Contrib. 4b. What future
for financial analysts?
by Peter Greenfinch (was Jan. 2003 working paper)
In our Internet age, and after
the stock bubble, the crash, and various scandals,
the stock analyst profession, as well as investors, are entitled to wonder how to
reorganize stock research and financial analysis diffusion.
focuses mainly on the sell-side research issue. But some remarks
apply also to buy-side analysts.
It doesn't pretend to offer a complete study and
to give turnkey solutions. Also,
some of its elements might seem controversial. Its only aim is to bring some
food to the thinking table.
1. The new situation, with its
Various factors might deeply influence the future of the stock research profession.
I see three main negative factors for the short / medium term future, but also two
rather positive ones for the long term.
Three short term negative factors.
1a. The general stockmarkets and economic picture:
After being exaggeratedly popular and buoyant, years after years, in the 90's, most
stockmarkets in the world have been falling dramatically from mid 2000 to 2003
In parallel, the world economy is encountering problems and risks, after an excessive
debt-based growth and some misallocation of resources, particularly in the
Various corporate accounting scandals, and related bankruptcies, added to the picture.
Not talking about the new geopolitical environment.
No wonder that stockmarkets and stockmarket professions have became less
popular, even if there is some reprieve at the moment!
1b. Conflicts of interests:
For various investment banks and stockbrokers, various conflicts of interests
appeared in full light, between:
their security analysis services (research and recommendations), which get
few direct revenues (by selling the analyses)
their stock selling activities. They include the brokerage activity (to the public,
to other institutions such as investment funds). And the money management
They bring customer fees, which fund indirectly the analyses activities.
their corporate / investment banking activities, bringing their own revenues,
helping also to pay for the analysis services.
As a result of this confusion and its effects, the stock analyst profession has been,
among other professions (auditors, fund managers, listed firms' CEOs...) put into
The "smoking gun" was that the recommendations that analysts gave to clients
have been generally poorly performing. Not to say misleading, once stock became
One reason usually given was the insufficient respect of a "Chinese wall" between
stock research and the corporate / investment banking activities, as seen above.
But there were also other biases, that might have played a more crucial role:
1) The "other" missing wall
A wall between research and selling is missing, as sell-side analysts are
involved in boosting stock sales (with bonuses based on their selling
It seems to be their main source of revenue, more sizeable than the
income from investment banking activities. As a result, consciously
they focus less in fundamental analysis and more in the search of
investment "ideas", as front-office sellers pressure them to supply
all the time new short term tips.
they have an incentive to boost stock prices. As a way to enhance
their predictive reputation, and to give immediate satisfaction to
the investors they advise.
This might explain why they gave many more "buy"
recommendations than selling advises.
2) Closeness with listed firms.
This explains also this bias toward positive recommendations, as security
analysts might be over impressed by the listed firms they frequent.
The more closely you frequent those firms, the more you absorb their
culture, lose your distance, feel like a partner. The less critical and the
more overconfident and overoptimistic (illusion of control / of knowledge)
Also, many security analysts might have felt that giving negative opinions
would offend those firms. They ran the risk that their CEOs and CFOs
would see them as enemies and dissidents and dmake them personae
non grata, which would cut their source of information.
3) Groupthink (peerthink).
It is pervasive in stock analysts circles, as seen often in other professions.
Many analysts seem enslaved in following the ""consensus"" of their
peers. It could be
A path towards personal "safety" ("better be wrong with everybody
else than to be right alone"). This was institutionalized by the
Analysts and fund managers are appraised on short term results,
compared to those of their colleagues. A thing that contradicts the
paradigm (which also has its own biases by the way) that stock
investments are a long term return performance tool.
Or just a symptom of pure herd instinct, a widespread trait common
to most human beings, who are ""social animals"" as Aristotle said.
4) Market reflexivity.
Analysts, when assessing price objectives, often gave more attention to
the exogenous picture (market trend and prices) than to the endogenous
(economic) valuation factors of the firms. This led to over optimism.
