“I’d rather lose half of my clients than lose half of my clients’ money.” – Jean-Marie Eveillard (First Eagle Global)
I think very few investment research firms other than Valuentum can say that they are truly free from conflicts of interest. As shown in the excerpt from FINRA attached at the end of this article, there are at least five sources of analyst conflict of interest: investing banking relationships, analyst compensation, brokerage commissions, buy-side pressures, and ownership interests. No matter how much you may want to believe that sell-side equity research, or research provided by companies such as Morgan Stanley or Goldman Sachs, is free from conflicts of interest, it simply is not. Valuentum prides itself on being one of the only true independent investment research firms that is completely free from conflicts of interest. We attribute this to our integrity, our user-paid subscription-model, our mission to serve others and how ideas are filtered through our research structure.
Let’s start with structure. In other research firms, for example, there may be as many as three or four individuals commenting on any single stock at any one time. For example, there could be an equity analyst, a credit analyst, a strategist, and then perhaps the head of research – all doing their own jobs but serving different types of investors at any given moment. Check out what could happen under this structure in the following Barron’s blog:
In one of those made for Wall Street moments, JPMorgan Cazenove’s equity strategy team is recommending investors short mining stocks, while its mining analysts rush in to defend some individual stocks, including BHP Billiton and Rio Tinto.
First the strategists. JPMorgan Cazenove’s Mislav Matejka and team offer seven reasons for their call. Here are a few of the more compelling ones…please see blog.
JPMorgan Cazenove’s metals & mining team, however, appear to have some reservations. They write…please see blog.
UPDATE: After reading a comment or two, I should note that there’s nothing nefarious going on here. The strategist team is looking at the sector in aggregate from the top down, the analysts at single companies from the bottom up. And they come to different decisions. The question for each of us is to decide which one matters more for our individual investing style.
We think the words in the ‘UPDATE’ are perhaps most informative. There’s nothing wrong with having varying internal opinions on the same group of companies (this is actually a good thing), but it is rather peculiar to publish externally these varying internal opinions, unless one wants to create a great deal of confusion. At the end of the day, one of these opinions has to be wrong.
There is a tremendous amount of pressure on analysts and strategists to meet different viewpoints. For example, if a client is bullish on such-and-such industry, a research firm may send them the bullish analyst piece. If a client is bearish on such-and-such industry, the research firm may send them the bearish strategist piece. Having a report that meets the client’s view simply opens the door for conversation and potential business – attaining common ground to exchange thoughts is just par for the course in the sales process. We’re not saying that any research firm would be interested in pursuing (or is pursuing) such a strategy, but the inherent conflict of interest and temptation certainly exists.
We also continue to see the ratings game played by analysts. Sometimes, we see instances of an analyst cutting an investment rating (from ‘Buy’ to ‘Hold’), but raising the price target and earnings estimates. We may see ‘Sell’ or ‘Hold’ ratings on firms that have price targets (where they expect the company will trade to) above their current price. Though there may be a good reason for all of this, the most likely reason stems from a combination of analysts trying to serve a wide variety of clients and the concept of ‘hedging’ (creating an explanation for if/when the stock price increases or for if/when it declines). Some of these research firms’ clients could be using analyst ratings exclusively while other clients may only be only looking at the earnings estimates or price targets. Consistency and ease-of-interpretation is often lost in all of this.
Another well-documented source of analyst conflict of interest comes from herding, which stems from analyst job preservation. We see a strong herding tendency, for example, with respect to earnings estimates and ratings, in part because an analyst may be out of a job if he or she goes against the crowd and is wrong. This herding tendency limits independent thinking. There are also pressures on analysts to perform well internally, whether to demonstrate knowledge of a methodology in front of superiors or to make a call that works out to gain peer respect. For example, you’d be hard-pressed to find an analyst that doesn’t have a good stock idea, even if the industry he or she covers is the worst industry out there and all of the companies within that terrible industry are truly overvalued. In yet other research firms, the pressure to showcase a particular methodology may lead to an overabundance of firms that fit the particular methodology. For example, roughly 60% of Morningstar’s (MORN) stock coverage universe now has what it describes to be an economic moat. Either the economic moat has become widely commoditized (irrelevant), or there is a selection bias akin to why most sell-side firms have a majority of ‘Buy’ rated stocks.
