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Aug. 19, 2004

Buying stocks? Don't listen to investment banks

ANN ARBOR, Mich.—Stocks purchased at the recommendation of independent research firms outperform those recommended by investment banks, according to a University of Michigan Business School researcher.

When it comes to selling though, investment banks did a better job than the independents.

A new study co-authored by Reuven Lehavy, U-M assistant professor of accounting, found that from 1996 to mid-2003, buy recommendations issued by securities firms with no investment banking business outperformed the buys issued by analysts at investment banks by an average of about 8 percentage points annually.

In contrast, hold-and-sell recommendations from investment banks outperformed (on the downside) those of the independent research firms by 4.5 percentage points annually.

According to Lehavy and colleagues Brett Trueman of the University of California, Los Angeles, and Brad Barber of the University of California, Davis, investment bank buy recommendation underperformance was concentrated in the period that followed to the NASDAQ market peak (March 10, 2000). During this time, stocks recommended by independent firms outperformed stocks recommended by investment banks by an average of 17 percent annually.

More strikingly, during this period buys recommended by investment banks following equity offerings underperformed those of independent research firms by almost 22 percent annually, they say.

"These results suggest that the underperformance of investment bank buy recommendations was at least partly due to a reluctance to downgrade stocks whose prospects dimmed during the early 2000's bear market," Lehavy said, noting that the findings mirrored those made by the SEC in its recent Global Analyst Research Settlement.

Under the settlement, the SEC and other regulators mandated that 10 of the largest investment banking firms provide independent research to their clients. Additional analyses found that the underperformance of investment bank buy recommendations extended not only to the 10 investment banks sanctioned in the SEC's research settlement but to investment banks not sanctioned by the SEC, as well.

"This uniform underperformance suggests that differentiating between the sanctioned and non-sanctioned banks, in terms of the requirement that independent research be distributed to clients, may not be justified," Lehavy said.

Contact: Bernie DeGroat
Phone: (734) 936-1015 or 647-1847
E-mail: bernied@umich.edu