Can you name three top-ranked sell-side analysts?  If you can, you're in the minority. Most retail investors probably couldn't name more than one or two top-ranked analysts, if any. But you can be certain that the buy-side folks know who's ranked where. The rankings do not resonate as loudly on the individual investor side as many don't appreciate the importance of the rankings. However, rankings do matter to institutions, and since that's the case, they matter to you. Institutions own by far the majority of shares and have much influence on the market.

Individual investors undoubtedly have strong feelings about sell-side analysts (analysts that make Buy/Sell recommendations but only advise - they do not buy any stock). We've received numerous complaints from our readers over analyst recommendations. The purpose of this piece is not to argue the merits of sell-side analysis, but rather to provide insight as to the role they play, their motivations and what steps we can take to benefit.

Every summer, Institutional Investor Magazine polls buy-side analysts (people who seek advice from sell-side analysts and actually decide which stocks to buy for their mutual funds, pension funds, treasury departments at corporations etc.) for their opinions as to which sell-side analysts made the best calls and were most knowledgeable about their sector over the past year. In October, the magazine interprets the data and publishes the results of the poll and ranks the analysts. The results for 2000 will be discussed in this article. To analysts, their I.I. ranking is a fixation they work towards the entire year. We cannot overstate how important their rankings are to them.

The benefits to the sell-side analyst of a high ranking are many. First, his ranking has a large influence on his salary. Most analysts have employment contracts where their I.I. ranking has a large effect on their year-end bonus. Also, a high ranking makes them attractive to other sell-side firms. These large brokerage firms are clamoring over each other to be able to advertise that they have X number of top ranked analysts and Y number of top-three analysts. Another benefit of a high ranking is that it makes that firm much more attractive to companies looking to dole out business through IPOs, secondaries, M&A etc. For example, if you're a B2B company looking to go public, you want the firm with the number one ranked analyst leading your deal, with the anticipation that the analyst will pick up coverage on your company and presumably make positive statements. A top-ranked analyst has the most pull in promoting your stock.

Another benefit is that it makes the companies already in the analyst's universe that much more attentive to that analyst. Management will return those calls first. This can be very important when critical news comes out on a company and a bunch of analysts are trying to talk to management. However, it will be interesting to see how the selective disclosure regulation (Regulation FD) which became effective in October 2000 will impact this relationship. The value of the analysts who do a lot of independent legwork should rise relative to the analysts who rely more heavily on friendships/contacts with high level management.

Whether you agree with the structure/purpose of a sell-side analyst or not, it's how the world works. Sell-side analysts affect stock prices so it's best to know what they say. OK, so it's important to the analyst to have a high ranking, why is it important to me? For at least a couple of reasons: 1) substantive and 2) timing.

Substantive: Obviously, higher ranked analysts have more weight. While it's true popularity (as opposed to performance) plays a role in the polling, institutions are still more likely to take the advice of the top-ranked analyst than others. See it from their perspective: it's a lot easier to defend an investment decision that's gone south when you can point to the lead analyst's opinion. Therefore, understand that high ranked analysts will move stocks.

Price Target Myths: Price targets were not invented for the benefit of savvy, buy-side analysts. They were created for the small investor and here's why: they are easy to understand, sort of a fast food financial analysis. It is simply a number which is easy to digest for a small investor. Small timers don't want price-to-sales ratios and discounted cash flow analyses. Just tell me where the stock will be in 12 months! Well, you get what you pay for. Don't expect the quality of a filet mignon in a fast food burger.

Conclusion: Don't base decisions on price targets - ignore them. The buy-siders know better - so should you. Base your decisions on the substantive reports generated by the sell-side - that's where the quality meat is. And do your own analysis. If you're interested in tech stocks, talk to your techie friends as to which products/services are better. For retail stocks, hit the pavement and visit the stores: are there a lot of items on clearance?

Timing: As for timing, it's important to understand how the balloting process works. Ballots are mailed in the spring and are required to be returned by mid-summer. Sell-side analysts know this. As a result, you're more likely to see an unranked analyst take a risk and make a controversial upgrade/downgrade. That analyst is swinging for a home run as a single or double will not get him ranked. But if he's right, he could vault into the top three.

So if you're in a top tier stock and everything is sailing along (analysts on board with the company's story/sector etc.), an analyst may come out of the woodwork and downgrade in order to make a name for himself. This would be more likely to happen in the early summer when the ballots are in the hands of the voters so if he's right, the upgrade/downgrade will be fresh in voter's minds when they send in the ballots. Conversely, an established analyst is less likely to rattle the cage during that period if he believes he has the lead. This does not happen often, but keep it in the back of your mind.

Do your homework: Know which analysts are more highly ranked as they will carry the most weight on a company. But don't stop there. Read SEC filings, find out which firms have banking relationships with which companies. Due to the inherent conflict of interest, relationships with companies influence analysts' decisions so keep that in mind when analyzing their opinions. Finding this information is easier with an IPO or secondary offering as the prospectus will list the underwriters of the deal. With respect to a merger, the companies will often name their M&A advisors in the press release. One major firm, Sanford Bernstein, has only nine ranked analysts but they also don't have any banking relationships with companies. As a result, the Street views them as having a de facto unbiased perspective. Also, keep in mind when ballots are cast in the voting and see if there are any candidates in your portfolio that are exposed to a downgrade as we discussed above.

Take the time to learn about the analysts: Go beyond the mere rankings and learn more. The anecdotal blurbs in the I.I. report are a good start. For example, the number one biotech analyst at Goldman is known as being very conservative. One buy-sider writes: when she's upbeat on a stock, you can make incredibly good money following her advice. While another says she is willing to back early-stage or high-priced stocks only if the fundamentals are sound. Knowing an analyst's reputation is particularly helpful to knowing which early calls to trust especially in a cyclical sector.

Go beyond the price targets and recommendations and read the reports: Having accounts at those firms allows you to have access: Merrill Lynch and Morgan Stanley tied for first with 55 analysts being ranked. However, Merrill has by far the most top ranked analysts with 22 vs. Morgan Stanley as the next competitor with 12. Other top firms: Salomon 46, CS First Boston 38, DLJ and Goldman had 35, Bear Stearns 32 and Lehman 31. Also, you can see how close these numbers are which helps explain the feverish rush to get analysts to jump ship and join another firm.

Robert Reid