3 Types of Analysts: Which Is Best for You?

Financial analysts are financial industry professionals employed by various institutions including banks, brokerages, pension funds, mutual funds, investment banking firms, hedge funds, and insurance companies.

Their role is to provide guidance for the investment activities of companies and individual investors. They do so by conducting research on companies, industries, and sectors and providing reports that include findings, conclusions, and recommendations.

Analysts fall into the three basic categories of sell-side analysts, buy-side analysts, and independent analysts. They focus on different kinds of clients with different standards and expectations.

Read on to discover more about each and whether they may be a good match for your investment needs.

Sell-Side Analysts

What They Do

Sell-side analysts generally dominate the headlines. They are employed by investment banking firms and brokerage houses to analyze companies and write in-depth reports after conducting what is sometimes called primary research.

Reports reflect the analyst's research, financial estimates, price targets, performance expectations, and purchase recommendations. These reports are used to sell investment ideas to investment banking firm or brokerage clients, whether individual or institutional investors.

Normally, such extensive research is free to clients. For example, to get free research from Merrill Lynch, you need to have an account with Merrill Lynch online or via a personal broker. Or, sometimes the reports can be purchased through a third party. Institutional clients (e.g., mutual fund managers) get research from the brokerage's institutional brokers. 

How They Do It

Researching and writing a research report is a time-consuming process. An analyst obtains information for their report by researching a company's filings with the Securities and Exchange Commission (SEC), meeting with its management, and if possible, talking with its suppliers and customers.

The sell-side analyst makes sure that their research report contains a detailed analysis of a company's competitive advantages and provides information on management's expertise and how the company's operating and stock valuation compares to a peer group and its industry. This peer companies comparison can help investors better understand the differences in operating results and stock valuations.

The typical report also contains an earnings model and clearly states the assumptions used to create the forecast.

This rigorous process limits a typical sell-side analyst to two or three industries and about 10 to 15 companies.

Potential Pitfall for Investors

The challenge facing the investment banks and brokerages is that it's extremely expensive to create all this research. Brokerages must recover the costs of paying sell-side analysts from somewhere, but deregulation has significantly reduced the ability to make a profit on anything except investment banking deals.

As a result, research departments cannot research smaller companies that do not have a potential investment bank deal in the pipeline (which may also indicate a potential conflict of interest that investors should be aware of). This leaves thousands of great companies without coverage.

Couple this with the fact that research departments drop coverage rather than issue sell recommendations, and you'll get the perception that analysts only issue buy recommendations.

Buy-Side Analysts

What They Do

Buy-side analysts are employed by fund managers like Fidelity and Janus, as well as insurance companies, pension funds, private equity firms, and hedge funds. Like the sell-side analyst, the buy-side analyst specializes in a few sectors and analyzes stocks to make buy/sell recommendations.

However, the buy-side differs from the sell-side in three main ways:

• They follow more stocks (30 to 40)
• They write very brief reports (generally one or two pages)
• Their research is only distributed to the fund's managers.

How They Do It

Buy-side analysts can cover more stocks than sell-side analysts because they have access to all the sell-side research. They also have the opportunity to attend industry conferences, hosted by sell-side firms.

During these conferences, the executives of several companies in a sector present their cases of why they are a worthwhile investment. After gathering this information, buy-side analysts summarize their findings in a brief report that also contains an earnings forecast.

The sell-side companies provide research and conferences to the buy-side companies in the hopes that the latter will execute large trades through them when clients act on the recommendation provided in the sell-side research.

Thus, to compensate the brokerage firms that provide what they perceive as the best financial information, funds will buy and sell stocks through them.

Independent Analysts

What They Do

Independent analysts are not employed by either brokerage firms or mutual/pension funds. "Indies," as they are sometimes called, are firms that provide objective research that is not influenced by investment banking deals.

They often cover companies ignored by Wall Street firms, such as companies with smaller market capitalizations.

How They Do It

Some independent analysts focus on serving institutional clients and are paid a fee to follow certain stocks and/or to find new ideas that the sell-side is missing.

In some cases, these institutional indies have a relationship with a brokerage firm and are compensated by trades that the brokerage executes for the funds. Or, sometimes the relationship is fee-only.

Other independent analysts provide their research to both institutional and individual investors on a subscription basis or for free.

In either case (and with any type of financial analyst), it is important to understand the nature of the relationship between the financial analyst, the requester of the research (e.g., a brokerage), and the company being analyzed (generally called the subject company).

Independent analysts attempt to bridge the information gap by providing research on stocks not covered by most Wall Street firms. While the internet revolution has increased the ability of individual investors to conduct their own research, it takes time and experience to do a thorough job. Legitimate indies can gather and interpret useful information, saving investors from doing the legwork.

Research Report Public Disclosure

Every research report is required to have a disclaimer that discloses, among other things, the nature of any relationship between the research firm and the subject company. This disclaimer generally appears at the end of the report and is in a small type. In it, the research firm must disclose if and how it is compensated for providing research. For example, major Wall Street firms will disclose that they provided investment banking services to the subject company.

Analyst Objectivity

The objectivity of research reports is a major concern with both the large Wall Street firms and independent analysts. Is Wall Street's research objective? Are sell-side analyst reports trustworthy if tied to high-vale investment banking deals? Can an independent analyst provide an objective research report if it is paid by the subject company? These are difficult questions to answer without reading a report, its disclosure, and knowing something about the firm and the analyst.

Just as with Wall Street firms in general, most firms and their analysts strive to meet a higher standard of ethical conduct while others just try to sell products and manipulate stocks. It is an investor's responsibility to understand and evaluate the integrity of the research information that they receive.

The Bottom Line

Investment research from the three types of financial analysts—sell-side, buy-side, and independent—can be valuable for investors. But it's important that investors judge that research with a clear understanding of the roles of each analyst and any potential conflict of interest.

Whether or not an investor has misgivings about what an analyst recommends, they can always simply focus on the wealth of information provided within a report and come up with their own conclusions.