Institutions vs. I-banks: who’s better?

A study by three Harvard B-school folks casts doubt on the assumption some execs have that overworked sell-side analysts are less reliable in their judgments than buy-side people with similar skills who work for institutional investors. It’s unusual to read something nice about the sell side.

“Buy-Side vs. Sell-Side Analysts’ Earnings Forecasts,” in the July/August Financial Analysts Journal, makes a quantitative comparison of earnings forecasts by two sets of analysts on the same 337 companies from 1997 to 2004. It’s a total of 3,526 buy-side and 58,562 sell-side earnings estimates.

Results: The buy-side analysts were more optimistic and less accurate in forecasting earnings than the sell side. Median buy-side estimates were 3 to 12 percent higher than the sell side’s. Median absolute forecast errors were 4 to 11 percent higher for the buy-side analysts.

The authors also offer some insights into differences in work life between researchers at I-banks and number crunchers for mutual funds. For example:

… Scope: Buy-side analysts may follow 50-100 stocks, in broad industry sectors, and write reports on about 15. Sell-side analysts also write on about 15 stocks, but focus on narrower business segments and do not attempt to track as many stocks in total.

… Writing: Buy-side analysts typically write brief reports, two pages or so, getting to the point for their portfolio managers. Sell-side analysts write detailed industry reviews and bottom-up company reports. Thorough reports and narrow specialties could give sell-side analysts deeper insights.

… Compensation: Buy-side analysts are rewarded for the performance of their recommendations and impact on their firms’ portfolio managers. Sell-side analysts are paid based on comparisons to other analysts (e.g., Institutional Investor rankings) and business-generation metrics such as commissions and soft dollars.

Comparing earnings estimates, of course, may be the wrong metric. If you’re a portfolio manager (or a mutual fund shareholder), the more important criterion could be returns on the analysts’ buy and sell recommendations. The sell-side focus, on the other hand, has always been on quarterly and annual earnings estimates. So the study reinforces the sell side’s expertise in short-termism.

The FAJ article doesn’t settle anything, but it’s an interesting commentary on the art of financial analysis on both “sides” of Wall Street. And an argument for IR continuing to reach out to both.


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