systems work and how accurate it is compared with what actually happens to the price on the stock market.

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.

I don't put much faith in the stock analyst rating system, and you shouldn't, either. As you start doing independent research on a company after reading its financial reports, take everything you read with a grain of salt. Collect all the information you can and then do your own analysis. In Part III of this book, I show you how to analyze the numbers in financial reports.

Taking a Look at How Companies Talk to Analysts

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.

Analyst calls

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.

You can find out about upcoming calls or listen to calls already completed at two websites: 24/7 Wallstreet (http://247wallst.com/companies/analyst-calls/) and Investor Calendar (www.investorcalendar.com/IC/index.asp).

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.

Press releases

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.

You can easily track press releases online. One of my favorite spots for following not only a company's press releases, but also any stories mentioning the company, is Yahoo! Finance (finance.yahoo.com). You can find out about any recent press coverage for a company by searching the website using the company's stock ticker, which is a multiletter abbreviation for the company's stock. Links to recent press coverage and press releases appear in a section called “Headlines.” If you want to go further back in history, most companies post at least three years’ worth of press releases in the press section of their websites.

Mobile apps

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.

Road shows

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.