ANALYSIS What's behind scarcity of 'sell' recommendations by Korean brokerages?
Authorities plan to strengthen independent stock research firms
By Anna J. Park
Only a fraction of stock analysis reports published by Korean securities companies advise investors to take a “sell” position, while the overwhelming majority of them offer “buy” recommendations.
According to data revealed by Rep. Kang Byung-won of the main opposition Democratic Party of Korea, out of 4,344 stock analysis reports published by 32 local securities firms from July 2021 to June 2022, only three ― or 0.07 percent ― contained sell recommendations. In contrast, 92.2 percent of the reports had buy ratings, while another 7.8 percent of the reports recommended hold.
The lopsided proportion of buy positions was in stark contrast to the actual bearish market sentiment during the surveyed period. The benchmark KOSPI index fell by nearly 30 percent and the tech-heavy Kosdaq index declined by about 28 percent as investors took profits after a bull market in 2020.
The skewed pattern has not changed at all this year.
According to Korea Financial Investment Association (KOFIA) data, the proportion of sell ratings accounted for only 0.1 percent of stock analyst reports published by over 30 local brokerages at the end of the first quarter. Buy reports accounted for 93.7 percent, while the proportion of hold recommendations stood at only 6.2 percent.
Global financial firms, in contrast, display a lot more leeway in publishing diverse ratings.
On average, sell reports constitute about 13.5 percent of global financial firms' stock reports. Buy recommendations account for about 55 percent, while hold ratings take up 32 percent.
Against this backdrop, the Financial Supervisory Service (FSS) called on local securities companies earlier this month to overhaul their research departments to make improvements in stock recommendation practices, pointing out the skewed proportion of buy positions in their stock analysis reports.
One of the reasons that prompted the state-run watchdog to call for the changes was a high-profile stock manipulation case involving eight issues whose share prices tanked in April. Out of the eight stocks that plunged that month, four of them received “buy” recommendations, with analysts failing to perceive the excessive discrepancy between the companies' stock prices and their corporate valuations.
“While Korea's capital market has grown much (over the decades), the FSS views that the current practices of stock research papers should stop if the country aims to develop further into a truly advanced market,” Hahm Yong-il, senior deputy governor at the FSS, stressed.
As a way to improve the skewed ratings of stock analysis reports, the FSS said it is mulling over the issuance of licenses to firms that focus on conducting independent stock research so they can be recognized as financial investment firms.
“No definitive decisions have been made on such considerations. We will continue to consult with securities companies as well as other financial authorities to draw up more specific measures,” an official from the FSS told The Korea Times.
Structural setbacks borne by local stock analysts
However, there are doubts as to whether the chronic problem could be solved even if the presence of independent research firms is further promoted. Stock analysts say there are many factors resulting in the current stock research practices at local securities firms.
Analysts primarily blame a widespread perception among Korean retail investors who regard stock analysis reports as part of the public domain instead of the intellectual property of brokerages. In Korea, stock analysts' research papers are distributed freely to retail investors, in contrast to global investment firms that disclose stock analyst reports only to a small number of institutional investors.
“Stock recommendation reports are obviously intellectual property owned by securities companies. But the reports are freely and ubiquitously shared online, although it is illegal to share them with individuals who do not hold the property rights over the reports,” a stock analyst told The Korea Times on condition of anonymity. “Securities firms can sue them, but they opt not to do so, as legal fees outweigh the actual benefits of pursuing such legal suits,” he added.
Stock reports can be widely read free of charge by almost every retail investor in the country, which generates another problem. Retail investors target analysts who recommend sell ratings on stocks they have invested in, due to fears of negative effects on the prices of shares they own. Some individual investors even file complaints against such analysts to financial authorities.
“It is a vicious cycle,” another stock analyst, wishing to remain anonymous, said. “As reports of sell recommendations are rare, analysts who write such reports receive an extreme amount of market attention, drawing protests from retail investors. In addition, stock analysts who write negative views of some listed companies also face other forms of pressure.”
He explained that stock analysts who write negative views of listed companies could be limited from accessing further information by firms that refuse to give out necessary information. Securities firms cannot remain independent from listed companies either. Securities firms have investment banking (IB) businesses, which handle mergers and acquisitions, initial public offerings and bond issuances. As a result, negative stock reports published by research departments of securities firms on a particular listed company can impair a securities firm's relationship with potential clients for its IB business.
“Consequently, analysts do not have any incentives to publish sell recommendations,” the analyst said.
Regulatory improvements needed to address conflicts of interest
Such views are shared by NH Investment & Securities CEO Chung Young-chae.
“As many local companies fail to provide earnings guidance, it is very detrimental for analysts, who should maintain access to such information, to sour their relationships with companies by publishing negative views. Strong protests by retail investors are another factor that hamper analysts' sell recommendations,” Chung told reporters earlier this month.
As a result, stock analysts hope financial authorities will focus on regulating the illegal distribution of research papers and monitoring the influence listed companies have on analysts if the authorities wish to improve the country's stock research practices.
Lee Hyo-seob, a senior research fellow at Korea Capital Market Institute (KCMI), ascribes the general lack of a long-short strategy in the local stock markets ― seeking to take profits from both stock price gains and declines ― to the scarcity of analysts' sell reports.
“From the perspective of economics, there's little demand for sell reports in Korean stock markets. Those who need stock analysts' sell reports the most would be hedge funds who use long-short strategies. As most institutional investors in Korea rely on long-only strategies, the demand for buy reports is much stronger than that for sell reports in the country,” Lee explained.
“Another issue is the conflict of interest within local securities firms. Even if analysts write a sell report, it could hamper the brokerages' investment banking profits by losing potential clients. Thus, we need to systemically overhaul regulations to solve the issue of conflict of interest,” the senior researcher added.
In the U.S., the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) jointly drew up rules in 2002 governing analysts and research reports to address problems, including conflict of interest.
For instance, the rule prohibits retaliation against analysts who write negative research reports on listed companies. The rule also required securities companies to disclose the proportion of buy recommendations among their entire reports. This regulation made securities firms increase the proportion of sell recommendations to raise the credibility of their stock reports.
Since adopting the rule, the percentage of buy reports drastically fell, while the proportion of sell reports also skyrocketed from the single to the double-digits. That demonstrated that appropriate systemic enhancements by supervisory authorities successfully brings about positive changes in research practices.