Brokerage could be so much friendlier really.

Photographer: Spencer Platt/Getty Images

Brokerage Firm Prefers to Keep Its Research Friendly

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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This Wall Street Journal story about Sidoti & Co., a small brokerage that "doesn’t allow analysts to issue any negative ratings on the hundreds of stocks they follow," is such a perfect little parable of the financial industry. Sidoti has two ratings categories: "buy" and "neutral." Most sell-side research has three ratings categories: "buy," "neutral" and "sell," or words to that effect. Some use five ratings, along the lines of very buy, buy, neutral, sell and very sell.  Spinal Tap's amps go to eleven. You can just have your ratings scale go to neutral, and make neutral louder. Sidoti has conveyed all the information it needs to convey with "buy" and "neutral": It thinks you should buy the "buy" stocks, and it doesn't think you should buy the other ones. You shouldn't own stocks that you wouldn't buy, so -- especially in Sidoti's coverage universe of "small-cap and micro-cap companies" -- there is no reason to distinguish between stocks not to buy and stocks not to hold. After Sidoti's refreshing simplicity, it seems like false precision to offer three or five ratings. Just tell me whether to buy the stock or not. That's all I care about.

Except that that's not what Sidoti's customers care about. Here's what they care about:

“Please remember,” Mr. Sidoti told his research and sales staff in an April 2012 email, “our accounts value management visits more than anything else that we do.”

Sidoti's research customers don't value its research that much, its chief executive officer and founder felt compelled to imply to its research analysts. (The Journal also mentions a professor who praises Sidoti's innovation in "hiring less-experienced analysts to control costs," which seems fascinatingly euphemistic.) The ratings, the price targets, whatever: Those are not the important things.

The important thing for Sidoti's customers is management access. Sidoti advertises its "Unmatched client access to company managements," which it provides through "Investor Forums" and non-deal road shows. Setting up those meetings seems more central to Sidoti's role than pure research:

The internal Sidoti emails underline how analysts’ bonuses depend on their ability to arrange these meetings.

“At a certain point, you must drop coverage of those names that show a history of not marketing with us and move on to companies that will market with us,” Sidoti’s then-head of marketing, Tiffany Orford, wrote in a June 2012 email to the firm’s analysts.

I once wrote that "You could have a model where the best thing that a research analyst could do for his investing clients is put a 'buy' on every stock he covers, so as to get lots of management access and let his clients decide for themselves." That's surprisingly close to the Sidoti & Co. business model!

Not everyone likes this model:

To some, including a former employee who has filed a whistleblower complaint with the Securities and Exchange Commission, Sidoti & Co. Inc.’s business strategy is the latest illustration of how Wall Street research firms may be marred by conflicts of interest and their work influenced by other financial incentives.

Ehhhhhh. Let's assume for a minute that the facts are as bad as can be for Sidoti: Let's assume that it over-rated companies and inflated price targets in order to flatter company managements into meeting with its customers, because "such meetings are crucial to generating trading commissions, because clients reward access with trading business." Would that be bad? I mean, sure, telling people to buy a stock when you don't think they should buy the stock is bad in an obvious first-order way. But if your favorable research gets you access, and you use that access to get your client a meeting with management, and the CEO turns out to be two 12-year olds in a trenchcoat, then the client has learned valuable information about the company that it might not have gotten from a less favorable research report. You could rationally conclude that the best way to advise your clients is to sacrifice honesty for access. Your clients could rationally agree. Everyone might decide that a norm of inflated ratings in exchange for management access is the best norm, not just for you, but for your clients.

But of course that's only true if the clients know about the norm. Do they? It is widely accepted on Wall Street that sell-side research ratings tend to be inflated. But it is not universally accepted: Some people don't know that "buy" doesn't always mean "buy," and "neutral" frequently means "sell." Sidoti's customers are a few hundred mostly smallish money managers -- no retail investors  -- and it is quite plausible that most of them use Sidoti for the management access rather than for the ratings, and are in on the joke to the extent there is a joke. But some of them probably do care mostly about the ratings, and would be sad if the ratings are just a bait and switch to lure companies into meetings that they never attend.

One way to fix this (potential) problem is disclosure. Begin all your reports with a disclaimer saying, "Ignore our ratings, they're just a way to flatter companies so they'll agree to come to our conferences, where you can get a good look at them yourselves." It's pretty obvious that this wouldn't work? Flattery is like a placebo; it only works if you don't call it what it is.

