Several types of analysts on Wall Street produce different kinds of reports because they have different kinds of clients with different standards and expectations.
Analysts fall in the basic categories of sell-side analysts, buy-side analysts, and independent analysts.
Buy-side analysts are employed by pension funds and by fund managers like Fidelity and Janus, and they generally specialize in a few sectors.
The buy side differs from the sell side in three main ways: they follow more stocks (30 to 40); they write very brief reports (generally one or two pages); and their research is only distributed to the fund’s managers.
Independent analysts are practitioners not employed by either brokerage firms or mutual/pension funds and provide research “untainted” by investment banking deals.
Some independent firms focus on institutional clients and are paid a fee to follow certain stocks and/or to find new ideas that the sell side is missing; other indies provide research to both institutional and individual investors.
Sell-side analysts generally dominate the headlines. They are employed by brokerage houses to analyze companies and write in-depth reports after conducting what is sometimes called primary research. These reports are used to “sell” an idea to individuals and institutional clients. Individual investors gain access to these reports mainly by having accounts with the brokerage firm.
For example, to get free research from Merrill Lynch, you need to have an account with a Merrill Lynch broker. Sometimes the reports can be purchased through a third party. Institutional clients (i.e. mutual fund managers) get research from the brokerage’s institutional brokers.
A good sell-side research report contains a detailed analysis of a company’s competitive advantages and provides information on management’s expertise and how the company’s operating and stock valuation compares to a peer group and its industry. The typical report also contains an earnings model and clearly states the assumptions used to create the forecast.
Writing this type of report is a time-consuming process. Information is obtained by reading the company’s filings with the Securities and Exchange Commission (SEC), meeting with its management, and if possible, talking with its suppliers and customers.
It also entails analyzing the company’s publicly traded peers to better understand the differences in operating results and stock valuations. This approach is called fundamental analysis because it focuses on the company’s fundamentals. This rigorous process limits a typical sell-side analyst to two or three industries and about 10 to 15 companies.
The challenge facing the brokerages is it’s extremely expensive to create all this research. Brokerages must recover the costs of paying sell-side analysts from somewhere, but deregulation has significantly reduced the ability to make a profit on anything except investment banking deals.
The main result of these “forces” is research departments cannot research any companies that do not have a potential investment bank deal of about $50 million or more. This leaves thousands of great companies without research. Couple this with the fact that research departments drop coverage rather than issue “sell” reports, and you’ll get the perception that analysts only issue “buy” recommendations.
Buy-side analysts are employed by fund managers like Fidelity and Janus, as well as pension funds. Like the sell-side analyst, the buy-side analyst specializes in a few sectors and analyzes stocks to make buy/sell recommendations.
However, the buy side differs from the sell side in three main ways: they follow more stocks (30 to 40), they write very brief reports (generally one or two pages) and their research is only distributed to the fund’s managers.
Buy-side analysts can cover more stocks than sell-side analysts because they have access to all the sell-side research. They also have the opportunity to attend industry conferences, hosted by sell-side firms. During these conferences, the management of several companies in a sector present why they are a better investment. After gathering this information, buy-side analysts summarize their case in a brief report that also contains an earnings forecast.
The sell side provides research and conferences to the buy side in the hopes the buy side will let them execute the large trades the funds make when they act on the recommendation provided by the sell side. To compensate the firm for this information, the funds will buy and sell stocks with the brokerage firms that provide the best information.
Independent analysts are practitioners who are not employed by either brokerage firms or mutual/pension funds. “Indies,” as they are sometimes called, are firms established to provide research that is “untainted” by investment banking deals.
Some indies focus on serving institutional clients and are paid a fee to follow certain stocks and/or to find new ideas that the sell side is missing. In some cases, these institutional indies have a relationship with a brokerage firm and are compensated by trades given to them by the funds. Sometimes it is a fee-only arrangement.
Indies play an important role in today’s market by providing research on small and micro cap stocks ignored by traditional brokerage research departments.
Other indies provide their research to both institutional and individual investors. These firms may provide their research on a subscription basis or for free. In either case, it is important to understand the nature of the relationship between the research firm and the company being analyzed (generally called the “subject company”), even if the report is not free.
Every research report is required to have a disclaimer that discloses, among other things, the nature of the relationship between the research firm and the subject company. This disclaimer generally appears at the end of the report and is in a small type. In it, the research firm must disclose if and how it is compensated for providing research. For example, major Wall Street firms will disclose they provided investment banking services to the subject company.
Indies play an important role in today’s market by providing research on small and micro cap stocks ignored by traditional brokerage research departments. Wall Street has become myopic, focused on big cap stocks and pleasing big institutional investors.
This has resulted in the majority of stocks becoming “orphans” despite their investment potential. Indies attempt to bridge this information gap by providing research on stocks Wall Street has orphaned. While the internet revolution has increased the ability of individual investors to do their own trades and research, it takes time and experience to do a thorough job. Legitimate indies take the time to provide useful information. It is up to you to judge its worth.
The objectivity of research reports is a major question asked of both the large Wall Street firms and the indies. Is Wall Street research objective? Can an indie provide an objective research report if it is paid by the subject company? These are difficult questions to answer without reading the disclosure and the report and knowing something about the firm and the analyst.
Just like on Wall Street, some indies strive to meet a higher standard of ethical conduct while others just try to manipulate stocks. But it is your responsibility to understand and evaluate this information.