From today's NYTimes-Do your own DD rather than relying on brokerage analysts--Good article in today's NYTimes for what our top GG's have said all along. Happy New Year everyone from a very appreciative lurker..
SongWrks
How Did So Many Get It So Wrong?
nytimes.com
December 31, 2000
By GRETCHEN MORGENSON
Of all the rude awakenings that the bear market in stocks has brought
to investors, perhaps the most jarring has been the realization of
how woefully wrong Wall Street's research analysts have been this
year on the stocks they follow. While the market sank to its worst
performance in more than a decade, many of those analysts kept
right on smiling and saying "buy."
How can so many who are paid so much to scrutinize companies have
blown it so spectacularly for their investor customers?
The answer lies in a subtle but significant change in the way Wall
Street analysts do their work and how they are rewarded for it.
That shift, which has brought riches and stardom to many securities
analysts, has cost investors billions of dollars in losses.
The fact is, although brokerage firm stock gurus are still called
analysts, their day-to- day pursuits involve much less analysis and
much more salesmanship than ever before.
"The competition for investing banking business is so keen that
analysts' sell recommendations on stocks of banking clients or
potential banking clients are very rare," said Arthur Levitt, the
chairman of the Securities and Exchange Commission. "Whether this
is an actual or perceived conflict, clearly, in the minds of many
institutional buyers, brokerage firm analysis has diminished
credibility." Robert A. Olstein, a mutual fund manager with 32
years of experience analyzing companies' financial results, agrees.
He said analysts today are more like racetrack touts than sharp-
penciled researchers.
"What passes for research on Wall Street today is shocking to me,"
Mr. Olstein said. "Instead of providing investors with the kind of
analysis that would have kept them from marching over the cliff,
analysts prodded them forward by inventing new valuation criteria
for stocks that had no basis in reality and no standards of good
practice." (Internet analysts, for example, have cited visits to a
Web site as a reason for optimism. But, Mr. Olstein said,
"Investors can't take page views to the bank.")
No one, of course, can predict what stocks will do tomorrow, much
less next year; but Wall Street's analysts are supposed to help
investors judge the attractiveness of companies' shares. Investors
look to analysts to advise them on whether to buy or sell a stock
at its current price, given its near- term business prospects.
Until the mid-1990's, that is how most analysts approached their
work. Today, there is virtually no such thing as a sell
recommendation from Wall Street analysts. Of the 8,000
recommendations made by analysts covering the companies in the
Standard & Poor's 500-stock index, only 29 now are sells, according
to Zacks Investment Research in Chicago. That's less than one- half
of 1 percent. On the other hand, "strong buy" recommendations
number 214.
Analysts have long been known for unrelenting optimism about the
companies they cover. But many investing veterans say that the
quality of Wall Street research has sunk to new lows. That decline,
they say, is the result of shifting economics in the brokerage
business that has pushed many researchers to put their firms'
relationships with the companies they follow ahead of investors.
The commissions charged by Wall Street firms to their
institutional and individual customers for trading stocks are one
factor. These fees were much higher in the 1970's and 1980's,
perhaps 10 cents a share on trades then versus a penny or less now.
Because analysts' recommendations helped generate trades and
commissions, research departments paid for themselves. More
important, an analyst who uncovered a time bomb ticking away within
a company's financial statements and who advised his customers to
sell its shares made an important contribution to his firm in
commissions those sales generated. In short, analysts were rewarded
for doing good, hard digging.
But as commissions declined, Wall Street firms looked elsewhere
for ways to cover the costs of research.
The lucrative area of investment banking was an obvious choice.
Analysts soon began going on sales calls for their firms, which
were competing for stock underwritings, debt offerings and other
investment banking deals from corporations. In this world, negative
research reports carried a cost, not a benefit.
The result, money managers say, is that the traditional role of
analyst as adviser to investors has been severely compromised. The
increasingly close relationships analysts have with corporate
executives has led many of them to be gulled by managements intent
on keeping up the prices of their stocks.
"Research analysts have become either touts for their firm's
corporate finance departments or the distribution system for the
party line of the companies they follow," said Stefan D. Abrams,
chief investment officer for asset allocation at the Trust Company
of the West in Manhattan. "Not only are they not doing the
research, they have totally lost track of equity values. And the
customer who followed the analyst's advice is paying the price."
For many investors, that price keeps going up. In the past few
months, as former stock market favorites crashed to earth, many top
analysts remained maddeningly upbeat all the way down.
Consider Mary Meeker, the analyst at Morgan Stanley Dean Witter
who became known as the Queen of the Internet for her
prognostications on e-commerce companies like Amazon.com and
Priceline. In 1999, as Internet stocks soared and new companies
were taken public in droves, Ms. Meeker made $15 million, according
to news reports.
Now that Internet stocks are in pieces on the ground, she has
become decidedly less vocal but no less optimistic. In her
reports, she still rates all 11 Internet stocks she follows as
"outperform" even though as a group they are down an average 83
percent. By comparison, the Interactive Week Internet index is down
60 percent from its recent peak. Of the 11 companies Ms. Meeker
remains positive on, 8 had securities underwritten by Morgan
Stanley.
