What Does a Sell-Side Analyst Rating Mean?

Posted on Friday, March 8th, 2019 MarketBeat Staff

Summary - In an age when investors have 24/7 access to information about a company and its stock outlook, there is still a need for experts who can provide a deeper context about a company’s revenue and earnings forecasts. Sell-side analysts help investors make informed investment decisions because of their access to company insiders and also their history and experience within a particular sector of the stock market. Sell-side analysts are most commonly heard from during earnings season when companies release their financial reports highlighting their performance from the prior quarter and their projected forward earnings. Analysts review this data and combine it with their own research to issue their recommendations, which are called ratings.

Analyst recommendations affect publicly traded stocks because they are used by institutional investors to gauge prevailing sentiment. A sell-side analyst typically covers only a few stocks or a sector and may give a rating that is in contrast to current market conditions. For example, the stock of an agriculture business may receive a sell recommendation due to tariff concerns while another company in the same industry may receive a buy recommendation due to an announced share repurchase plan which signifies a strong cash reserve.

Sell-side analysts are different from buy-side analysts because of their role in the investment process. The sell-side analysts work for firms such as brokerage houses that are seeking to market the stocks they research to buy-side analysts. The buy side analysts work for private equity firms, hedge funds, asset managers and the like who are looking to deploy capital in a profitable way.

Introduction

Earnings season is a time when investors hear the words “analysts’ recommendations”. Did this stock exceed analyst expectations? Why did this stock fail to meet expectations? But before an investor can determine whether a company meeting, exceeding or falling short of analyst expectations is meaningful, they should first ask who these analysts are? How do they arrive at their forecasts? Are their forward-looking projections grounded in sound accounting principles or speculative hype?

Why are those questions important? In our information age, a consensus “buy” or “sell” recommendation can send a stock soaring or plummeting in minutes. This means the security of an investor’s portfolio can be affected when an analyst’s research becomes public.

In this article, we’ll attempt to answer some of these questions by defining what are known as sell-side analysts. These analysts play an important role in advocating for stocks, but can also be seen as having a conflict of interest. We’ll explain how sell-side analysts are different from buy-side analysts. We’ll also review the different types of recommendations and what they mean, the process sell-side analysts use to come up with their recommendations, and things you can do to ensure an analyst’s rating is objective and accurate.

What are sell-side analysts?

Sell-side analysts work for institutions (such as an investment bank or brokerage firm) that receive money from investors. The job of a sell-side analyst is to track the performance of various securities, (most frequently equities like stocks), for certain companies and use their research models to project a company’s future financials. Some of the research they provide comes from the company itself and some of it comes from their own fundamental and technical analysis. The sell-side analyst’s work culminates during earnings season when they provide an equity research report that includes a recommendation and stock price targets. Since different firm will hire their own sell-side analysts, it is not uncommon for a stock to have a dozen or more analysts’ recommendations. When all the analyst ratings are released, the recommendation that is most common is known as the consensus estimate.

Although a sell-side analyst’s recommendation is available to the public and usually issued to the financial media within minutes of being released, the primary job of the sell-side analyst is to present investment recommendations to their clients based on their research of the companies they are following. This is done in an effort for the analyst to bring money into the firm that they work for. In almost all cases, this research is given to the client at no cost.

The client of a sell-side analyst is a buy-side analyst. These analysts work for the institutions that have skin in the game. They may work directly for an asset manager at an investment institution such as a mutual fund company and have positions (i.e. be invested) in the stocks that they analyze.

Sell-side analysts versus buy-side analysts

The basic difference between sell-side analysts and buy-side analysts is their role in the investment process. A sell-side analyst has the responsibility of convincing a decision maker on the buy side to make an investment in a particular stock or security. Buy-side analysts are responsible for making their own individual recommendations to the entities in their firms who make the investment. This distinction may become clearer when looking at where a sell side or buy side analyst works.

As we mentioned above, sell-side analysts generally work for investment bankers, commercial banking institutions, brokerage firms or market makers. Their primary job is to ensure money flows into their firms. To do this, they make recommendations. Buy-side analysts are on the other side of the table. They work for private equity firms, hedge funds, asset and portfolio managers, institutional investors and retail investors. Their primary job is to ensure their firms make wise use of capital. Both analysts strive to “get the analysis right”. However, there are more consequences for the buy side analyst if they are wrong.

What does a sell-side analyst’s rating mean?

The sell-side analyst conducts equity research to come up with a recommendation. Along with a rating such as “Buy”, “Hold”, or “Sell”, an analyst’s recommendation comes with price targets. The basic ratings of an analyst are as follows:

  • Strong Buy or Buy Recommendations: This means that the analyst is making a recommendation for investors to buy a particular stock or security.
  • Strong Sell or Sell Recommendations: This means that the analyst is making a recommendation for investors to sell or liquidate their position in a particular stock or security
  • Neutral or Hold Recommendations: This means they are not calling for the investor to take a specific buy or sell action; rather they are giving their opinion on the performance of the stock. Typically this rating is given when an analyst expects the stock to perform in a way that is consistent with the performance of the broader market, or with comparable companies within the analyst’s sector of expertise.

