Bad Advice: Wall Street Conflicts Make Analysts' Calls Suspect
New York, June 30 (Bloomberg) -- Stock trader Marty Fiascone says he's not normally a sore sport. Yet one trade continues to irk him.
In March, he lost $70,000 of his own money when the shares of MicroStrategy Inc., an Internet software company, tanked. Fiascone, a managing director at Stafford Trading in Chicago, insists securities analysts knew MicroStrategy would restate its books to conform with standard accounting practices and that its earnings and stock price would suffer.
Rather than alert him, the analysts kept urging him to buy shares, he says. On March 20, MicroStrategy did announce the accounting change. The stock plummeted 62 percent to 86 3/4 that day. Yesterday, it closed at 32 5/8.
``They have no credibility,'' Fiascone says, getting angrier at the analyst corps with each breath. ``They should be exposed for what they are. They're used-car salesmen.''
Fiascone isn't alone. Many investors these days complain that stocks they own fall precipitously without a warning from the analysts who persuaded them to buy the shares in the first place.
Palley-Needelman Asset Management, a San Diego money manager, says it lost almost $10 million on its UnumProvident Corp. shares last year because it believed analysts who kept recommending the company in the face of evidence that its disability insurance business was deteriorating. Palley-Needelman sold the stock in December.
P&G Falls
Molly Guenther, who oversees $220 million in investments at SunTrust Banks in Atlanta, had about 4 percent of her customers' money in Procter & Gamble Co. stock on March 7. That day, the consumer-products giant said its earnings would fall short of analysts' estimates. The shares tumbled 30 percent.
Guenther says she had no idea something was awry. Many of her clients were unaware of P&G's problems until they got their quarterly reports -- and then started calling her. ``It's one thing to lose money in an aggressive, speculative investment, but for a company like P&G to have a drop like that is very upsetting to them,'' she says.
Why didn't Wall Street pros issue warnings before the routs? Well, why would they? Analysts are more rainmakers than researchers these days. They're paid to be positive: Their fawning research reports help their firms win and keep investment- banking clients -- and keep the brokerage machine oiled.
The Skinny
``An analyst is just a banker who writes reports,'' says Stephen Balog, former research director at Lehman Brothers and Furman Selz, who left the latter firm after ING Groep bought it in 1997. ``No one makes a pretense that it's independent.''
Analysts would sooner stop covering a company than recommend selling its stock. Of 28,000 analyst recommendations on 6,700 companies in the U.S. and Canada, less than 1 percent are ``sells'' or ``strong sells,'' according to First Call Corp., which tracks ratings. By contrast, one-third of the ratings are ``strong buys,'' another third are ``buys'' and almost all the rest are ``holds.''
The ratio hasn't changed since First Call started to keep count five years ago. It's not likely to change as long as analysts' pay -- $2 million to $3 million annually for the top- ranked names and as much as $15 million for the superstars -- is linked to how much business they bring to their firms.
At Donaldson, Lufkin & Jenrette Inc., for instance, analysts get quarterly bonuses from the investment-banking budget. Tom Brown, chief executive of Second Curve Capital, a hedge fund, says that when he was a banking analyst at DLJ, an analyst who brought in, say, a midsize bank with assets of about $10 billion as a potential merger candidate could earn a $250,000 bonus if the merger came about. A DLJ spokesperson says the bank doesn't comment on compensation.
Small Print
Analysts must disclose their firm's relationship with companies covered, and they usually do it at the end of a report, in tiny type that's easily overlooked.
The pressure from the top of the firm for buy recommendations can put analysts through the wringer. Sean Ryan, a former banking analyst at Bear Stearns Cos., says he recommended NetBank, an Internet bank based in Alpharetta, Ga., even though he thought it was a crummy company. ``I put a `buy' on it because they paid for it,'' says Ryan.
Bear Stearns underwrote two stock offerings and one subordinated debt sale for the company in the first half of 1999, helping it raise $307 million. Morgan Keegan, a boutique investment bank in Memphis, Tennessee, that managed the bank's initial public offering in 1997, had downgraded the stock a year earlier.
