Cautionary tale of research reports

  • Business
  • Saturday, 27 Feb 2016

THE US$100,000 fine slapped on a former Deutsche Bank analyst for issuing a positive research report on a company when he actually had negative views on it is a stark reminder of why financial opinions should be taken with a pinch of salt.

It is also a firm reminder to retail investors, in particular, that financial opinions conveyed in research reports sometimes do not reflect the true belief of the analysts.

The more seasoned investors would know how to differentiate between the good ones and the rest. However, retailers are often caught in the game where everything is driven by commissions.

Last week, the Securities and Exchange Commission found that Charles Grom had published a glowing report on a discount retailer in March 2012.

However, in private communications with Deutsche’s research and sales staff, Grom indicated that he had maintained a positive recommendation on the company to maintain good relations with the management of the firm.

This runs in stark contrast to what is required of research analysts when they prepare their reports for investors. Research analysts are required to actually state what they truly believe about the stock.

In a nutshell, they cannot express an opinion or recommendation in public that runs contrary to what they state in private.

In Malaysia, of late, there have been some research reports that are conspicuously “lacking” in terms of material for proper analysis that it makes one wonder if the analysts who had crafted the reports really believe in the financial opinion stated.

The projections and assumptions used in arriving at earnings are long term in nature which makes it hard to justify a research report on the company in the first place. It could have been done when the assumptions had a higher degree of materialising.

The reports are particularly on small-cap stocks that do not have a track record.

For instance, a leading bank-backed research unit recently devoted 20 pages to a small-cap construction company.

The assumptions used in arriving at the profit projections were simply outrageous, to put it mildly.

And the basis of arriving at the profit numbers of the construction company was largely due to its connection with external parties that may pave the way for it to land some large construction jobs.

There was little devoted to the fundamentals of the company itself, its track record in carrying out large jobs and what happens if the “connections” do not pay off.

The research report on the construction firm is not the only one that glaringly lacked substance.

There are a few others and all involved small-cap stocks. There was a lengthy report on a pharmaceutical company whose valuations had already gone ballistic and another on an oil and gas (O&G) company where a “buy” call was maintained simply because it was able to recover some cost from its drilling operations.

The report did not delve into the risk of the earnings of the O&G firm coming down significantly, considering that jobs in the sector were scarce and margins were narrow.

A retired analyst, who is a successful fund manager, said that the structure of the equity research in the capital markets requires analysts to continuously come out with stock ideas and make definite calls.

The sales people and fund managers generally don’t like to hear a “hold” call. They expect a “buy” or “sell” recommendation because then they can proceed to advise their clients to trade with the stocks.

It brings them and the brokerage commissions. Most of the time, an analyst may have spotted a company that had potential, but the analyst needs time to come up with a credible research report that he himself is convinced of, which he or she may not have.

Due to time constraints and pressure from the bosses, the analyst has to come out with a report. And most of the time, because the company that the research is based on is a client of the brokerage, the analyst has to come up with a bullish report.

Essentially, the research analyst has two parties to answer to – one is the brokerage firm and the other is the company that the research is based on. The brokerage pays the analyst, while the company pays the brokerage.

There is nothing wrong in promoting stocks that have potential. However, not many investors are able to read between the lines and analyse a research report well.

Which is why all research reports are supposed to have limited circulation. But in today’s world, there is nothing limited in circulation.

Good analysts go on to become better fund managers because they employ the same set of skills.

Out of the many fund managers, very few can actually claim to be good equity analysts who consistently dish out credible research reports.

The reason is because their financial opinion conveyed in research reports does not always reflect their true beliefs. They are most of the time forced to comply with the nature of the business.

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