BackA stock analyst has to face long-term structural pressures
The investment community can collectively and persistently, through advocacy, bring about a change
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Both in India and the US, investment research has been making news but for all the wrong reasons. On 26 November 2014, a research analyst was reportedly remanded to custody by a Gurgaon court on a complaint filed by a company whose stock the analyst covered. Earlier, in 2011, the analyst’s report on the complainant company’s stock was seen as a trigger for a heavy sell-off in that name. In 2012, the analyst published another report on the same company, subsequent to which the company is said to have filed a suit in India against the analyst and other associates. The research firm where the analyst worked, too, has been reported to have filed a suit in Canada against the complainant company. Separately, notably, the group of companies associated with the complainant company was criticized by India’s capital markets regulator, Securities and Exchange Board of India (Sebi), in 2013, for holding six annual general meetings in a span of seventy five minutes.
The claims and counter claims between the analyst and the complainant company remind us of how fragile the atmosphere can be in which the investment community operates. Irrespective of who the wrong doer is, potentially expensive litigation, trust deficit and uncertainty may have created another wall of worry for the publishing analyst. How “free" then is the analyst community from greed and fear in doing their jobs?
An exercise conducted to investigate analyst research recommendations confirms a bias that analysts could be facing in assigning a “sell" recommendation. Recommendation data (as of 27 November, source: Bloomberg) tells us that the average sell-side analyst in India has not been as willing to put a “sell" rating on stocks. This may not be an entirely new revelation. But the extent of the bias against “sells" in India is uncomfortably high and stands out. On average, India’s (Nifty) sell rating percentage is at 13.4%—the lowest among the global markets that were analysed. This compares with an average “sell" rating of 49% in Japan (Nikkei), 46.4% in the US (S&P 500), 35.7% on the Hang Seng Index and 21.5% in Korea (Kospi 200).
One could argue that the latest low average “sell" rating in India is a result of the current bull market sentiment. But even in the worst of market moves—2014 and 2011—India’s average “sell" ratings peaked at 14.7% and 15.5%, respectively.
The sell rating percentage is calculated as the percentage sell recommendations compared with total recommendations. The formula is: Number of sell recommendations/total number of recommendations. A low sell rating percentage—such as the 13.4% for India—indicates that out of the 100 recommendations that analysts make, only 13.4% are “sells", while 86.6% are either “buys" or “holds".
What are the pressures that could be dragging the sell-side analyst to a mediocre report? In India’s case, an average sell-side analyst has to typically compete with tens of peers. Axis Bank Ltd, for example, is being “covered" by 67 analysts (according to Bloomberg data). The annual brokerage commission for the top liquid names in India could be pegged at around $500 million (assuming commission at 20 basis points, or bps; one bps is one-hundredth of a percentage point).
There is an abundance of analysts who are covering Indian stocks. Uncertain revenue pie—trading and commissions generated from trading (a source of revenue for research analysts through soft dollars)—has not grown as much as the coverage from the sell-side analysts. Secondly, trading activity is also a function of India’s growth, foreign institutional investor interest in the market, and retail or domestic investor participation in the market. Significant competition and an uncertain revenue pie are a long-term structural pressure that the analyst has to face.
In terms of stakeholders, for the sell-side analyst, important parties include the buy-side, the companies being researched and the regulator. Companies, quite naturally, do not like a “sell" recommendation on their stock. Many reputed chief executive officers have on record expressed their dislike towards the earnings season and questions from the analyst community (an example would be in the book Who Says Elephants Can’t Dance, by Louis Vincent Gerstner Jr, who was chairman and chief executive officer of IBM).
However, openness to criticism and avoiding prejudice against critical analysts would be required from companies to create an environment of fearlessness. Maintaining informational access in letter and spirit to analysts who assign a “sell" rating is an area that may need support from both the companies and the regulator. The regulators could look at improvising mechanisms for fair and open access to corporate information. Above all, the buy-side, through its retail investor representation, is in a position of significant influence to persuade not just the regulators but also the overall culture in the investment community.
Markets on one hand need the independence and objectivity that an analyst is required to bring to a recommendation. But on the other hand, unaddressed fault lines may be creating barriers that are counterproductive to all participants. These walls and lapses highlight the need to uphold values enshrined in code of ethics for creating a robust investment canvas. The investment community can collectively and persistently, through advocacy, bring about a positive change.
Shreenivas Kunte is member of advocacy committee, Indian Association of Investment Professionals—member society of CFA Institute.
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