Ryan then called a few customers -- some who paid Bear Stearns a lot in trading commissions -- and told them what he really thought. ``I said, `We just launched coverage on NetBank because they bought it fair and square with two offerings,''' he says. ```Unless money is burning a hole in your pocket, there isn't any reason to own it.''' NetBank traded at 12 3/16 yesterday, down from a high of 83 in April 1999.
Censored?
The analyst says he left Bear Stearns in January to form Byrne Ryan & Co., a brokerage that promised unbiased research. (It closed in May, and Ryan joined Banc of America Securities in June.) Ryan alleges that Bear Stearns censored his tough reports on First Union Corp., then refused to let him write about the bank.
Bear Stearns disputes Ryan's version of events. "Bear Stearns stands by the quality and integrity of our research," the firm said in a written statement. ``Our analysts are encouraged and expected to maintain their independence and provide the best possible research product to our clients. Since his departure from Bear Stearns, Sean Ryan has made disparaging comments about the Bear Stearns research department in an effort to generate publicity for his latest business venture. The comments are the same ones he has made before and, as in the past, are totally inaccurate.''
Comment, Please
Many analysts routinely send drafts of their research reports to the companies being covered for comment and tweaking. ``The way the game is played is that we want to make money for our clients,'' Richard Leggett, head of research at Friedman, Billings, Ramsey & Co., a small investment bank in Arlington, Va., said at a conference in late March. ``So if a company guides us lower in our earnings estimates and then the company blows out the estimate, I look good, the company looks good,'' he said. ``We all win.'' Except, of course, for the investors who took the analysts' advice at face value.
Headhunters know the game. The first question they ask about an analyst they might hire is whether the analyst is investment- banker friendly, says Balog. That is, does the researcher bring in deals, or if a bank does a mediocre deal, will the researcher look the other way?
Today's star analysts are Jack Grubman, 46, of Salomon Smith Barney and Mary Meeker, 40, of Morgan Stanley Dean Witter & Co. These people are much more than stock pickers.
In February 1998 executives at SBC Communications Inc., pondering an acquisition, invited Grubman to a strategy session in Arizona and asked for his overview of the industry and his opinion of where it was heading.
``He confirmed the strategy we were working on,'' says James Kahan, SBC's senior executive vice president of corporate development, who adds that the company didn't specifically discuss possible acquisition targets. ``We valued his judgment because of his experience and knowledge.''
Salomon on Board
In April 1998 San Antonio-based SBC hired Salomon to advise it on its plans to acquire Ameritech Corp., another former Baby Bell, based in Chicago. Kahan says SBC's decision to retain Salomon for the Ameritech acquisition, which it announced that May, was not connected to Grubman's comments. Salomon earned $33 million on the SBC/Ameritech deal, which closed in October 1999.
Grubman, who did not return phone calls seeking comment for this story, covers 34 companies. He has ``buy'' recommendations on all but three. Last November, Grubman raised his rating on AT&T to ``buy'' from ``neutral.'' Rival analysts suggested that Grubman had to be nice to AT&T so that Salomon could win a role in the largest U.S. IPO ever: the $10.6-billion sale in April of a so-called tracking stock in AT&T's wireless unit. AT&T did, in fact, name Salomon, Goldman, Sachs & Co. and Merrill Lynch & Co. to manage the underwriting.
In May, Grubman praised WorldCom Inc. for first-quarter results that put the company far and away at the top of the industry. The glowing report came just at the time Salomon was comanaging a $5 billion sale of bonds for the telecommunications company. Asked to comment on these developments, a Salomon spokesperson said, ``We as a firm do objective research.''
Analyst Marketers
It can't be easy for analysts with such extensive access to keep their dual duties separate. ``They're trying to be analysts, but at the same time they're marketers for the company,'' says Kent Womack, a finance professor at Dartmouth College. Because of that, opinions generally are more biased than they used to be, Womack says.
