Why City analysts get it wrong so often

The City employs hundreds of analysts who spend their days studying companies and telling people what to do with their shares. Yet countless studies show that they have a terrible track record of predicting the future.

Indeed, most evidence shows that most analysts simply extrapolate what has happened in the past into the future (so if a company's earnings are rising, they'll expect them to continue to rise), rather than accurately spotting turning points.

So what are analysts actually for? And should you pay them any attention at all?

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What analysts do

There are two main categories of analysts working in the City: 'sell-side' and 'buy-side'.

Those who work for the big investment banks and stockbrokers such as Goldman Sachs and Barclays are known as 'sell-side' analysts. This is because they sell research on companies to customers (mainly the fund managers who look after your pension or rainy-day savings) in exchange for commissions.

'Buy-side' analysts are typically employed by fund managers who make decisions based on the investment objectives of the funds that they manage. Buy-side analysts are likely to produce more value-added research that hopefully makes money or failing that, stops them from losing money. You will rarely read about the efforts of buy-side analysts in your newspaper; that's because they don't want you to benefit from their hard work.

Sell-siders on the other hand, are only too happy to tell people their views. This diminishes the value of their efforts. The trouble is, for information to have any value, it needs to be scarce just as is the case with any other commodity. Once everyone has read a research report, any value it can add will have been incorporated into the share price.

Why are sell-siders so happy for their research to be widely distributed? It's because they want fund managers to trade more. This is because brokers make most of their money through trading commissions. If managers don't trade, the broker doesn't get paid. This also means that sell-side recommendations tend to be very short-term focused, rather than looking at the long-term value of investments.

Of course, smart fund managers understand that over-trading hurts their investment returns. So they increasingly ignore the advice of brokers and bypass their services.

Meanwhile, commissions from trading shares have been forced down in recent years they can be as low as 0.05% of the transaction value. This means that brokers have to sell a lot of shares to make real money.

Other types of business are far more lucrative. For example, investment banks can charge fees of 0.5%-3% of transaction value for rights issues, share placings, IPOs, and mergers and acquisitions. But how do they get a piece of the action?

Why analysts rarely say 'sell'

More often than not, the answer rests with issuing favourable analysts' reports on a company. The glowing report with a 'buy' recommendation becomes the calling card of the investment banker touting services to prospective corporate clients.

This is one reason why analysts say 'buy' more often than 'sell', and why their research is tilted towards higher-paying corporates than long-term investors. It is also the reason why so many poor-quality companies are foisted on investors as they represent big paydays for the sponsoring banks the dotcom boom springs to mind here.

The fact is, if a sell-side analyst puts a 'sell' on a company, he runs the risk of upsetting three groups of people.

Firstly, his investment banker colleagues who might be considering approaching the same company. The last thing they need is an unhelpful analyst saying 'sell'. Come bonus time, these things are remembered, and most analysts know this.

Secondly, the company concerned. Even though they would deny this, analysts with 'sell' recommendations are often unwelcome and may be offered little help in understanding the company better. Comments and reports by 'sellers' will be screened for the smallest inaccuracies and may be pounced upon when they arise. It is not unheard of for analysts to receive intimidating letters from company solicitors advising them to change their views, whilst inaccuracies in 'buy' recommendation reports are conveniently ignored.

Thirdly, fund managers may not like analysts recommending 'sell' on their shareholdings, as it might 'undermine their investment'. Given that the career paths of analysts are heavily dependent on their popularity with fund managers, it is another reason why many don't say 'sell' too often.

That's not to say that analysts can't make successful and popular 'sell' calls. The rise of hedge funds and an increasing number of funds that can make money by selling shares (known as going short or shorting) makes this type of analysis more popular. But the analysts involved here are more likely to work for these funds rather than a broker (in other words, they will be on the 'buy side').

Analysts can't predict the future

But surely sell-side analysis is at least useful for doing your own research, and screening stocks?

The trouble is, despite all the forecasts they lay out, analysts can't predict the future. Think about it for a moment: companies themselves, with all their information about customers, sales and costs, cannot really predict how much money they will make in the future, so what chance does an external analyst have?

A more cynical use of analysts' forecasts is also worth noting. Some companies engage in 'expectations management'. This is where a company deliberately guides analysts to publish profit forecasts that it is sure it can beat, knowing that this is likely to drive its share price higher when results are announced.

In short, 'sell-side' analysts work within a system that actively encourages them to have an optimistic bias, with many of their forecasts sourced directly from the companies that they're writing about. They get better rewarded for saying what people want to hear, than for getting their calls right.

It's all the reason you need if you weren't already convinced of the case to take their views with a pinch of salt and do your own research before buying any stock.