Ms. Meeker declined to comment for this article. But Ray O'Rourke,
a Morgan Stanley Dean Witter spokesman, defended the star analyst,
saying that her picks had been made for the long term. Moreover, he
said, Ms. Meeker warned investors last March that Internet stocks
were volatile.
Asked about Ms. Meeker's record and whether her nonstop optimism
had anything to do with the fact that most of the companies had
engaged Morgan Stanley as an investment bank, Mr. O'Rourke said:
"It is what it is. But you shouldn't be surprised necessarily to
see `outperforms' on the companies, because we've been very
vigorous on the companies we've chosen to bring public."
Anthony Noto, at Goldman, Sachs, is another Internet-stocks
analyst who remained upbeat on shares that were trading at a
fraction of their former values. On Dec. 18, he lowered the ratings
to "market performer" on four of the nine stocks he follows,
including the Webvan Group, an Internet grocer; Ashford.com and
eToys, two troubled e-tailers, and PlanetRX.com, an online resource
for medical products that was in danger of being delisted by the
Nasdaq stock market.
The companies were downgraded after they had dropped on average
98.2 percent during the previous 52 weeks. By contrast, the Nasdaq
is down 39.3 percent this year.
Of the nine stocks Mr. Noto follows, seven had stock offerings
underwritten by Goldman, Sachs.
"Our research is driven by fundamental analysis and is not
influenced by anything else," Mr. Noto said. He went on to explain
that the companies he followed had their stock prices drop last
spring not because their operations were failing, but because
market psychology had changed. He downgraded the stocks much later
because only then had it become clear through his research that the
companies' results were deteriorating. "In hindsight," he said, "we
should have lowered our ratings sooner. We regret that."
Faces are also red or should be at Salomon Smith Barney. Jack
Grubman, the highest-paid analyst at the firm and, perhaps on Wall
Street, reportedly made $20 million last year in his job covering
the telecommunications industry. Investors who have followed his
picks have not done as well.
Mr. Grubman began to advise caution on the 11 smallish telecom
companies he covers in the so-called competitive local exchange
carriers sector only two months ago, after the stocks in the group
had already lost 77 percent of their value. All 11 had securities
underwritten by Salomon.
Mr. Grubman declined to comment. But in an article in Business
Week last May, he scoffed at the idea that his help peddling
investment banking services to corporations put him in conflict
with his firm's investor customers. "What used to be a conflict is
now a synergy," Mr. Grubman was quoted as saying.
Investors in Rhythms NetConnections, a high-speed local access
data provider that Mr. Grubman has favored the last 21 months, may
feel otherwise. The meteoric rise and crushing fall of the
company's shares neatly illustrates how much money investors can
lose by following the advice of conflicted analysts.
Rhythms NetConnections was not much of a company back in April
1999 when its shares were offered to the public at $21 each in a
deal managed by Salomon Smith Barney and Merrill Lynch. But it
quickly became a monster stock, soaring to $111.50 during one
trading day. Its closing high was $93.13 on April 13, 1999.
At its peak, the company's market value was $8.9 billion, even
though its revenues for the prior year had been $528,000 and in two
years as a private company, it had racked up $39 million in losses.
Before it issued shares, the company's capital consisted of $158.3
million in borrowings.
Today, Rhythms NetConnections trades at $1.13 a share, giving it a
market value of $89 million. Some $8.81 billion in value has
vanished.
As those billions were vaporizing, one of Wall Street's most
powerful analysts following the stock, Mr. Grubman, and two
analysts at Merrill Lynch recommended the company to investors. At
Merrill, Mark Kastan recommended the company until he left the firm
in 1999; Kenneth Hoexter picked up coverage in May when the stock
was $21.
After its initial offering and with the analysts recommending the
stock, Rhythms was able to tap the equity and debt markets for $870
million, in four underwritings led by Merrill and Salomon. Fees
earned by the two firms on the company's stock offerings alone
totaled $3.8 million.
Meanwhile, top management and directors at Rhythms NetConnections
were selling almost a million shares, reaping $26.4 million.
On Oct. 18, when the stock was at $2.81, Mr. Hoexter cut his
rating on Rhythms from a "near-term buy" to "near-term neutral."
Mr. Grubman did not temper his enthusiasm for the stock until Dec.
5, when its shares closed below $1 for the first time. He reduced
his rating to neutral.
Mr. Hoexter said he remained high on Rhythms for so long because
it continued to meet his near-term estimates. "To us, it wasn't so
visible that there was something wrong at the company," he said.
But Mitch Zacks, vice president of Zacks Investment Research in
Chicago, questioned the claims of analysts who said they did not
see the freight train bearing down on them. "It's not that they're
oblivious to things getting worse," he said. "But the way an
analyst can get fired is to damage an existing investment banking
relationship with a company or sour a future investment banking
relationship. The way you do that as an analyst is coming out and
telling people to sell a stock."
And it is not just a company's management that analysts must worry
about angering. They must also weigh what their negativity would
mean to the portfolios of the venture capitalists that send their
firms companies to take public. If an analyst advises investors to
sell a stock that its venture capitalists still own a stake in
and they often hold such shares for years the likelihood of
getting future deals from those people will be slim.