Meeker made her name with a 300-page report in 1995 that hailed the dawn of the Internet age. She has since turned corporate finance on its head by valuing companies on their potential rather than their past. The upshot: start-ups now routinely seek her backing. Morgan Stanley has underwritten such IPOs as Priceline.com Inc., HomeGrocer.com Inc., Martha Stewart Living Omnimedia Inc., Ask Jeeves Inc. and Drugstore.com. Inc.
Forever Bullish
Dubbed Queen of the Internet, Meeker has been consistently bullish about her subjects. She has recommendations of ``outperform'' (read ``buy'') on all but two of 20 companies she covers; she's ``neutral'' on VeriSign Inc., a maker of Internet security software, and Electronic Arts Inc., a designer of interactive entertainment software.
Morgan Stanley managed underwritings on 14 of the IPOs for these companies and comanaged another. Says a Morgan Stanley spokesperson, ``Long before the IPO boom, we erected a strict system of Chinese wall separations between the research and banking functions, and it still serves us well today.''
The schmoozing and selling an analyst must do these days takes time away from doing research. That, in turn, reinforces a researcher's dependence on spoon-fed information from the companies. Junior analysts right out of college or business school often crunch the numbers. ``It's private-label research,'' says Ryan, the former Bear Stearns analyst. ``You just slap your name on it. Even I did that.''
Ryan says Bear Stearns expects analysts to make 150 calls per month to clients, mostly institutional investors, to update them on companies they follow and to pitch stocks. A survey of 2,181 analysts at 102 securities firms by Tempest Consultants found analysts spent 40 percent of their time doing fundamental research in 1999. The analysts expect to spend less time this year -- 36 percent -- on research and more time on selling stocks.
SEC Concern
Analysts' conflicts of interest have worried Securities and Exchange Commission chairman Arthur Levitt Jr. for some time. In speeches in April and October of 1999, the stock market's top regulator complained that analysts all seem to have graduated from the Lake Woebegone School of Securities Analysis: the one that boasts that all stocks are above average.
Levitt warned that analysts were protecting business relationships at the cost of fair analysis. ``I worry that investors hear from too many analysts who may be just a bit too eager to report that what looks like a frog is really a prince,'' he said in April. ``Sometimes a frog is just a frog.''
Analyst conflicts aren't new. Wall Street is for bulls, and nobody in a firm likes to hear an analyst say sell. Investors have learned that a ``hold'' recommendation is really a warning to sell the stock. Still, researchers used to be thought of as people who visited companies, kicked some tires and drew independent conclusions.
That started to change after 1975, when brokerage firms could no longer fix commissions and Wall Street started to make more money from new stock and bond sales and mergers. The stakes have soared since: The top 25 investment banks handled $68.9 billion in U.S. initial public offerings during 1999, up from $4.5 billion a decade earlier. The value of mergers and acquisitions stood at $1.6 trillion, 11 times the amount for 1990.
Campaigning
Big-name analysts always have been a magnet for new business. That's why securities firms campaign each year to get money managers to vote for their analysts when Institutional Investor magazine picks the top research talent. Now the stars are even more important as the returns from investment banking and mergers businesses increase.
Consider the case of Regeneron Pharmaceuticals, based in Tarrytown, New York. The company shifted its business to Merrill Lynch, largely because biotechnology analyst Eric Hecht had moved there three years ago from Morgan Stanley Dean Witter. Morgan Stanley handled the company's last stock sale in 1995. Regeneron's chief financial officer, Murray Goldberg, says: ``A bank is basically selling a company's stock to its customers. It can only do that if the analyst supports it. You need an analyst who understands your industry and your company and who has enthusiasm for the company.''
Biotech Booster
Hecht, 40, filled the bill. A medical doctor who ranked third in his category in Institutional Investor's latest poll published in October, he had long been a biotech booster. Better yet, he liked Regeneron even though it hasn't made a cent in the 12 years it's been developing drugs to treat obesity, arthritis, cancer and other diseases.