Long-term members of Valuentum know that we have a single firm-wide view on each company and that our best ideas are always included in the Best Ideas portfolio and Dividend Growth portfolio. The structure of our team is such that all ideas roll up to be considered in the portfolios (we don’t talk out of both sides of our mouth), and we execute upon the goals of the portfolios with complete transparency. We are here to serve our members, and as the introductory quote to this piece highlights, we’d rather lose half of our members than lose half of our members’ money. Unlike other providers of research, we simply refuse to introduce any conflicts of interest to our investment process. We remain laser-focused on providing the very best valuation and dividend growth analysis of any independent provider on the market today, and our team is fully driven to achieve the goals of the Best Ideas portfolio and Dividend Growth portfolio through all business cycles.
With all of this said, please find pasted below FINRA’s excerpt on ‘Conflicts of Interest’ (source), which walks through the five sources of conflicts of interest mentioned at the beginning of the article:
Research analysts study companies and draw on a wealth of industry, economic, and business trend information to help their clients make better investment decisions. Retail investors may believe that most analysts work for them — that their primary obligation is to the investing public. But in fact, the full story is much more complicated.
Some analysts are unaffiliated: they sell their independent research to financial or investing institutions, banks, insurance companies, or private investors on a project or subscription basis. But a large number of analysts are employed by institutions whose financial stake in their recommendations may go well beyond their accuracy.
For example, many analysts work for large financial firms that underwrite securities. An underwriter acts as an intermediary between the company publicly offering securities and investors buying the new stock. Even after the initial public offering, or IPO, it may have an ongoing relationship with the company or own a significant amount of the company’s stock. And it will often stand to benefit from analyst recommendations that would tend to support the price of or encourage trading in that security.
Other analysts work for institutional money managers, such as mutual funds, hedge funds, or investment advisers. They may provide research and advice for institutional clients whose investment decisions can differ significantly from those faced by ordinary investors. A mutual fund that relied on its analyst’s earlier positive recommendation in acquiring the stock of a company might be harmed by any revised recommendation that would tend to lower the market value of the security.
Just by thinking about these kinds of employment arrangements, you can begin to imagine the kinds of conflicts that analysts may face as they develop and offer their opinions in research reports. For example:
Investment Banking Relationships. Providing investment banking services, such as underwriting an IPO or advising on a merger or acquisition, can be a lucrative source of revenue for an analyst’s firm. Thus, the analyst may feel an incentive not to say or write things that could jeopardize existing or potential client relationships for their investment banking colleagues. On the other hand, the analyst may also be more knowledgeable or diligent in his research because his firm did the underwriting.
Analyst Compensation. Brokerage firms’ compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, many analysts are paid at least partly and indirectly on the basis of their firms’ underwriting profits. So they may be reluctant to make recommendations that could reduce such profits, and hence their own compensation.
Brokerage Commissions. An analyst’s report can help firms make money indirectly by generating more buying and selling of covered securities — which, in turn, result in additional commissions for the firm.
Buy-Side Pressures. A mutual fund with large holdings in a stock has little desire to see an analyst put out a “Sell” recommendation on that security and possibly contribute to a sharp decline in its price. Hence the proliferation of euphemistic ratings — such as “Hold,” “Retain,” and “Market Perform” — which small investors may take at face value, but which professional and institutional investors know are often tantamount to “Sell.” As a result, ratings inflation became as widespread and unhealthy in our markets as grade inflation in our schools.
Ownership Interests in the Company. An analyst, other employees, and the firm itself may own significant positions in the companies or market sectors on which the analyst conducts research and makes recommendations. The analyst may own such shares directly, or through employee stock-purchase pools.
These economic realities certainly do not mean that analysts are corrupt or even biased. But because analysts are called upon to make so many judgments that are not black and white, any of the above factors can put pressure on their objectivity — no matter how honest or competent they may be. So you should bear these realities in mind before making an investment decision.
Thank you for reading!