In the world of securities, they’re the men and women behind the curtain. They hold enormous sway over a company’s stock, but to the average investor, and even to many CEOs, they’re nearly invisible. They’re buy-side analysts.
In contrast to sell-side analysts, who work for brokerage houses like Morgan Stanley or Merrill Lynch, buy-side analysts work for institutional investors like mutual, hedge, or pension funds. Those institutions control two-thirds of all U.S. equities, and that means their analysts have substantial clout.
“For anybody who has a retirement fund, they’re the person who is managing your money,” says Michael Clement, accounting professor at McCombs, “and yet we know almost nothing about them.”
That’s by design, he adds. Unlike their sell-side counterparts, they don’t issue public reports or talk to the press. “If I have a good idea, I’ll share it with my portfolio manager, but not with people outside the firm,” Clements explains. “I don’t want everybody else making money from my ideas.”
In new research, however, Clement has pulled back part of the curtain. With colleagues Lawrence Brown of Temple University, Andrew Call of Arizona State University, and Nathan Sharp of Texas A&M University, he conducted a first-ever survey of 344 buy-side analysts at 181 funds. For more detail, they interviewed 16 respondents by phone. The results shed light on who these elusive analysts are, what drives their stock picks, and what gets their attention.
Paid for Performance, not Popularity
They turn out to be different from their colleagues on the sell-side, whom Clement has previously surveyed. For one thing, they’re better trained in accounting and finance and are more likely to have MBAs and far more likely to be Certified Financial Analysts.
That might be because they have more at stake.
For 83 percent of buy-side analysts, their pay depends largely on the profits their stock picks produce. Make the wrong recommendations, and pensions and account balances could plummet. If that happens, their compensation could do the same — or they could be out of a job.
“For anybody who has a retirement fund, they’re the person who is managing your money, and yet we know almost nothing about them.” — Professor Michael Clement
In his sell-side study, by contrast, only 35 percent of analysts said their stock recommendations were important to their pay.
Sell-siders’ compensation depends more on a different kind of result: The business they attract from institutional investors. Institutional investors poll their staff — including their own analysts — about which sell-side analysts they find most useful. They then do their trading through those brokerage firms. According to 67 percent of sell-side analysts, those votes affect their compensation.
“A buy-side analyst has a lot to do with what a sell-side analyst earns,” Clement says. “[The sell-side analyst] wants to do what he can to keep buy-side analysts happy.”
What keeps them happy? It’s not public stock recommendations; buy-side analysts often assume there’s a conflict-of-interest and largely disregard them. Said one to the researchers, “When they have their investment banking units targeting some of these same companies for services, as much as there’s supposed to be a wall, I’m not sure it fully exists.”
“I disregard buy, sell, and hold ratings. They’re useless.” — Analyst and survey participant
What is useful, to 73 percent on the buy-side, is in-depth knowledge of particular companies and industries. The average institutional analyst has to track between 26 and 50 firms in multiple sectors. “When you’re trying to get up to speed on how an industry works, like how its supply chain works, that’s when a sell-side analyst is useful to you,” says Clement.
Talking to the Top
As such, most buy-side analysts also value a sell-side analyst’s personal connections to senior management — the ability to make an introduction when they’d like a closer look at a company.
That’s because one-on-ones with CFOs and CEOs are key input for buy-siders’ decisions. According to the researchers, 37 percent talk an average of twice a month (or more) with senior management in the industries they cover.
This offers managers an opportunity, says Clement. If there are institutions that hold large chunks of their stock — or others they’d like to — it’s a good strategy to ring up their analysts, especially once an earnings conference call is over. “They may have questions you can clear up on a private call afterwards,” he says.
The questions often dig into the latest 10-K or 10-Q reports, which are important to 48 percent of buy-side analysts. They watch especially for indicators that profits are sustainable over time. Does the company use the same accounting standards from year to year? Are the earnings backed by operating cash flows?
If there’s a wide gap between earnings and cash flows, many analysts see it as a red flag, which suggests that management might be skewing results. Other tip-offs for suspicion:
- Weak internal financial controls, like insufficient audits;
- Weak governance, like directors who are too close to management;
- A lot of one-time accounting items, which can make earnings see saw.
Corporate executives can be aware of such flags before they talk to analysts and have explanations ready, Clement suggests. “You can reassure them it’s not representative of your true controls or that there are mitigating circumstances. You don’t want the analyst to sell your stock and put downward pressure on your stock price.”
Another tactic, he says, is to invite them to visit and see operations for themselves. Such primary research is prized by 64 percent of institutional analysts. Says Clement, “It gives them a chance to develop their own perspective on a company, rather than management feeding it to them in a 10-K.”
While his research offers insights to CFOs and sell-side analysts, Clement hopes it will help buy-side analysts as well, by letting them benchmark their strategies against their secretive peers. As one analyst told the researchers, “The buy side is this whole poker game of, ‘I don’t want to show my cards, but I want to see your cards.’”
Putting more cards on the table could mean getting a closer look at how competitors at other funds “think about issues, what they use as inputs to decisions, and who they find it useful to talk to,” says Clement. “If I’m not doing much primary research, and I see others are doing it, I might want to start doing more.”
Inside the "Black Box" of Sell-Side Financial Analysts is published in the Journal of Accounting Research. The Activities of Buy-Side Analysts and the Determinants of Their Stock Recommendations is published in the Journal of Accounting & Economics.