On Feb. 23, when he recommended Regeneron shares as a ``long- term buy,'' Hecht was the only analyst covering the company. One was enough: Regeneron's stock price, which had crawled along the floor at less than 10 for most of 1999, jumped 75 percent the day Hecht's report came out and reached an all-time high of 57 3/8 six days later.
No Precondition
Regeneron moved quickly to take advantage. Goldberg says that a week after the report came out, Regeneron met with underwriters and hired Merrill to lead the deal. On March 6, it registered the sale with the SEC. The company sold 2.6 million shares on March 29 to raise $77.4 million. Goldberg says the bullish coverage was not a precondition for Merrill to win the business.
The preponderance of glowing research reports coming from Wall Street has made it increasingly difficult for investors to discern the truth. Stock trader Fiascone, for one, relied on favorable reports on MicroStrategy from firms like Friedman, Billings, Ramsey. That firm had helped take MicroStrategy public in June 1998 and comanaged a $54 million secondary issue in February 1999. FBR was also in on another sale of 4 million shares being planned for March.
Michael Saylor, who started MicroStrategy in 1989, was never shy about his company's mission. He boasted that his firm would purge ignorance from the planet with data-mining software that could tell companies who was buying what where. Managerial and personal quirks like a mandatory annual Caribbean cruise for the staff (no spouses allowed) and lavish parties at places like Washington's Corcoran Gallery lifted the company's profile.
After MicroStrategy went public at 12, its prospects looked good. The company's client roster included big names like General Electric Co. and Est e Lauder Cos. Analysts loved the stock, which rose to 150 in late November 1999. If anyone saw trouble, they didn't admit it.
`Monstrous Deal'
From month to month, FBR analyst David Hilal was unrelentingly bullish on the company's prospects. ``Vision becoming a reality,'' he wrote on July 28, 1999. ``E-business just starting to take off,'' said an Aug. 16 note. ``MSTR Rings the Cash Register-Monstrous Deal With NCR,'' he wrote on Oct. 5. On Jan. 28, he predicted the by-then split-adjusted stock would reach 200.
MicroStrategy topped Hilal's price target of 200 on March 6 and shot up to 313 by March 10. Ten days later the company announced that it was restating its earnings and would report a loss of 43 cents to 51 cents a share for 1999 instead of a profit of 15 cents a share. The stock plummeted.
Analysts like Hilal apparently missed an obvious problem. MicroStrategy had explained in its 1998 annual report that it booked product-license revenues after it signed a contract and shipped the software. Service fees were deferred over the life of the contract. Wrong, say accountants.
Waiting Period
``The revenues should not be booked until the seller has completed providing the services that are required under the agreement,'' says Howard Schilit, an accountant and president of the Center for Financial Research & Analysis in Rockville, Md. ``It appeared that those services had yet to be performed.''
The company's accountants -- and the analysts -- didn't seem to understand this. ``The evidence is pretty persuasive that the original financial reports were wrong,'' says Schilit. MicroStrategy said in April the SEC was investigating the accounting change.
Hilal, 29, who has been an analyst for three years, says he trusted MicroStrategy's accountants. He even noted in a Jan. 6 report that the company planned to book $10 million in revenue for the fourth quarter of 1999 for a $65 million deal it had just announced that day.
He says that if the company had been superaggressive, it would have recorded the entire amount of these megadeals up front. ``We did extensive work,'' says Hilal. ``We always thought it was probably slightly aggressive, but when the auditors sign off, at some point you defer to them.''
Denying Pressure
Hilal says FBR's investment bankers were not pressuring him to favor MicroStrategy. ``We have complete autonomy; we can do what we want,'' he says. Sort of, anyway. It was, after all, the firm's research director, Richard Leggett, who publicly stated at a conference in March that the firm works closely with its clients to fashion earnings estimates to get the biggest bang out of a stock price.
The Monday-morning quarterbacking doesn't console Fiascone. ``It's one thing if you're just wrong,'' he says. ``But they overlooked a basic accounting principle that's taught freshman year in college and in business school.'' Hilal continues to recommend MicroStrategy's stock.