In recent years, many analysts have started to add clarify the expected movement of their stock forecasts using two additional categories:

  • Underperform Rating: This means the expectation for the stock is that it will perform below the market or sector average. To add further nuance, words like "moderate sell”,“ weak hold", or “underweight” may be used in the place of “underperform”.
  • Outperform Rating: This is the opposite of an “underperform” rating. Stocks that receive this rating are expected to outperform the market or sector average. Other words like “moderate buy”, “accumulate”, or “overweight” may be substituted depending on the analyst.

Investors should be careful to take each analyst report at face value since not all ratings mean the same thing. A “hold” from one analyst may be more bearish than a “sell” from another analyst who may be pointing out a short-term technical challenge for a stock that they feel has a long-term bullish outlook.

How does a sell-side analyst develop a recommendation?

Since a stock price is affected by corporate earnings, the job of an analyst is estimating what earnings they think will be reported. In a perfect world, companies would provide complete transparency and analysts would be able to make a recommendation with a high degree of confidence. In the real world, companies have an obligation to their shareholders to put their company in the best possible light. And while the Securities & Exchange Commission (SEC) has strict rules that act as a deterrent from companies outright manipulating their filing documents, the information they provide is limited and in some cases provided without much context.

The analyst needs to create this context. They do this by using their own computer models, valuation calculations, and factoring in current economic conditions. They will also take into account generally accepted accounting principles (GARP) when reviewing a company’s balance sheet to see if their revenue and profit met expectations. The balance sheet can also provide clues regarding how much debt a company is carrying. Sell-side analysts will also listen to the conference call (or earnings call) to get clarity on their own findings and to listen for unexpected surprises or disappointments. 

And after all that, a sell-side analyst’s recommendation is only one of many.  Every firm employs its own sell-side analysts because they are typically dedicated to a particular sector, and possible to only a few companies within that sector. Many equity analysts may provide stock recommendations on the same stocks for years. Over time, this can make their recommendations carry more weight for the buy side analyst. However, the buy side analyst will always conduct their own proprietary research that will be in addition to research provided by the sell-side analyst. Unlike a sell-side analyst’s research report, the equity analysis of a buy-side analyst is not available to the public.

Are sell-side analysts objective?

One of the criticisms leveled against sell-side analysts is that the nature of their jobs presents a conflict of interest. Many of these analysts develop close relationships with executives in the companies that they issue reports on. There is a concern, therefore, that they could allow a favorable opinion about a person in a leadership position to interfere with their objective view of the stock. Investors should pay attention to the disclaimers of every earnings report for details on how the analyst is compensated. This can help explain any bias an analyst may present when issuing a particular rating.

This has been less of a concern since the tech bubble crash of the early 2000s due to increased regulation from the Federal Government that requires analysts to use commonly accepted valuation methods in their analysis. However, this movement towards regulation is creating growing concerns among buy-side analysts about the availability of significant research, particularly regarding small companies. This is particularly true in Europe where the EU recently issued the Markets in Financial Instruments Directive (MiFID II) which unbundles research and transaction costs. This measure prohibits the common practice of using “soft dollars” (which can be monetary or non-monetary) as an incentive for one party to trade with another. It also means that EU investment managers can only receive research from sell-side analysts if they pay for it. Not surprisingly, this is leading to a lack of research, particularly on smaller companies, a shrinking pool of sell-side analysts, and a tendency for some research to contain more “speculative hype” to set it apart from the research that a buy-side analyst could perform themselves. 

The final word on sell-side analysts

A sell-side analyst is a researcher who is employed by a trading institution to provide an objective analysis of a stock's perceived future performance. The job of a sell-side analyst is to market specific equities to buy-side analysts at investment firms to ensure their institution gets business from these firms.

Analyst coverage of a stock is based on guidance provided by the company in its earnings reports and via its conference call to investors as well as specific valuation models. The traditional ratings an analyst uses are “buy”, “sell”, and “hold” although they may use additional categories such as “underperform” and “outperform” to show a broader spectrum of potential outcomes to investors.

An analyst’s rating is a snapshot of a company’s performance based on their opinion. Any rating given by an analyst, especially if it is an outlier from where consensus opinions lie has to be looked at carefully in line with where the analyst is employed and how the analyst is paid. One of the concerns related to sell-side analysts is the potential for a conflict of interest because of relationships they may have with executives at the companies they research. Since the tech bubble crash of 2001, the Federal Government has imposed new regulations to bring transparency to how the data is presented. However, analysts still have the latitude to interpret that data at their discretion.

 

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