How analysts operate
Regulators, investigators and grumpy investors are digging hard for the dirt on Wall Street's stock analysts. Here's what they're finding and how those analysts play the ultimate game of skill.
Sunday, May 05, 2002
BY JOSEPH R. PERONE
Star-Ledger Staff
NEW YORK -- Mike Mayo was a few miles into his morning jog through Central Park when it struck him.
Profit goals at a big bank were too ambitious.
Mayo, a Prudential Securities stock analyst, sprinted back to his apartment. Still dripping with sweat, he started outlining a 74-page report on FleetBoston Financial. The bottom line: "Sell."
Plenty of investors listened, as they do when the controversial Mayo issues a recommendation.
"I just ask myself a simple question" to evaluate a company, Mayo said. "Would I tell my mother to buy this stock?"
It is a question many of his peers may have ignored during the heady days of the late 1990s, when Wall Street cranked out paper millionaires faster than stock analysts could raise their price targets on no-name, no-profit companies.
The announcement last month that New York Attorney General Eliot Spitzer was going after brokerage houses and their research operations has turned Wall Street upside down. The investigation promises to shine a light into the murky world of stock research and the interplay between brokerages and the companies their research analysts are paid six- and seven-figure salaries to examine.
"We know they were pushing stocks they didn't believe in," Spitzer said Friday, pointing out analysts and senior officers of brokerages "share responsibility for a system that went off the tracks."
The Justice Department, the Securities and Exchange Commission and a multistate task force including New Jersey also are lining up for answers. Among the questions is this: Did brokerages issue tainted stock recommendations to develop, maintain or enhance lucrative investment banking deals with companies?
"What we are talking about are conflicts of interest which disadvantage retail customers," New Jersey Attorney General David Samson said. "There is sufficient evidence that suggests these practices are widespread."
Ultimately, experts agree, the once-staid research profession -- which traces its roots to slide rules and the jazzy days of railroad bonds -- has been scarred and will be forced to change its ways.
"Plenty of people feel they were misled," said U.S. Sen. Jon Corzine (D-N.J.), the former chairman of investment banker Goldman Sachs. "There will be enforcement actions and large settlements as a result of these actions."
THREE SEPARATE PARTS
The craft of evaluating securities is practiced by dedicated professionals trying to provide a fair assessment of companies, according to Margaret Draper, vice president of corporate communications for the Securities Industry Association, a trade group.
Most of the 24,000 securities analysts in the United States "work diligently to provide highly reasoned, independent analysis and produce work that is valuable to the investor," she said.
Still, the securities industry, Congress and regulators are scrambling to restore public confidence in Wall Street and recommendations by brokerages to buy, sell or hold specific stocks.
The potential problems unfolding this spring arise from the long- tangled operations of Wall Street's white shoe brokerages. Specifically, it is the relationship among research, sales and investment banking -- long thought to be protected by an invisible wall -- that lies at the heart of the controversy.
Analysts work for investment banks such as Merrill Lynch, Morgan Stanley, Citigroup's Salomon Smith Barney and other venerable names with storied histories.
They work in the research department, while brokers work for the sales department, and investment bankers -- who raise money for corporations by arranging stock sales to the public -- work for the investment banking department.
Brokerages fund expensive research operations with profits from investment banking. In theory, one could not exist without the other, which is why brokerages will fight attempts to split the two.
Investment bankers rake in huge profits for brokerages by advising companies on mergers and acquisitions, arranging initial public offerings of stock and setting up loans and additional stock offerings.
Just by helping companies sell stock, brokerage firms can make money three different ways, according to a 2001 study by Maureen McNichols of Stanford University and Hsiou-wei Lin of National Taiwan University.
First, they can obtain a fee for helping to underwrite a stock or bond offering, basically serving as middlemen between a corporation and the investing public.
Secondly, brokerages can receive a management fee for acting as lead underwriter -- think of them as general contractors for stock sales. And, finally, they are paid for helping sell the stock, the study said.
With that much at stake, bankers eventually turned to research analysts to identify companies that wanted to go public. Often, according to the study, an analyst's bonus was riding on their ability to find new business. And once the business was brought into firms, the study said, bankers were motivated to "discourage negative research reports" that might affect relationships with clients.
Taken together, analysts suddenly had the difficult job of being a "neutral umpire and a salesman at the same time," said John Coffee, a professor of securities law at Columbia University Law School.
FOCUS ON ANALYSTS
Stock analysts earn a median income of $190,000 a year, meaning half earn more and half earn less, according to the Association for Investment Management and Research, a nonprofit trade group. But analysts who reach the top of the annual Institutional Investor list of the best analysts -- the industry's version of an All-Star team -- can earn $2 million or more, people familiar with the rankings said.
