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Hi Fools,

This is partly in response to a post from my friend Alex who referred to sell-side analysts price targets and recommendations as herd mentality. http://boards.fool.com/Message.asp?mid=16763844

I had also meant to talk about this topic (the Sell-Side Game) as I said I would in this post: http://boards.fool.com/Message.asp?mid=16546885

While I agree with Alex's cynicism about sell-side analysts (from now on, I will refer to sell-side analysts as simply analysts, unless otherwise stated) recs and price targets, I wouldn't call it “herd mentality”. Analysts' research reports are simply part of what I prefer to call it the "Sell-Side Game". Once you understand that game, you understand those recommendations and targets and you realize that they are not intended to you as an investor. I would be more inclined to criticize those who follow the sell-side analysts' recommendations than criticizing sell-side analysts. Sell-side analysts are not the herd; it is those who follow them who are part of the herd.

The clue is to understand sell-side analysts' purposes. Their purposes are mainly two-fold: generate commissions and generate deals for their investment banking division. The most lucrative are the deals for the investment banking division. Note that I never mentioned anything about the well-being of investors… which is the key to understand the game.

Here's a typical example of the sell-side game:

If a Merrill Lynch (or any other) analyst were to have a "sell" on Juniper in November 2000 (the stock was trading at around $100), it would have killed any chance of Merrill Lynch Investment Bank to be the leader or co-leader in Juniper's $260 M acquisition of Micro Magic in Dec. 2000 (I don't know if they were, but that's not the point). Likewise with price targets (if targets are below the current price, that's the equivalent of a “sell”). A $260 M deal can generate somewhere between $2 M and $5 M in fees for the bank (and perhaps more, I am not totally familiar with fee schedules). Not too bad for a local division that employs something like 10-20 employees... Thanks to the sell-side analyst who had a strong buy on the stock.

Brokerage firms also get commissions from institutional and individual investors who trade based on those reports/recommendations. They know that there is a "herd mentality" on Main Street and among many institutional investment management firms. Those who trade on upgrades and downgrades are momentum investors (or uninformed investors who don't understand the sell-side game) and rarely true buy and hold business perspective investors.

In any case, those sell-side analysts have no choice but follow what the market dictates because they need to generate business for their investment bank and a sell recommendation is a total turn-off for a prospective firm looking for an investment banker. Therefore, it is the dynamic of investment banking that forces analysts to act in such way for recommendations and price targets. It's not their stupidity or lack of intelligence. However, you've got the “herd” that follows their recommendations, which creates a vicious circle as prices go up, so do price targets.

When you understand this game, you realize that it is not the analyst who is responsible for having buy recommendations and price targets with P/Es of 40. It's the "sell-side game". Sell-side analysts have to generate commissions and get deals to their investment banks, therefore, they can't have negative stories to sell because investors don't buy bad ideas and companies don't do deals with investment banks whose analyst has a sell recommendation on their stock.

In fact, many of those analysts are very good at understanding business dynamics, and perhaps better than many on the buy-side, for one reason: they only have one sector to cover.

You will rarely see me criticize a sell-side analyst for having a buy recommendation and a price target that is overvalued (unless the analyst really sucks (but that's another story)). I understand the game, I understand their job, which is not to act in my best interest but to generate business for their investment bank division. I simply disregard their recommendations and price targets and look at their research as background information. If their research really sucks, I will not give them my commission but that is a small price to pay (for them) for the potential upside in investment banking deals.

So in conclusion, what Alex calls "herd mentality", I call it the "sell-side game", which has no negative connotation. I am pretty much agnostic about those recs and targets because I understand the game. There is no point in criticizing those two issues since the game won't change until there is a massive reform (which I am totally in favor of) in the sell-side industry. The analyst's job is not to act in the best interest of the investor, due to the dynamic of the investment bank industry, which puts analysts in an obvious conflict of interest situation.

What I am cynical about however, is to those who follow the sell-side analysts' recommendations and price targets. By looking at the price movements, I know that there are thousands of those. Let me ask a rhetorical question: “Who is the fool, the fool or the one who follows the fool?”

Sell-side analysts are totally aware of the game they are playing and I am sure that they laugh at the herd that follows them. I speak to many of those analysts and many of them are totally aware of what they do and don't shy away from being cynical about their recommendations and price targets: “You know, I work on Wall Street…” they often say, and I understand that game, they understand the game, there is no point in bringing those ridiculous price targets, it's unconstructive. I know that there is a conflict of interest, and understanding the sell-side dynamic allows me to filter the information.

No need to bring those price targets and recommendations at the high of Juniper's stock. It's just a game. Worry about your own investment process and disregard sell-side recommendations and price targets. It's a more constructive, in my opinion. At best, sell-side reports are good for their background information, not for their vision and predictions.

When it comes to learning, always watch your sources and beware of sell-side initiated research, books and/or speeches… Their job is to sell. Personally, my influences come from Warren Buffett, Peter Lynch, Philip Fisher, Whitney Tilson and my professional mentor, who are all from the buy-side and have no other purposes than to beat the indices and protect the capital of their investors. I would shy away from investments books written by sell-side analysts, especially from those who are still practicing their profession.

On a final note, I think that the NPI board would be better off not quoting predictions or visions from sell-side reports, unless we have found supporting evidence of such claims. Of course, in that case, share the evidence and not the sell-side analyst's thoughts. Sell-side reports are not intended at us, as investors. They serve other purposes and Fools must understand that for their well-being.

Fool on!

Andrew
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