Such a practice might have been helped by the "market efficiency" credo,
which states that market prices always reflect real values. Also that over
optimism has been boosted by the fantasy - sorry, the paradigm (!) - that a
15% return on capital and/or a 15% yearly earnings growth should be
expected for the eternity ahead.
Those two kinds of "rationalization" of irrational beliefs made for illusory
stock price objectives
1c. Investors attitudes.
Many investors suffered from that situation once the bull run hit the wall.
As a result, they lost in a big way their confidence in the stockmarket
and in financial institutions.
They are now less enthusiastic to put money into stocks, and more conscious of
the risks and traps involved, to the point of becoming excessively risk averse.
For the future, prospects of fast economic growth and spectacular stock price
gains seem to have faded, maybe for several years ahead, if not a decade, at least
in some parts of the world.
Of course, some selective investment opportunities will inevitably arise, but
stockmarkets lost some of their luster and appeal. As everybody knows, it is
faster to lose trust than to build it up again.
The number of active investors has dwindled, and might stay low for a prolonged
The effects for financial institutions, and mostly for brokers, are of two kinds:
1) The market for their business shrank, and it might not recover quickly.
This leaves them with less money available for their (costly) financial
2) They have to face rising problems of legal responsibility, and are submitted
to new obligations, among them to isolate analysts from their other activities.
Two long term positive factors.
1d. More sophisticated investors
A new class of investors arose during the buoyant years. But it was often lured
by technical analysis methods, a thing propitious to herd instinct. Also fast
communication reinforced their tendency to go along with the trend, however
excessive the level reached by market prices.
But among them, some more sophisticated / educated ones appeared. Those who
are still active and who learnt the lessons might be readier now to make, use and
peruse fundamental analysis, instead of waiting for advises and tips, or following
mysterious graph patterns.
Also, since Daniel Kahneman was awarded a noble prize in 2002, as a pioneer in
behavioral finance, financial analysts as well as investors might be more interested
in understanding the market anomalies and the psychological biases that causes them.
That evolution towards more sophistication would help to refine the
stock research methods, and create new information needs for investors.
Those new needs offer new opportunities to the profession. If it adapts
1e. The Internet became an important media for financial services:
1) It plays a more and more important part as a diffusion tool for financial
2) This role will be strengthened if brokers will have to give less advises (or
information that might be construed as advises), via their sellers, because
of the legal responsibility involved (see 1b/1c). This opens the way for more
independent information and analyses.
3) After a period where most things in the web were free, people start to
get used to pay for information and other services found on it. One of the first
sectors where this evolution is taking place is finance.
There is a new market for value-added research services, paid by investors,
mostly on the Internet.
2. The consequences (adapting to the new investors needs)
The new needs for investors (which should be checked, by making adequate
surveys) seem to be that:
2a. Financial institutions isolate their stock analysis services from
their other activities, and even from selling (see 1b/1c), by creating
"independent" structures to host their research teams.
2b. Those information and analyses be diffused, not via sellers
recommendations, but independently, on paper, or better by Internet,
which allows instant access / update.
2c. Those analyst reports and conclusions be invoiced to clients separately
of brokerage fees. Thus, analysts, getting revenues independently of the
volume of the clients' operations, would have less incentive in inducing them
to be overactive and multiply their stock operations just to create turnover.
2d. More generally, buy side research gain importance comparatively to
sell-side research. As a buy-side practitioner said, such a business model
based on paying research is not very easy, and thus some "starting help"
would be needed.
2e. They include, to justify the selling price of those research reports,
elements bringing more added value to clients. For example, more detailed
economic projections could be given and more sophisticated valuation and
risk appraisal techniques could beused, as we will see in 3c.
2f. Brokers be cautious in giving advises / recommendations to their clients.
And here I will introduce a bit of controversy:
1) It seems abusive, however popular and usual it has become, to
give buy / sell recommendations, or to communicate stock price
This is the responsibility of the investor himself, after perusing
information and analyses. Well, maybe I have the "those who
counsel are not those who pay for the mistakes" bias
2) It is not certain that people unable to analyze and decide by
themselves should be encouraged to invest heavily in stockmarkets,
whatever the famous statistically-backed fantasy that says: "in the
long term, it is the best investment".