You can have vaguely shady-seeming norms that grow up organically and are recognized by everyone, or almost everyone, in one segment of the financial markets, all without ever being explicitly stated. And those norms might work really well for everyone, or for almost everyone, in that particular market segment. But when they're exposed to outsiders, they look shady. They can look like "conflicts of interest" and "other financial incentives" -- even though, in Sidoti's case, the financial incentives come from the customers, presumably because this is what the customers want.  The outsiders don't see how the norms grew up, or how they provide value to the customers. They just see what looks like dishonesty. This is arguably part of the story of the foreign-exchange fixing scandal, among other things.

There is also the fact that meeting with management is valuable, which is its own little puzzle: Aren't companies not supposed to disclose anything material in one-on-one investor meetings that they haven't already made public? And yet investors really like to meet with management. There's no substitute for getting to know a management team and really understanding the business. Certainly published sell-side research is no substitute, anyway.

The question in finance is so often how intermediaries add value. The obvious places to look for value -- the recommendation, the written product, the thing that produces a fee -- are not necessarily where you'll actually find value. Sometimes the bit of the business that looks like a rip-off is what the customers actually want. 

  1. Goldman Sachs, where I used to work, has "Conviction Buy" and "Conviction Sell," and at least some others have "best ideas" and "strong buys" and so forth. 

    Actually Sidoti seems to offer a "Best of the Buys" list to approximate "very buy," too.

  2. Oh, what, you want guidance on which stocks to short? I feel like "don't short underfollowed micro-cap stocks" is not crazy blanket advice. Also of course Sidoti gets to pick its coverage universe, and argues that its research is about finding previously undiscovered gems rather than just providing ratings on all possible stocks. There are other research firms that specialize more in finding undiscovered stocks to short.

  3. To be fair, Sidoti also provides price targets, which unlike ratings in theory offer infinite (and possibly false!) precision. If a stock is at $40 and you rate it neutral with a price target of $20, then, umm, you know. Sidoti sort of says that neutral plus a low target might be code for sell; e.g.: 

    We launch coverage of a Company at a “BUY” rating on companies that we project offer at least 25% capital appreciation potential over the 12-month period from the date of the report, and at a “NEUTRAL” rating when we believe a stock is unlikely to produce as meaningful a gain. We complement our BUY and NEUTRAL ratings with price targets. We regularly update our research reports and these reflect the views of our research analysts as of the respective dates of the reports. Their views also will be reflected through changes to the price targets included in such reports; however, the fact that we use only two ratings, even though they are detailed on our website and explained, may result in potential confusion regarding the firm’s view. For example, a NEUTRAL rating could be applicable to a company about which our analyst may have a relatively negative view. Because we do not have a “SELL” or “NEGATIVE” rating, there is the potential for investor confusion. 

    But the Journal article hints that Sidoti might have been neutral with price targets when it should have been negative, e.g.:

    A Sidoti sales executive in an April 27, 2012, morning email to Sidoti sales, trading and research staff noted the firm’s “bearish” position on Micros Systems Inc., a Maryland technology company. The email referred to Micros shares as overvalued, citing multiple business concerns.

    In a research note published the same day, however, Sidoti maintained its “neutral” rating on Micros Systems, while lowering its price target from $61 to $56, where the stock was trading. “We argue the shares are currently near fair value,” the note read. The shares fell 10% over the following two months. Micros was acquired in 2014 for $68 a share.

  4. "Marketing with us" here doesn't seem to mean "paying us banking fees" or anything: It just means, like, taking meetings with our customers.

  5. I mean, you could have figured it out, and told them. But you are a "less-experienced analyst." Some clients want to trust their own eyes.

  6. The prospectus says: "We do not serve retail clients, and we do not make our research available to retail clients." The website says that Sidoti serves "nearly 500 institutional clients in the U.S., Canada and the U.K., including many leading managers of portfolios with $200 million to $2 billion of assets," who "are generally underserved by other larger brokerage firms that typically target larger managers."

  7. Ha I mean this is not even true of placebos.

  8. The research customers, not the companies, are the ones who "reward access with trading business." Sidoti has a small amount of investment banking revenue, though no investment bankers.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net