An even more basic principle -- that the bottom line is the bottom line -- seemed to elude some analysts covering insurer Unum Corp. (The company merged with Provident Cos. in June 1999 to become UnumProvident Corp., America's largest seller of disability insurance.) In Unum's case, the tendency of companies and analysts to focus on the top line, or sales growth, to gauge the strength of an insurance company's core business became a distraction.
Expenses Rising
The sales numbers for 1998 were impressive enough: Premiums collected for the year increased 13.4 percent to $4 billion, and total revenue was up 11.9 percent to $4.6 billion. Expenses, though, were rising slightly faster: up 14.2 percent to $4.1 billion. Net income dropped 2 percent to $363 million.
Then, in the first quarter of 1999, net income plummeted 83.4 percent to $15.5 million after the company took a $101- million charge for a money-losing reinsurance unit. (The company's 1999 annual report would later put the total charge for the debacle at $328 million.)
The disastrous quarterly results didn't faze Vanessa Wilson, an analyst at DLJ who had covered the company since 1991. In April 1999 she even upgraded the stock to a ``top pick'' from a ``buy.'' The merger with Provident fueled her optimism. ``Good news was not in short supply,'' she wrote in a May 10 report.
Wilson emphasized revenue growth and described the $101- million charge as a way to box in the reinsurance problem. Also on May 10, Wilson raised her 12-month price target to 70 from 62.
Billion-Dollar Pool
Bad news would soon be in abundant supply. In August, the new UnumProvident announced a $191 million loss for the second quarter, blaming merger-related expenses. The stock declined 30 percent to 36 3/8. Total charges related to the merger would eventually run to more than $1 billion -- largely to fill Unum's reserve pool against future claims, which were growing.
Wilson maintained her ``top-pick'' rating on the stock and predicted earnings were bottoming out. ``By `setting the dials right' with accounting and pricing changes in 1999, UnumProvident is marking the bottom of the 1999 trough,'' she wrote in a Sept. 7 report. It continued, ``The Unum/Provident merger provides a dose of humility, new management, and the potential for a clean slate.''
At the same time, though, Wilson acknowledged a slow, continuous deterioration in the prospects for disability insurers. People collecting on disability claims were living longer and becoming more sophisticated about how to fight insurance companies, she noted. And they had been for some time.
Suspicion
Wilson also wrote that Unum had loosened its underwriting standards to write policies for higher-risk customers to boost revenue growth. ``Investors are suspicious about whether disability was ever a good business, the integrity of Unum's recent financial statements is in question, and the credibility of management has taken a pounding,'' her Sept. 7 report stated. Wilson still rated the stock a top pick.
If this were a steady trend, why hadn't the analyst noticed it earlier? ``In retrospect, I asked most of the right questions, kept asking, and got sucked in by fairly credible answers from management,'' Wilson says. Unum insisted its rising prices would offset worsening risk. When Wilson presented Unum with a specific customer who seemed to get an unreasonably low price, Unum would say its competitors charged even less.
``The company lied to themselves,'' she says. ``There's no way any outsider could figure this out. They always had a reasonable explanation about why it was temporary and that it would get better.''
The trough that Wilson called in September became deeper and deeper. On Feb. 10, Unum reported a loss of $183 million for 1999 and earnings of 57 cents a share for the fourth quarter -- 15 cents short of the consensus estimate. The stock price dropped another 37 percent to 16 1/4 that day -- then its lowest level since 1991. Yesterday, the stock closed at 19 7/8.
Red Flag
Wilson's change in tone from May to September raised eyebrows among investors. Jim Edelman, an analyst at Highland Capital Management in Memphis, wondered if Wilson's upgrade of her rating for Unum on April 14, 1999, was related to the IPO of StanCorp Financial Group Inc., another insurance company, a day later. DLJ was one of Stancorp's underwriters, and good news about a single stock is often good news for others in the same business. Edelman says his firm sold almost half of its 236,975 Unum shares in December.