3. Approaches to practical solutions
3a. Proper legal structures should be found for the ""independent"" research
teams that would sell analyses to investors.
They should not get revenue from the corporate / investment banking activities
(which could have a perverse effect, as seen below). Ideally, if we go one step
further, they should not be any more financially dependent of financial institutions.
However, things might not go that far, because of various problems. Even if some
firms make money by selling analyses to the public (Value Line...), profitability
cannot be immediate for the newly independent outfits. The analyst profession
might shrink somewhat, creating less competition and stifling research on small
caps stocks. The economic reasons behind this risk of research attrition are:
1) the cost of fundamental analysis. A full fledged stock research service
in a large financial institution costs several hundred million dollars a year.
Those costs start to be slashed, as seen below, but stay impressive.
Presently, many sell-side analysts left, or were fired or got less paid
But it can be in the detriment of quality, and of quantity (unfashionable
sectors and most small caps become neglected).
Also a part of the job, the corporate accounts analysis, is now more
often often outsourced to specialized firms, created mostly in India for
2) the absence of revenue from corporate / investment banking activities (the
perverse effect could be that it gives an even greater incentive to act as stock
sellers so as to get more revenue from brokerage).
3) the decrease in the number of active investors (see 1c), and among those, of
investors ready to buy analyst reports
4) the need to offer attractive tariffs at the start to those investors. most of
them not being really used to pay a fair price, or to pay at all, for this kind
Most of those firms will need therefore to receive money contributions from the
brokerage business. The main banks and brokers (in the US) pledged, in a
settlement with regulators, to subsidize during 5 years independent analyst firms.
The brokers might thus become ""subscribers"" of such facilities. Normally, they
should pay those firms a fixed yearly subscription, based on the work done, thus
not proportional to brokerage fees. What is not clear is if those research suppliers
1) Research firms made at the initiative of the financial institutions by farming
out previous research teams. Those would go on working more or less
exclusively for their previous institution. Those institutions, via their sellers,
would use their research and advises to inform their customers, freely or
for a nominal fee.
The main resource to fund research work would therefore keep being the
brokerage fees, in just a little more transparent way. It would be a cosmetic
change that would not improve much the situation.
2) Or ""co-operatives"" of several brokers / banks / funds (as merging existing
teams might lower the costs). But that would go against competition and a
diversity of research centers, thus uniformizing valuations.
3) Or purely independent buy side firms. The financial institutions would be
among their customers, but with no exclusivity. Ideally, most revenues from
those firms will gradually come from direct retail sales of reports to investors /
subscribers. This would be the ideal solution. Although it would offer poor
profitability and economic safety for those independent firms, at least after
4) Or, for each broker, several research firms of the various kinds described
That means splitting a (lower) budget between several suppliers. This would
lower the selling prices of the reports. On the other hand, that will mean that
each research firm would have several institutions as clients.
Anyway, in case the linkage between analysts and bank / brokers will not be
completely broken, the other precautions stated below will be even more crucial.
3b. Analysts might have to be more independent of their good relations
with the firms they analyze.
They should not replace their homework with what the firm communicators
This seems to preclude the alternative solution that firms would pay for the
financial analysis of theirs stocks, as they do for auditors.
A way to be more independent of the firms' information is for them to:
get more interested and extensively informed in what can happen in the
macro- / micro-economy, so as to make their own forecasting of economic
trends and their effects on the firms they analyze.
be more aware of the behavioral biases (of the firms, of investors, and
To sum it all, get, when needed, more training not only in accounting,
but also on economics / forecasting, on business management, on
psychological aspects, and of course on ethical matters.
3c. They should better focus on ""simulations"" (see chapter 4), instead of
recommendations, and give more sophisticated pricing information with their
stock reports, as a way to:
adapt to new types of investors (1d),
obtain marketing differentiation through added value (2e),
use more caution (2f) and stay rather informative and neutral, maybe
except in extreme cases (alerts),
Thus, as examples of the new types of ""products"" they might offer, I suggest
they provide (as illustrated in chapter 4) at the end of each report:
1) Several price scenarios. To do that necessary task would also avoid
them to be too influenced by other analysts' recommendations, and will
incite them to explore all ""what if"" hypotheses,
2) Not only their ""economic"" projections / valuations (which as seen
in 1b, were often biased by the ""reflexivity"" phenomenon), but also
their "behavioral" valuations. Those will take into account (this time
openly) the potential market biases. In other words, the valuations
would combine openly intrinsic and extrinsic calculations.
