I had worked on the trading floor of a sell-side firm, but not in any sales, trading or research capacity. The division I was part of is engaged in all activities related to capital markets: equity sales, equity trading, equity research, bond trading, investment banking, etc. I had built, integrated, and managed the software they use for most of their business activities.
The equity sell-side cycle: equity research team
This team consists of research analysts with 1 or 2 associates assigned to each of them, and is the cost center of the business. At its core, the analysts initiate stock ratings (ie buy, sell, hold) and price targets, and regularly publish research articles for distribution by the sales team, trading team, and CRM-maintained email distribution lists to the buy-side clients for pre-earnings, post-earnings, and any otherwise large moves in the stock. These articles are distributed for free with the intent of building rapport between the buy-side and the analyst, for future upselling. Each analyst owns a specific vertical (ie technology, healthcare, financials, etc) and maintains the theses on the stocks in his coverage universe, meanwhile a much lower-compensated associate performs most of the heavy lifting to collect data and elaborate on the thesis.
The analyst would often travel to specific cities or regions to meet with buy-side clients in their corporate offices in order to discuss their stock ratings. Because of stringent financial regulations around how a buy-side client may compensate for sell-side services (due to concerns over breach of fiduciary duty, unjustifiable high maintenance fees, etc) and the overwhelming paperwork involved in documenting gifts, services, or meals provided by the buy-side, the sell-side firm pays for all travel and meals. For a satisfied buy-side client to compensate for the services provided, they would send trade desk flows to our trading desk which is fulfilled via dark pools and phone calls; the public exchange is a last resort if the buy-side client updates the order for imminent execution.
The equity sell-side cycle: equity trading team
Traders execute trades submitted to them by buy-side clients as an upsold service for the value provided by the analyst. They live in and stare at the Bloomberg terminal from sun up to market close. They do not trade after-hours, and they do not often hold the shares on their books if they can help it. This is how your broker typically operates, by finding the other side of the trade. On the rare occasion that the trader does decide to fulfill the trade on the books, an accompanying options position is initiated to hedge the delta; the options position depends on imminent risks on the event horizon.
Unlike the equity research team, traders are assigned to accounts which means they own the order flow for that account and receive a part of the commission for trade execution. They tend to have a good idea who’s a buyer and seller at certain levels. On some occasions, the trader will have to cooperate with another in-house trader in order to find the other side of the order. In such ideal arrangements, both traders get paid and the firm is happy to be involved in both sides.
Traders rarely travel – and the ones who do travel tend to be in more senior position and would accompany an analyst on his trip in order to talk client relationship, business development, etc.
The equity sell-side cycle: equity sales team
The equity salespeople talk more than anyone else and make most of the noise on the trading floor when a trader is not screaming profanities. Their job is to call new and existing clients and pitch an analyst report. If they do not hook their audience within seconds of the pitch, they have lost the client interest and opinion in the salesperson’s value-add. When not pitching analyst reports, the salesperson is pitching meetings with the analyst, meetings with corporate execs at our hosted conferences, private meetings with corporate execs in the client’s office to talk the company (NDR, or non-deal roadshow) or to raise money through share offerings (DR, or deal roadshow). The latter three are corporate access services which are highly valued and sought after by the buy-side, and therefore fill up very quickly. Anyone would be lucky to be 1 of the 3 caller questions that a company takes on their quarterly earnings call. These meetings offer the buy-side clients 30-60 minutes of face-to-face with these same executives, and is an opportunity to inform their investment decision in a way that their competitors cannot.
These services are offered for free upfront, and are indirectly compensated for via trade desk flow.
How it all comes together, and why the game is rigged
If you have asked yourself any of the following questions while reading this, then you’re starting to get the bigger picture:
- Why would the CEO of a publicly traded company travel with our research analyst instead of another analyst from another firm?
- How are the highly sought-after corporate access events with corporate execs filled or prioritized?
- Why is that most analysts have >90% buy ratings, a few neutral ratings, and only a few to no sell ratings?
- How does this influence the sell-side management to pressure research analysts on their stock theses?
The top priority of the sell-side is to make money. In order to make money, they have to provide a value to the buy-side that makes them money in their investment decisions.
In short, this means that management always pressures the research analysts to initiate buy ratings on stocks (even if they believe these stocks will tank), for the sole purpose of establishing a relationship with the CXO of these companies. A positive relationship means meetings to fill, shares for the trade desk to execute as compensation, and money for the sell-side to keep the cycle going. This is also why sector or industry analysts don’t really exist: you can’t cozy up to CXOs when you’re initiate buy/sell recommendations on ETFs.
The buy-side is not stupid. They understand this business model. However, it’s precisely because of this business model that they love sell-side services. Unless you’re large holder of the stock, you won’t ever get into corporate access (unless it’s some undersubscribed small cap). The corporate execs’ goal in these meetings is to project confidence and get the buy-side fund to hold/buy more shares to lift the stock.
It is because of this business model that analysts that are often right or often wrong make the most money for the sell-side. In fact, during my time there, our most highly demanded analyst was one who was wrong over 80% of the time, followed by one who was right over 70% of the time. In being wrong almost all the time, this works out great for all parties involved: the research analyst has better corporate penetration because the stock is struggling, which makes it easier to cozy up to CXOs for corporate access events; the CXOs has better access to fund managers to project strength in private meetings; the analyst can be used as a counterweight and the buy-side often does exactly the opposite of each stock buy rating (as evidenced by sell order flows reaching our desk despite the buy ratings). Keep this in mind whenever you following an online tracker for an analyst track record – these guys who always get it wrong often get compensated the most.
On the flipside, sell ratings face heavy internal scrutiny from the sell-side management as they are often viewed as a death sentence for any relationship between the sell-side and corporate execs. Management does not care about the analyst’s feelings on the stock – if you like or hate it so much, trade it in your own account is how they see it.
Nevertheless, a sell rating can be viewed as either a strong conviction, or a chess match to flip the corporate exec. Management’s strategy would depend on the analyst’s track record. For an analyst that is often right, he has more freedom to initiate a sell rating as a strong conviction idea in order to maintain that record which the buy-side values. Otherwise, management may see it fit to initiate a sell rating because Wall Street is saturated with buy ratings and you cannot stand out in the pack by joining the pack. This kind of maneuver is sometimes successful in getting the attention of the CXOs at the company and initiating a conversation in order to flip it into a buy rating, in exchange for some service or corporate access.
TLDR; The game is rigged. Don’t believe the majority of sell-side analyst ratings. There is a reason why an overwhelming majority of analyst ratings are buy ratings, and it is not just because markets tend to be bullish. They exist predominately to build relationships and upsell services.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.