Reading Financial Reports for Dummies (47 page)

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Part V: The Many Ways Companies Answer to Others

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 raised by analysts help you find crucial details you should 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:

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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.

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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.

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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 won’t work specifically for you. That’s why you need to read and analyze financial reports yourself.

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For bond-rating firms:
They review a company’s debt structure, financial health, and bill-paying ability in order to rate the bonds issued by the company.

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 different types of analysts master various domains of financial analysis. Regardless of what type of analyst you’re dealing with, the one thing you can be sure of as an individual investor is that analysts won’t work for you unless you’re the one paying them for developing the information. They primarily gear their reports to the needs of those 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 managed by their firms. In other words, buy-side analysts’ bosses are major institutional buyers of stock. Some buy-side analysts work for mutual funds or pension funds directly; others work for independent analyst firms hired by the mutual funds or pension funds.

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Buy-side analysts write reports that help portfolio managers determine whether a stock fits the firm’s portfolio-management strategy, but it 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 would pan may get 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 Web site (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 have shown (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.

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Analyzing the analysts

During the scandal-ridden technology crash Then-New York State Attorney General Eliot of 2000, sell-side analysts working for broker-Spitzer helped expose this entire mess by

age houses were caught between the needs of

unearthing e-mails from superstar analysts

their firms’ investment banking division to help

like Henry Blodget of Merrill Lynch, who wrote

sell new offerings and the needs of their firms’

positive reports about stocks being sold by his

individual investors, who were clients of the

investment banking divisions while privately

salespeople. The investment banking side won,

calling these stocks “dogs,” “junk,” and “toast.”

and individual investors got hosed.

Spitzer charged that Blodget’s recommenda-

tions helped bring in $115 million in investment

By writing glowing reports about the stocks or

banking fees for Merrill Lynch. Blodget got rich,

bonds involved in investment banking deals, too — he took home about $12 million in com-sell-side analysts helped pull in new investment

pensation, according to Spitzer’s findings.

banking clients and kept existing clients happy.

While the brokerage houses made millions on

Merrill Lynch wasn’t the only company that

investment banking deals, individual inves-

Spitzer’s investigation exposed. Other firms

tors lost big chunks of their portfolios buying

caught in Spitzer’s net include Morgan Stanley

analyst-recommended stocks, many of which

Dean Witter & Co. and Credit Suisse First

dropped dramatically in value after the market

Boston. In fact, most brokerage houses that

crash of 2000, leaving investors with ruined have an investment banking division got caught portfolios filled with worthless stocks. Overall,

up in the scandal.

investors lost billions.

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:

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Prohibit investment banking divisions from supervising analysts or approving their research reports.

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Ban the practice of tying analysts’ compensation to specific investment banking transactions.

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Prohibit analysts from offering favorable research to bring in investment banking business for a firm.

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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.

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Restrict personal trading by analysts in securities of companies they analyze or report on.

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Dictate that a firm discloses 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 —

those that
aren’t
paid by a brokerage house or other financial institution but 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 Web sites for a per-report fee to individuals who are researching a specific company. Your rule of thumb about independent analysts’ reports should 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 and not specifically for you.

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Part V: The Many Ways Companies Answer to Others

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 to visit the Web sites of major investment research firms like Morningstar (www.morning star.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 those of an independent analyst and can be as low as $100

per year, depending on what information you need.

Bond analysts

Bond analysts
are most concerned about 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.

Bond analysts, prior to this fiasco, 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.