Analysts should be independent sources of information for investors, but it does not always turn out this way. By the early 2000s, analysts were issuing more and more Buy recommendations, and less and less Sell recommendations not because stocks are necessarily fundamentally good but because their Buy recommendations help their employers to maintain existing or to generate new investment banking business. This attracted the attention of regulators, who introduced new rules for analysts. Recent research suggests these rules have in fact resulted in a more balanced distribution of stock recommendations.

Rule 2711 was approved by the US Securities and Exchange Commission in 2002 to prohibit members of the NASD and NYSE from tying analyst compensation to their company's investment banking transactions. Members were also banned from offering favorable research or a specific rating or price target to a company as an inducement for future business.

Peter F. Chen of HKUST and his co-author Chih-Ying Chen show that the rules changed the way analysts generate stock recommendations. The changes indicate that analysts are more independent in making stock recommendations.

"Rule 2711 reflects the belief that linking analyst compensation to investment banking business diverts analysts' efforts from forming objective valuations and recommendations, to currying favors with managers," they said.

"We find that Rule 2711 has enhanced analysts' independence. Post-Rule, their stock recommendations are more strongly related to the intrinsic value estimates of a stock, and more weakly related to conflicts of interest."

Intrinsic value estimates, in particular the residual income and price-earnings-to-growth, can be used to predict future stock returns, so a stronger link between this and stock recommendations is a sign that analysts' recommendations are based more on fundamental values estimated on their earnings forecasts rather than outside influences.

For conflict of interest, other studies have found analysts affiliated with brokerage firms that have investment banking business are slower to downgrade from Buy to Hold in their stock recommendations, and faster to upgrade from Hold. Conflict of interest here is measured by both the demand of the external financing and the amount of underwriting business of the analyst's company. The higher is the amount of investment banking business of the analyst' employer, the higher is the analyst's conflict of interest. Second, the higher is the demand for external financing of the company that the analyst cover, the higher is the degree of analyst's conflict of interest.

The authors looked at more than 400,000 company-month observations from 1994-2005, straddling the introduction of Rule 2711 so they could see the before and after effects.

The results indicate that stock recommendations are significantly and positively related to fundamental values (Residual income or PEG models) after Rule 2711 was introduced. But the authors do not find any significant relation between recommendations and fundamental values in the years before the Rule 2711."This is consistent with our the idea that analysts' stock recommendations are more strongly related to the intrinsic value estimates relative to stock prices under Rule 2711," they said.

In terms of conflict of interest, there was a 30 to 45 per cent decrease in the link between the conflict measurements and stock recommendations after Rule 2711 was introduced. "The positive relations persist but become significantly weaker post-Rule 2711. The results suggest the influence of conflicts of interest on analyst stock recommendations has weakened since the introduction of the Rule," they said.

Various alternatives were tested to see if these could explain the differences, but the authors' findings still held up. The authors' results using accounting-based valuation tools contribute more convincing empirical evidence on the effect of Rule 2711 than those in existing literature.

"Prior research has shown large increases/decreases in the percentage of analysts' Sell/Buy recommendations and an increase in the profitability of their recommendation after Rule 2711 was implemented. We demonstrate that analysts incorporate intrinsic values relative to stock prices into their stock recommendations to a greater extent, and investment banking opportunities to a lesser extent, than before Rule 2711," they said.