The possibility of earning fees also explains why analysts are
loath to highlight a company's troubles even when it is on the
brink of failure. Mr. Zacks said: "The company could do a
restructuring or spin off some assets," requiring aid from a
brokerage firm.
Joanne Tutschek, director of communications for research at
Merrill , disputed the idea that the firm's analysts work for
investment bankers first and investors second. "Our analysts'
credibility in the marketplace is determined by our institutional
and retail investors," she said. "And if an analyst is not
credible, then he loses his franchise. So I don't think an analyst
is going to throw that away for a bad banking deal." She said the
firm's research department was independent.
There is no denying that the business of research has become
extremely lucrative to analysts today and that much of that lucre
comes from banking departments.
According to Joan C. Zimmerman, principal at G. Z. Stephens, an
executive search firm in New York, $10 million was the top pay for
star analysts in 1999, while junior analysts received $350,000 in
annual compensation. This year, the numbers were $15 million for an
analyst in a hot sector and around $500,000 for junior research
analysts.
"If a firm wants an analyst who is investment-bank friendly, the
type who will help pitch deals but will also generate ideas and
timing on deals, there is an inevitable return to that analyst,"
Ms. Zimmerman said. "An analyst may have fabulous relationships
with investors, but if they are not known to be banker-friendly
they will see diminished compensation unless the research director
is very strong and can defend them."
This race explains why many analysts sound more like cheerleaders
than they do researchers. As such, they helped propel stocks to
prices never seen before.
A new practice that has become deplorably common, Wall Street
veterans say, is the use of absurd stock price targets in research
reports. "These price targets fanned the fires of speculation in
the market and did a lot of damage to a lot of people," said Mr.
Olstein, the fund manager.
Perhaps the most famous price target put on a stock was $1,000,
given to Qualcomm by Walter P. Piecyk Jr., an analyst at
PaineWebber, on Dec. 29, 1999. It soared 30 percent, to $656, on
the news and hit a high of $717.24, presplit, on Jan. 3. This year,
it has been all downhill for the company's shares, which split 4
for 1. Qualcomm closed at $82.19 on Friday, 67 percent below Mr.
Piecyk's price target.
Mr. Piecyk is no longer at the firm, which was acquired by UBS
Warburg earlier this year. He could not be located for comment.
Outlandish price targets also have proved embarrassing for
analysts who tend to reduce them only well after the stocks are
crushed. For instance, on May 26, when Internet stocks were
swooning, Jamie Kiggen, of Donaldson, Lufkin & Jenrette, issued a
note on GoTo.com, rating it a buy and setting a $160 price target;
the stock was then trading at $15.13. Only in early September did
Mr. Kiggen lower his price target. With the stock trading at
$23.31, Mr. Kiggen said he expected it to reach $80 in the next 12
months. A month later, he reduced the target to $25. The stock
closed at $7.31 on Friday.
Mr. Kiggen, now an analyst at Credit Suisse First Boston, said
that the slowing economy was the surprise that made him ratchet
down his targets for the stock. "Our price targets aren't arbitrary
numbers," he said. "In any early stage company, the inputs into
calculating the risk, magnitude and timing of future cash flows are
very unpredictable." But Mr. Kiggen added that investors also have
to take responsibility for their mistakes. "Using the fact of a
price target as a substitute for analysis if you're an investor is
dangerous," he said.
Price targets are just one symptom of the larger malady that
permeates Wall Street research today, according to David Eidelman,
a money manager at Eidelman, Finger & Harris in St. Louis. He also
criticizes the new tendency of analysts to create their own
valuation methods to justify recommending stocks at any price.
"Analysts no longer focus on tangible factors, such as discounted
cash flows, that make a stock worth what it's worth," said Mr.
Eidelman, who headed research departments at two regional brokerage
firms in the 1970's. "For instance, analysts have valued internet
retailers based on how many customers they had. This may have
nothing to do with earnings, but since they can't justify buying a
stock based on its earnings, they justify it with some valuation
method they invented."
Other money managers cite the focus only on income statements, not
balance sheets, as another flaw in many equity analysts' reports.
As companies loaded up on debt, many analysts were silent on the
potential for difficulties when an operation could not pay its
interest costs. Many companies in the telecommunications sector are
now in such straits.
As investors tote up the losses they have suffered at the hands of
ebullient analysts, they may tune out what analysts have to say. A
study of research analysts conducted by Tempest Consultants for
Reuters earlier this year looked at 2,300 analysts working for 228
securities houses. It concluded that, among fund managers, almost
40 percent spent less time reading brokerage firm research in the
previous 12 months than in 1999.
Jacob Zamansky, a lawyer at Zamansky & Associates who represents
public customers in securities cases in New York, believes analysts
will become the subject of lawsuits brought by investors who lost
money on their picks.
"Lawyers will be examining the conflicts of interest between these
recommendations by analysts and the compensation received by their
firms in investment banking and brokerage fees," Mr. Zamansky said.
"It may well turn out that the analysts pumped up this tech bubble,
reaped huge fees and left the investment public holding the bag."
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