We are in the last quarter of 2009 and so are now faced with the perennial focal point for fund managers and listed corporations, that is, the year-end closing.

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This is when the investment world looks forward to analysts’ forecasts for the year ahead. The main dilemma we face is what the analysts’ forecasts will look like, which could be an upgrade of a particular stock (known as a “buy”), a downgrade (a “sell”) or just a “hold”, that is, neither a “buy” nor a “sell”.

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At a recent briefing by a prominent regional research-and-broking house, one of the main points we brought up was how sensitive listed corporations were to analysts’ ratings and forecasts these days. We were told that, with the recent run-up in stock prices, many analysts had downgraded their stock recommendations from a “buy” to a “hold”. This apparently enraged the management of one of the companies whose stock was affected thus, so much so that they went to no less than the chief executive officer of the investment bank that owned the research-and-broking house, to demand that his analyst change the recommendation on that company.

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The company’s management was indignant about their stock being rated merely a “hold” now despite the analyst’s attempts to explain to them that the company’s earnings were such that its stock was now fully valued and unlikely to rise further in price. The analyst would have preferred to have called for a “sell” but felt that would have been far more damaging.

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The analyst then complained that he, too, has to grapple with a few concerns. The first was, of course, that his research house risks sullying its reputation whenever it sends out its research reports to international fund managers. As you can imagine, many international firms rely a good deal on analysts’ recommendations and if they so much as get a hint that these recommendations are massaged on any stock, the analysts’ credibility will be in jeopardy, to say nothing of the long-term credibility of the research house at which he works.

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The second concern he faced was the credibility of the market itself. International fund managers all talk to one another and news that a particular research house massages its recommendations will eventually get around the entire industry. This may discredit the entire market in which the research house operates and may result in fund managers downgrading its weighting even to zero weight.

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The analyst in question went on to say that the company whose stock he had downgraded from a “buy” to a “hold” was about to launch a real estate investment trust (REIT) and had thrown a pile of valuations at him.

 

The analyst had, however, already reviewed these valuations independently, and found them over-optimistic and outdated at best.

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The enraged company went on to accuse the analyst of not knowing how to value its properties fairly and also threatened to shut out his parent investment bank from working on the initial public offering (IPO) of its upcoming REIT.

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With all that arm-twisting in mind, we kept asking those we met about the pressure on research houses to stand firm on their recommendations on a stock. Interestingly, those analysts who worked in research houses that were affiliated with investment banks all dealt differently with such pressure. Many senior analysts revealed that they preferred not to argue with the banks’ clients, but at the same time would also not budge on their recommendations. But when the banks’ clients were dissatisfied with the recommendations and tried to lean on the banks to browbeat the analysts into re-assessing the ratings, the analysts’ solution was to cease coverage of such stocks altogether.

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If you are an investor and have been reading research on a particular company only to find that, suddenly, the research house has “ceased coverage” on it, you may want to find out exactly why it is no longer analysing it. It is certainly a potential red flag and you then have to ask:

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Is this cessation of coverage a result of the company:

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(a) failing to grow?

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(b) being in a sunset industry?

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(c) constantly pressurising analysts to write favourably about it?

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We would also suggest that investors find out if the investment bank affiliated with the research house in question had been acting for the company concerned. If so, that would be rather telling of why analysts had halted analysis of its stock.

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Knowing all this, we would urge regulators to put in place a whistle-blowing system that analysts can use to protect their integrity and investors in general. The regulators would do well to appreciate that there are a good many responsible analysts out there who are keen on doing the done thing but have no avenue to do so at present. That puts the overall credibility of a market at risk while keeping listed corporations who are bent on getting good reviews in a fantasy world of their own making.

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The market is mature enough to accept periods of downgrades. In fact, there are many opportunities for investors to seize even during downgrades.

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For a start, the regulators should, perhaps, consider carrying out a survey as to:

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1. How much pressure analysts are under to make favourable recommendations?

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2. How they go about maintaining their recommendations under such pressure?

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Otherwise, by allowing listed companies to pressure analysts continually for favourable stock recommendations, the market is in danger of having a reputation of being manipulated unnecessarily.