"They're paid like baseball managers because they have no job security," said Randy Woolridge, professor of finance at Penn State's Smeal College of Business.
The intense scrutiny of these stars began after Spitzer, the New York attorney general, subpoenaed Wall Street firms last year.
Spitzer, who has been accused of using the investigation to advance his political career, locked horns this spring with Merrill Lynch over internal e-mails. Those e-mails showed Merrill analysts disparaging Internet stocks they were recommending to investors.
The research conflict was seemingly apparent in a 2000 company memo that asked Merrill analysts to define "your involvement in advisory work on mergers or acquisitions, especially where your coverage played a role in securing" business for the firm, according to an affidavit filed by Spitzer's office.
"The evidence in our affidavit is very powerful," Spitzer said. "There are millions of Mr. and Mrs. Smiths on Main Street in Topeka, Kansas, who were told by their Merrill Lynch broker to buy stock because of what a Merrill Lynch analyst said about the company."
Merrill is negotiating potential reforms with Spitzer's office, and the company's chief executive, David Komansky, apologized a week ago for e-mails that fell "far short of our professional standards."
Still, the firm is standing behind its 700 analysts.
"We believe our research is among the best and most unbiased on Wall Street," Merrill Lynch spokesman Joseph Cohen said.
The most visible character in the drama is Henry Blodget, a baby-faced analyst who became one of the New Economy's instant prophets.
Superstar analysts such as Blodget, Jack Grubman of Salomon Smith Barney and Mary Meeker of Morgan Stanley rode winners to the top, but picked their share of losers as Internet stocks collapsed. Meeker stumbled badly with Priceline.com, Blodget with Internet Capital Group and Grubman with Global Crossing.
In hindsight, experts said, Wall Street traded healthy skepticism for a cheerleader's megaphone.
"During the 1990s, a tremendous number of new analysts came into the business, and many were nothing more than glorified stenographers," said Chuck Hill, director of research for Thomson Financial/ First Call and a former analyst with Bache Securities during the 1970s. "All you had to do was regurgitate what management told you, put out the research ... and you'd look like a hero."
BEHIND THE CURTAIN
Blodget, who earned $12 million last year before leaving the firm, wrote some of the internal e-mails that have placed the spotlight on Merrill Lynch, according to Spitzer. Merrill employees called stocks the firm was touting "crap" or "a dog," the affidavit said.
Before Spitzer launched his probe last summer, analysts rated stocks and wrote reports with little fear of oversight from outside their firms because "stupid research is not fraudulent research," said Coffee, the Columbia professor.
But Spitzer used a back door to enter Merrill's research department. He invoked New York's Martin Act, which prohibits firms from using deception to sell securities. The broad scope of the Martin Act helped him win a court order that forced Merrill Lynch to reveal more about its investment banking operations.
"This was not a matter of taking a few bad apples out of the cart," Spitzer said. "There were incentives in place generating behavior that was endemic of what was wrong throughout the industry."
Merrill, the world's largest brokerage firm, has agreed to disclose potential conflicts regarding stock offerings for companies it follows. And, on Wednesday, the SEC will vote on rules proposed by the National Association of Securities Dealers and the New York Stock Exchange that would remove some potential conflicts.
But for many, the changes are too late.
Gary Del Piano, an East Orange pharmacist, filed a complaint with the NASD that he lost more than $400,000 because of Merrill's Internet research.
One of the stocks recommended to him, he said, was Internet Capital Group, a stock Merrill underwrote and one of the firm's top picks. A stock for which he paid $128 a share in early 2000 burst with the Internet bubble that spring and eroded to $30 a share, he said.
Today, ICG stock, which hit an all-time high of $212 in December 1999, trades for 40 cents a share -- a loss of 99.8 percent.
Del Piano said he relied on Blodget's research and the advice of his broker. "Henry Blodget kept talking the stock up even when it was in the $30s," he said, calling the stock "hyper-inflated."
Merrill Lynch called Del Piano's complaint "without merit" and said it will vigorously defend itself.
A DIFFERENT APPROACH
Prudential Financial no longer does investment banking, which is one of the reasons Michael Mayo joined the firm last year.
Mayo is 39 years old, slim and he eats nearly the same lunch every day at his desk -- a turkey sandwich, carrots and two pints of skim milk. He is known to be fiercely independent, so much so, Mayo said, that it is the reason he was fired in 2000 by Credit Suisse First Boston.
(CSFB said Mayo "was not terminated for issuing negative research. The decision to terminate Mayo was made solely by the management of CSFB's equity research department.")
After joining Prudential last year, Mayo slapped "sell" ratings on half the 18 banks he follows. He since has reduced "sell" ratings to four.
"People call me a maverick," said Mayo, who tries to be home every night to bathe his 21-month-old daughter, Lily. "I think I'm a traditional analyst, and the rest of the world is out of synch."