Wilson says the two events are unrelated and that DLJ's investment bankers or salespeople have never influenced her research. ``I act in the interest of shareholders,'' she says. ``There's no one with a gun to my head.'' DLJ says it has participated in one $100 million bond issue for Provident, and the firm is one of five that manage UnumProvident's $25 billion bond holdings. Wilson says she has never received any pay related to that work.
Dumped
Money manager Palley-Needelman absorbed its loss on UnumProvident shares in December, before the stock plummeted again. An analyst at Palley blamed investment-bank researchers for being too willing to believe what the company told them. ``Have you ever been dumped by a girlfriend or boyfriend?'' he asked. ``It's the same feeling with a stock like this.''
Imagine, then, that you've been married for decades and never had a reason to mistrust your spouse. Until now. The shareholders of Procter & Gamble know what that's like. When then Chief Executive Durk Jager announced that the company wouldn't meet its earnings target, its stock took its steepest daily drop in at least two decades.
If analysts had done their job, the shock might not have been so great. Jager blamed the rising costs of oil and pulp for much of the shortfall. Oil prices tripled from January 1999 to March 2000, and pulp prices rose 30 percent in 1999.
Hadn't analysts noticed? Some did, but they didn't sound the alert. Andrew Shore, then an analyst with Paine Webber Group Inc., remarked on the commodity risk in an August report. Then he raised his rating on P&G shares to ``attractive'' from ``neutral.'' This was stranger still because, just two months earlier, Shore had complained that P&G management hadn't delivered to investors for six quarters and wouldn't be able to turn the company around soon.
Buy, He Said
Shore turned even more favorable on P&G in January, when he crowned the shares with a ``buy.'' He praised the company for walking away from a possible merger with pharmaceutical companies Warner-Lambert Co. and American Home Products Corp., calling it proof that management wouldn't be financially irresponsible. Sales growth that was accelerating for the first time in two years gave him new confidence, too.
``It could likely be one of the best investments in our group over the next 12-24 months,'' Shore said of P&G shares, even though the company had for the second time in a few months lowered its estimate for quarterly results.
When P&G issued yet another profit warning on March 7, Shore was no longer with Paine Webber, having jumped to Deutsche Banc Alex. Brown. At his new firm, he immediately cut his rating on P&G to ``market perform'' and halved his 12-month price target to 60.
The question is whether Shore had turned favorable on P&G to help Paine Webber win business. The firm managed an $81 million debt sale in October, though Goldman Sachs Group has handled four of eight public issues since 1996. Did Paine Webber or P&G pressure him to be more positive? Or did he simply change his mind? Shore did not return repeated calls or respond to e-mail or fax messages seeking comment.
One person who didn't survive P&G's soaking in the market was Jager. He quit on June 8.
Little Recourse
Shareholders can complain about being sandbagged by analysts, and that may be all they can do. The courts probably won't be much help, says John Coffee Jr., a professor of securities law at Columbia Law School. Although the law technically bars analysts from releasing false or misleading statements, there's nothing illegal about being wrong and it would be tough to prove intent to defraud.
Most class-action lawyers target the companies because it's easier to show that managers have a direct interest in moving a stock price, says Coffee. Numerous class-action lawsuits are pending against MicroStrategy, UnumProvident and P&G.
Call the SEC
Fiascone turned to the SEC instead. He called the chairman's office to complain after MicroStrategy's fall. ``No one would accept this behavior in any other area of their business life,'' he says. ``Imagine if a family member got a full-scale checkup at the Mayo Clinic and no one checked for prostate cancer, or something that big was overlooked by industry experts. It's that absurd.''
Arthur Levitt has made it clear that he thinks analysts' conflicts are a problem. He has asked the industry's self- regulating bodies -- the New York Stock Exchange and the National Association of Securities Dealers -- to review the issue. ``We cannot settle for boilerplate disclosure, cloudy language that masks a firm's position, or small-type disclaimers at the end of a document,'' he said in October.
Investors will always have to deal with Wall Street's conflicts of interest. But as securities analysts increasingly cross traditional lines of behavior, at least the conflicts should be disclosed in bold print.
Jun/30/2000 2:45 ET
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