Also, those valuations should not to be given as price objectives, but as
ranges of potential prices in given hypotheses of economic conditions
and market behavior,
3) A classifications of each stock in its family of risk, growth and price
This would give investors more information in order to pick their stocks
(and define their own objectives) according to each one's own preferences,
4) and - this is the closest to giving buying / selling recommendations and
price objectives - a rating (cheap, expensive...) based on the current price
level of the stocks involved. That would apply less pressure on investors
and will be more neutral in their relations with the listed firms.
3d. In parallel, bank / brokers should:
1) Control that very active customers know what investing is about and
what risks they take,
2) Offer investors more information and training in stock assessment,
money management (in the US, they pledged to provide money for that
purpose) and ...market psychology.
3e. Personal ethics and legal responsibility should be stressed.
They should apply to analysts, thanks to a kind of Hippocratic oath. But it is
at least as important that they apply also to their institutions and contractors,
which are responsible for the analyst's job descriptions, assignments, guidelines,
objectives, and their control :
Analysts, for example, should be forbidden, by their contractors,
- obviously, to own stocks / derivatives of the firms they analyze,
- maybe also, to own any listed stock or derivative (except through funds).
An "Hippocratic" code of fair practices (which already exists in many
countries and institutions) would be the base for the legal responsibility of
analysts and their institutions.
4. Example of simulations
As seen above, multiscenarios simulations can be an alternative to
Technical remark: to calculate the stock economic value, analysts can chose
Mine is close to the Bates model. I see two advantages in it: it is very simple
and it takes into account that investors, thus market prices, have a "PER bias".
Of course, analysts might chose more sophisticated economic value models.
In that case they might need to recalibrate the image coefficients that I use
as a bridge between the economic values and the ""behavioral"" potential
Name of stock: ____________________ Simulation updated on: __.__.__
Pick your scenario
A - Estimated Economic Data
. EPS 5 years variation estimate (1)
+ 20 %
+ 30 %
. Estimated EPS 2008
. Estimated normalized midcycle EPS
. Current or estimated. (3) interest rate (bonds)
. Current or estim. (3) inflation rate
. Primary PER (see PPER table)
B - Estimated Economic Values (EEV) calculations
. EPS x primary PER =
. Present gross dividend x 5 =
1,6 x 5 = 8
. EEV (= EPS x primary PER + 5 x dividend)
C - Estimated Potential Image coefficients
Image stability / structural image level
+ Stock family(ies)
low volatility / medium level
. Low image (4)
. Structural image (4)
. High image (4)
D - Estimated Potential Market Values (EPMV)
. Low EPMV (= EEV x low image)
. Structural EPMV (= EEV x struct. image)
. High EPMV (= EEV x high image)
E - Price / value rating simulation
Current price. Current value ratings
Abs: 3 / Rel: 4 (6)
(1) in current money value (not deflated)
(2) theoretical data that may be used to refine comparisons, but the market does not take it
much into account, often the contrary.
(3) you may use estimated rates instead of current ones if you expect important forthcoming
(4) the narrower (=with the least stocks) indexes such as the CAC or DJ, are a reference for
The stocks belonging to this "exclusive" club have a liquidity and notoriety above the
Thus their prices enjoy a specific quality premium, with images about 10-25 % higher than
the whole market's image shown in B table.
(5) the low / high image bracket could be the same in each scenario even if, more often, images
tend to be high when EPS are rising and low when they are falling.
(6) 1 = very expensive, 2 = expensive, 3 = rather expensive, 4 = average, 5 = rather cheap,
6 = cheap, 7 = very cheap;
Abs = in absolute / Rel = relative to the whole market level (this supposes to have made a
current price rating of the market, see SP 500 sim).