When analysts get paid to provide positive opinions

People will respond to rewards. This is one of the most consistent findings in psychology. Whether the reward is pecuniary, emotional, or philosophical, people will (within reason) do whatever it takes to get rewarded. So if my business partner asks me to do something that is unimportant, I am likely to do it, distracting me from things I consider more important, because it matters to me what he thinks of me. If I am paid by someone to do something, I will make sure I act in such a way as to continue to get paid.

Acting in such a way as to continue to get paid is a problem when a person or company is being paid to give an unbiased opinion about a company. This is why Fitch, Moody’s, and S&P all have given absurdly high ratings to CDOs and other structured bonds: they were paid handsomely by the banks who put those bonds together. Those types of structured finance provided much of the profit growth of the ratings agencies over the last few years.

This same conflict of interest is often present in the micro-cap world. For example, I have previously criticized Beacon Equity Research for being paid by many microcap companies to cover them. Its reports are unfailingly bullish. The problem is that many investors do not take the trouble to investigate the company and they consider the reports meritorious. If an investor had invested in many of the companies covered by Beacon Equity Research, he or she would have lost lots of money. However, if the investor had instead read my blog and taken my advice (on stocks covered by both Beacon and myself), they would have avoided many losses.

For example, on February 6th, Beacon issued a positive report on Continental Fuels (OTC BB: CFUL), when it was trading at $0.28 per share. The analyst’s target price was $0.53. My most recent opinion on Continental Fuel’s valuation came last December 28th, when I said that the stock, then at $0.40 per share “continues to trade at 40x my fair value estimate of $0.01 per share.” The stock has since fallen to $0.03 per share.

Lighting Science Group (OTC BB: LSCG) makes another great example. Jeff Bishop of Beacon Equity Research published a positive article on the company on SeekingAlpha on February 8th. The stock closed that day at $9.80 per share. On February 22nd, I posted a negative article on the company on this blog. The stock price has since fallen from $9.90 per share to $2.85 per share.

Investors should always be careful to examine how analysts are compensated for their services. They would do well not to pay attention to any analyst paid by the company they are covering. In the end, each investor is responsible for his or her own investment performance. Those who are incapable or unwilling to put forth the necessary effort to understand the companies they buy deserve what they get.

Disclosure: I have no position in any company mentioned. I was short LSCG when I last wrote about it, as I disclosed at the time. I have a disclosure policy.

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