His ratings are anything but traditional. In 2000, fewer than 1 percent of the research reports on Wall Street were "sell" recommendations, according to the SEC.
On most days, Mayo gets on a 7:30 a.m. conference call with several Prudential analysts. Known as "the morning call," the meeting is like a radio broadcast about stocks for Pru brokers.
On one call two weeks ago, Mayo spoke for 30 seconds about an unconfirmed report that Citigroup was in talks this year to buy Deutsche Bank of Germany. Mayo said it makes sense for Citigroup, which is already "as big as Portugal," to expand in Europe.
Later that morning, he met with several Japanese investors and then checked in with a colleague listening to a Web cast for an out- of-state banking conference. He will listen to hours of canned presentations just to learn a bank is prepared to defend its market share in the Midwest at all costs.
Next, he heads up to the institutional trading desk and tries to lobby Tom Butler, the director of research, to let him talk on a morning call about whether the financial crisis in Argentina will spill into Brazil. Butler, who acts like a radio producer, tells him to simplify the message so brokers can easily explain it to their clients.
Mayo then approaches an institutional trader and asks if there was reaction to his Citigroup call.
"They found it intriguing," she said. Mayo smiles at the feedback.
"The image of a research analyst is that they sit in an ivory tower," he said, climbing the back stairway to his office. "But I like to talk to the traders and find out how we are doing."
FINDING THE CLUES
Analysts get their information from regulatory filings and by talking to competitors, suppliers and distributors. They study sales growth and expenses, then compare companies within the industry they cover.
They have traded slide rules for computer models that forecast a company's potential earnings and its stock-price-to-earnings, or P/E, ratio. Then, they predict stock price targets and establish ratings that can range from "strong buy" to "sell." Analysts write reports or research notes. Some are dry recitations of the numbers; others are more lively presentations that quote lyrics from singer Alanis Morissette.
Companies monitor the projections and what analysts say. In addition to their reports, analysts are quoted every day in newspapers around the world like this one. Those who don't play ball with companies can expect trouble, said Edward Stavetski, president of Pembroke Capital Management, a Wayne, Pa., money manager and a former analyst.
Mayo has faced his share of hostile receptions. He worked at four of the world's largest brokerages -- UBS Warburg, Lehman Brothers, CSFB and Prudential -- has an MBA, and trained at the Federal Reserve, the nation's central bank.
Still, nothing could have prepared him for life on Wall Street.
After rating a company's stock "hold" one year, he and his boss received an angry call from the company's chief financial officer, who shouted at Mayo and threatened to pull his investment banking business from their firm.
Mayo has been excluded from bank dinner meetings with other analysts and survived a disinformation campaign by one bank that told large investors he had not done his homework when he issued a "sell" recommendation.
"Within six months, I was proven correct" because of problems with the bank's earnings, Mayo said. His best call was when he predicted the end of the bear market for banks in 1994.
"My goal," he said, "is simply to be right."
LOOKING AHEAD
So what will the upheaval ultimately mean to the brokerage industry?
The cost is expected to easily top the $600 million in penalties paid by Drexel Burnham Lambert during the junk bond scandals of the 1980s, said David Hendler, an analyst with CreditSights Inc., an independent research firm in New York. The probe could cost Merrill Lynch nearly $2 billion in penalties, civil damages and lost business, Prudential brokerage analyst David Trone said.
Regulators and top officers of brokerage firms bear some of the blame for not maintaining the invisible wall between investment banking and research, according to Hendler. Small investors, he said, had about as much chance against the pros as sending "a kid from Little League to the major leagues and expecting him to hit the pitch."
Meanwhile, the NASD and NYSE have proposed rule changes on securities firms that would:
Prevent investment bankers from supervising analysts or approving reports.
Bar analysts from being compensated based on specific investment banking deals.
Ban the publication of favorable research reports to solicit business.
Increase disclosures of business relationships and ownership interests in companies.
Disclose a firm's stock picking record.
Restrict analysts from trading stocks they follow.
Spitzer said the proposed rules should completely bar analysts from receiving a bonus based on any of the firm's investment banking business. "The moment you compensate analysts for contributing to investment banking, you have a tension and a taint that will lead them to provide non-objective research."
Congress might have to take "legislative action to expand the jurisdiction of the SEC" over analysts, said Norman Ornstein, senior resident scholar for the American Enterprise Institute for public policy in Washington, D.C.
Mayo, for his part, wants an SEC clearinghouse so analysts can report retribution from companies they cover. That way, analysts can get back to being financial detectives for investors.
"Sometimes, I feel like Columbo," he said. "You know when something doesn't smell right."
Joseph R. Perone can be reached at jperone@starledger.com or (973) 392-4262.
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