Is that buy recommendation really a buy?

By Al and Mark Rosen | December 9, 2016 | Last updated on September 21, 2023
4 min read

You probably ignore them, but shouldn’t: those boilerplate disclosures on the back of research reports that carry a heavy but veiled warning.

These multi-page information dumps mandated by regulators include the latest breakdown of buy, hold and sell recommendations made by a brokerage firm (see Table 1). They also show what percentage of each cohort paid the firm for investment banking services over the past 12 months.

The investment banking angle is a core reason for the disclosure. It’s one explanation for why so few companies are categorized as sells. Banks make their money in capital markets through equity underwriting, corporate loans and advising on M&A. Contrary research could undermine that primary effort.

Table 1: Disclosure of distribution of investment ratings by a large Canadian bank

All recommendations Investment banking clients
Amount % Amount %
Buy 762 50.7 231 30.3
Hold 644 42.8 121 18.8
Sell 98 6.5 9 9.2
1,504 100.0 361 See note

Note: The figures are disguised, but the percentages are the actual proportions disclosed by one of the Big 5 banks. The proportions shown above tend to vary little from other firms that provide investment banking services. The investment banking clients column represents a portion and does not add up to 100%.

Sources: Anonymous Big 5 bank disclosures; Accountability Research Corp.

The investment banking breakdown seems to show a lack of independence. If you’re rated as a buy, you’re more likely to conduct investment banking with the firm, or vice versa, many would argue. It also exhibits the volume of investment banking done by the firm. Three hundred and sixty-one of the 1,504 investment ratings, or 24%, were for companies that paid the bank for investment banking services, which again highlights where the real money is made.

A clearer picture

The disclosures unfortunately miss the mark. A more useful and direct analysis would be to show the buy, hold and sell breakdown of investment banking clients versus non-investment banking clients. We’ve done this by simply re-working the same numbers (see Table 2). Depending on the detail provided, advisors can do similar math for themselves using the disclosures on the back of their own firm’s research.

Reworking the numbers shows an even greater skew in favour of investment banking clients. If a company is an underwriting client of this particular bank, its chances of being rated a buy increase from 46.5% to 64.0%. Likewise, the chances of being rated a sell drop from an already low 7.8% to a miniscule 2.5%. These gaps are not evident in the mandated form of disclosure shown in Table 1.

Table 2: Reworked disclosure of distribution of investment ratings for a Big 5 bank

Non-investment banking clients Investment banking clients
Amount % Amount %
Buy 531 46.5 231 64.0
Hold 523 45.7 121 33.5
Sell 89 7.8 9 2.5
1,143 100.0 361 100.0

Note: The percentages are the actual proportions disclosed by one of the Big 5 banks, which we’ve left anonymous. These proportions tend to vary little from other firms that provide investment banking services.

Sources: Anonymous Big 5 bank; Accountability Research Corp.

Home country bias

The research ratings also suggest home country bias. These figures are not provided by firms in their back-page disclosures, but can be gleaned from other information providers. They show that the banks tend to favour domestic-listed securities (Table 3).

With the proportion of buy ratings mostly flat, a firm’s chances of being rated as a sell at this particular bank are 7% if it’s foreign-listed, which drops to a mere 2.3% if it’s listed in Canada.

Table 3: Ratings of Canadian versus foreign-listed firms for a Big 5 bank

Canadian-listed firms Foreign-listed firms
Amount % Amount %
Buy 166 51.4 611 51.7
Hold 149 46.3 488 41.3
Sell 7 2.3 83 7.0
322 100.0 1,182 100.0

Note: The percentages are the actual proportions disclosed by one of the Big 5 banks, which we have left anonymous. The proportions tend to vary little from other firms that provide investment banking services.

Sources: Anonymous Big 5 bank; Accountability Research Corp; Bloomberg

Combining what appears to be investment bank bias and home bias makes it worse for advisors trying to find some independent advice. At the bank whose ratings we used for this article, only 1% of Canadian-listed firms that conducted investment banking business with the financial institution were rated as a sell.

It makes you wonder whether that buy recommendation on your desk right now is based on fundamentals—or has it been influenced by investment banking or home country bias?

What about second opinions?

Many advisors understand the value of a second opinion. Unfortunately, many of the alternative choices may also be conflicted. Borrowing research from another Canadian bank or broker will likely result in similar analysis. Our research has shown that, over the course of decades and across most Canadian banks and brokerages, there is a very similar trend in the ratings provided to underwriting clients.

Some advisors have access to U.S. investment bank research, but the culture of investment banking still prevails (Table 4). The research from U.S. underwriters most used by Canadian advisors takes a similar view of Canadian-listed firms.

Table 4: Research ratings on Canadian-listed firms from secondary providers

J.P. Morgan Credit Suisse Morningstar
Buy 25.5% 38.8% 18.0%
Hold 73.5% 49.1% 78.2%
Sell 2.0% 12.1% 3.8%

Sources: Accountability Research Corp; Bloomberg

Other firms, like Morningstar, have an even smaller proportion of sells than most banks. But with 78% of companies rated as a hold as of mid-November 2016, Morningstar equity research takes an unusual approach. It publishes “fair value estimates” derived from a static quantitative process, which produces fewer actionable buy and sell ideas.

Seek outside help

Advisors can get a better read-through of ideas by using their internal advisor support teams, whether through model portfolios or top-pick lists. These teams, where they exist, work outside capital markets divisions and have the ability to exhibit greater independence.

Although not immune to investment banking-driven ideas, you can normally count them on your side. And when needing to filter the vast stream of equity research in Canada, advisors should use all the help they can get.

Al and Mark Rosen

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.