IF STOCK analysts' "buy" and "sell" recommendations were assigned their own rating, it likely would be "investor beware."
Recommendations have come under fire lately, largely because many analysts last year continued to hype technology stocks even after they began tanking.
In fact, looking at returns since the mid-1980s, University of California researchers found that for the first time last year the stocks with the least favorable recommendations outperformed those with the most positive ratings. Stocks panned by analysts outperformed the market by 49 percentage points. Highly touted stocks lagged behind the market by 31 percentage points.
All this fuels speculation that analysts' recommendations favor companies at the expense of investors. It also raises concern that small investors may not understand the business conflicts that could influence an analyst's rating of a stock.
Last month, the Securities Industry Association released voluntary guidelines to encourage independent recommendations, just two days before Congress launched hearings into analysts' bias. The Securities and Exchange Commission also issued an investors' alert on recommendations.
And this month, Merrill Lynch became the first major brokerage to prohibit its analysts from buying stock in companies they cover. The nation's largest brokerage also agreed to pay $400,000 to a former client who said he lost more than $500,000 in an Internet stock because of his broker and the "buy" recommendation by star analyst Henry Blodget.
It used to be that analysts cranked out research reports behind the scenes. That changed when the market heated up in the 1990s.
"Now they are television celebs," said Peter Ricchiuti, assistant dean of Tulane University's business school. "What they say has so much more short-term effect than it did before. The analysts are going right to the people."
That means investors must do their homework and look what's behind a recommendation.
Investment firms use different ratings. Analysts generally have a range of five ratings, from "strong sell" or "sell" to "strong buy."
It's rare to see "sell" ratings. Of 26,000 recent recommendations, a mere 1 percent were "sell" or "strong sell," said research firm Thomson Financial/First Call.
Often, analysts couch a "sell" recommendation in the more polite "hold" rating. "Hold is a French term for `I'm getting out. You hold on,'" Ricchiuti said.
There are reasons for the soft-pedal.
Investment firms make more in commissions from "buy" than "sell" ratings, experts said.
Often, too, firms are pursuing the even more lucrative investment banking business, where they help a client company go public or issue bonds or additional stock. A negative mark by an analyst might make a company take its business elsewhere.
An analyst's bonus, too, may be tied to how much investment banking business is brought in, experts said. And analysts or their employer might own shares in the company and don't want to see its stock drop.
Even analysts without these conflicts face other pressures. Analysts, for instance, must be wary of angering a company with a negative rating.
Though companies are now required to release important information to everyone at the same time, an analyst with a good relationship with a company is more likely to get phone calls returned from management, said Jim Angel, a finance professor at Georgetown University.
Still, some experts say, analysts' reputations are built on picking winners and they can't afford to rave about losers too often. And even if an analyst's firm has a potential conflict, it doesn't necessarily mean that the recommendation is worthless.
"It's just another piece of information that investors should know in making their evaluation of the company," said Christopher Frink, a portfolio manager with Mercantile Capital Advisors in Baltimore.
When weighing recommendations, here's what experts advise investors to look for:
Check the prospectus to see if the analyst's firm underwrote the stock being touted, suggested the SEC. The prospectus, as well as other company documents, are available through the agency's online database at www.sec.gov/edgar.shtml.
Check ownership, although this isn't always easy to determine. Some documents filed with the SEC will list those who own more than 5 percent of a company's stock.
Read the footnotes and other small print in analysts' reports to find certain required disclosures, such as the analyst's firm has done investment banking on behalf of the company in the past three years, the SEC said.
Look for "lockups," cases where analysts or their firms acquire a stake in a company going public and are prevented from selling the stock for a certain period, the SEC said. Once the period ends, the shares could be sold off and hurt the stock's price, the agency said.
Or, rosy research reports might be released just before the end of the lockup to prop up the stock's price.