Debate Club: Analysts Should Own Their Stock Picks, Part II

And here is Felix Salmon’s reply as the next installment in the "analysts should own their stock picks" debate I’m having with the man from Portfolio:


Hi Paul —

Sorry for the delay in replying, I was watching Germany beat Turkey 3-2 in the semi-finals of Euro 2008. Gotta keep one’s priorities straight.

I think that the problem here is that we’re starting from two very different base cases. You’re approaching the issue from a "why not" perspective: you see bans on analysts owning the stocks they cover as "a heady mixture of cynicism and paternalism" which are ripe for abolition. I, on the other hand, come from a "why" perspective: I see no need whatsoever for analysts to own stocks, and I can foresee a whole host of problems should it start to happen. In other words, the downside is large, the upside is extremely tenuous, and there’s nothing really broken about this ban in the first place so why on earth are we trying to fix it.

I do think it’s fair to ask what kind of benefits you think that investors would see were all analysts, pretty much by definition, to be talking their book the entire time. Well, you say, if someone’s talking his book, you can take him seriously. But you’re in the minority there: most people, if they know their interlocutor is talking his book, will mentally discount everything he says accordingly. True objectivity can never really be achieved, but it can be aspired to. And encouraging analysts to own the stocks they’re overweight – that’s just a recipe for guaranteed bias. Do those biases exist, in slightly weaker form, already? Yes. But I see no reason to needlessly exacerbate them.

What other benefits would there be? Would the quality of the analysis improve? Would sell-side analysts become better stock pickers? It’s conceivable, although I doubt it. Quite possibly analysts would become vastly more obsessed with their buy/sell recommendations than they are right now, at the cost of what they’re actually paid to do, which is analysis. And insofar as extreme swings (from strong buy to strong sell, say) or far-distant price targets (Amazon $400!) are more likely to move the market, we’d probably see that many more of them. Which again would not be particularly helpful in the grand scheme of things.

The funny thing is that you admit yourself that "among the best performing factors in some current quant funds’ models is relative changes in consensus recommendations" – these recommendations are clearly serving a useful purpose in their present incarnation. Why throw a spanner in the works by making fundamental changes to the role those recommendations play? As for the use of recommendations by non-quant funds, any fund manager who buys or sells a stock on the basis of a one-word summary from a sell-side research shop should be fired immediately. Recommendations are a single datapoint, – and not a particularly important one, at that; a good piece of research includes many, many others. Are recommendations ever used by buy-siders? Yes. But they’re probably used as a contrary indicator as much as they’re used on a face-value basis. You seem to think that most buy-siders are prone to simply taking the sell side’s advice; surely you appreciate that’s a little naive.

The fact is that analysts are not stock pickers, no matter how much they might like to kid themselves that they are, and their value lies not in their stock picks, but elsewhere. Good stock pickers can get paid billions of dollars a year: they’re called hedge fund managers. Good analysts have a different skillset. Let’s celebrate diversity a little, here, and say that analysts help investors generate alpha; they don’t generate alpha themselves.

Cheers, and go Germany!