07/24 02:00
Analysts That Investors Trust Don't Work on Wall Street
By Adam Levy
New York, July 24 (Bloomberg) -- In the time it takes Philip Orlando to eat a sandwich for lunch, more than 30 e- mail messages have lit up his computer screen -- all pitches from Wall Street analysts touting stocks. After lunch, Orlando, chief investment officer of Value Line Asset Management, which manages $6 billion, deletes them all.
``I really don't use this stuff,'' Orlando says from his Manhattan office. ``There are too many conflicts of interest, and the research just doesn't add much value.''
Well before the stock market peaked in March 2000, institutional investors such as Orlando had given up relying on the big Wall Street brokerages for insight into companies -- and for the best of reasons. Even though the five largest brokerage firms spend as much as $1 billion a year each on research, they can't beat the stock-picking results of much smaller, independent research boutiques.
Only six of the 28 firms that provide research on at least 500 stocks had posted gains in the past 12 months, according to rankings by Investars.com, an online investment information service. All six are small, unheralded research firms with a nothing-but-the-facts approach.
Investors cite additional reasons to shun the megafirms. Analysts such as Merrill Lynch & Co.'s Henry Blodget, Morgan Stanley's Mary Meeker and Salomon Smith Barney's Jack Grubman emerged as household names in the bull market 1990s, when the ranks of amateur investors swelled.
Star System
Institutional investors grew wary of that star system -- and of the conflicts between analysts' recommendations and the investment banking business their firms pursued.
``Wall Street research is biased, unreliable and not exclusive, and I ignore most of it,'' says Nikos Monoyios, who invests $17 billion at OppenheimerFunds Inc. in New York.
That attitude has become more widespread in recent months as regulators question whether analysts have become marketing shills for more-lucrative investment banking operations.
In May, Merrill, Wall Street's biggest securities firm, agreed to pay a $100 million civil penalty to settle New York Attorney General Eliot Spitzer's probe into whether the firm's supposedly independent research had instead been geared toward winning banking business.
Now, Spitzer is investigating Morgan Stanley and Salomon, according to Darren Dopp, a spokesman in his office.
Analysts' Conflicts
The U.S. Securities and Exchange Commission has opened 10 investigations into analysts' conflicts. Officials at the National Association of Securities Dealers and the New York Stock Exchange say they're looking into more than three dozen cases.
More than 30 fraud lawsuits have been filed against Merrill Lynch alone, according to an analysis of court records.
The long-standing relationship between analysts and investment banking had drawn little scrutiny until stocks collapsed from their highs, causing some $4 trillion in losses, much of it in stocks that Wall Street analysts had touted. Enron Corp., Tyco International Ltd. and WorldCom Inc. alone have accounted for $175 billion of investor losses in the past year.
Prescient Advice
Much smaller research firms, meanwhile, were handing out more prescient advice. A prime example is Callard Asset Management, a two-person research boutique on the eighth floor of the old Lumber Exchange Building on Chicago's LaSalle Street.
Callard -- run by Charles Callard, a 79-year-old former statistics professor, and Ricardo Bekin, a 39-year-old Brazilian analyst -- has trounced Wall Street at the stock- picking game.
Its stock recommendations rose 7.5 percent during the 12 months ended July 23. Merrill Lynch's picks dropped 14 percent during the period; Lehman Brothers Holdings Inc.'s fell 21 percent, according to Investars.com, which compiles a computer analysis of stock recommendations.
Callard, in a report to its clients last August, said Global Crossing Ltd. was overpriced. The telecommunications company filed for bankruptcy in January, and its shares closed at 5 cents on July 23, down more than 99 percent.
Dead-On in February
Callard was dead-on in February, when it spotted trouble at Adelphia Communications Corp., then $22 a share.
The cable company filed for bankruptcy June 25, and its shares sold for 13 cents on July 23.
Callard's best call was in an Aug. 14, 2001, report to clients recommending they sell Enron, then $42.11 a share. The next day, Goldman Sachs Group Inc., Lehman and UBS Warburg LLC reiterated their buy ratings. Enron filed for bankruptcy on Dec. 2, and its shares traded for 9 cents on July 23.
The firm's white-haired founder, Chuck Callard, doesn't look the part of a market guru. Dressed one day this past June in a yellow shirt with a white collar and an ink stain from a pen that had leaked inside his chest pocket, Callard said his firm combines financial theory with financial management.
Slowly and Deliberately
Callard talks slowly and deliberately, and he rarely finishes a thought before moving on to a new topic. Bekin, who's been with Callard for about 10 years and who's involved in stock valuation modeling and portfolio construction, finishes every other sentence his partner and mentor starts.
``Stated briefly, stock prices are determined by future cash flows and the cost of capital,'' says Bekin. ``Fact is, most major market changes over the past 100 years have been driven by changes in the cost of capital.''
As Callard and Bekin see it, when the cost of capital is high, as it was during the 1930s and 1970s in the U.S., most companies have difficulty expanding, earnings shrink and stock prices fall. When the cost of capital is low, as it was during the 1990s, the opposite happens and stocks rise.
For years, Callard toiled in obscurity. The firm's office is disheveled -- with threadbare chairs, scuffed walls, a buzzing air conditioner and wires and phone lines hanging from the ceiling.
Reams of Data
Callard produces reams of data that show its portfolios outperforming benchmark stock indexes; for instance, Callard's Small Dynamic portfolio has beaten the Russell 2000 Index by more than 700 percent since the start of 1999, and its medium-size-stock picks are up more than 70 percent relative to the Standard & Poor's 500 Index.
The firm's customers say they know the results are no fluke. In August 2001, Dana Merrill, who invests $180 million at his Boston-based investment firm, Trust & Fiduciary Management Services, did as he always does: He ignored Wall Street's Enron call and heeded Callard's advice to sell the stock.
Enron's former Chief Executive Officer Jeffrey Skilling resigned the same day Callard issued its report; Enron was still two months away from revealing billions of dollars in hidden debt that would lead to its December bankruptcy filing.
`That Doggone Stock'
``I lost a little on that doggone stock,'' Merrill says. ``If I'd listened to Wall Street, it would've been a different story.''
Callard is buoyed by -- and hopes to capitalize on -- the attention investors are paying to some of its recent picks. Once a research-only concern, the firm now also has an asset management arm that invests in securities for both individuals and institutions.
The firm plans to launch a hedge fund within months so it can capitalize on its stock-picking system; Chuck Callard is chipping in half a million dollars.
``It's about time the tide has shifted to the people who actually crunch the numbers and make stock picks that work,'' Bekin says. ``Of course, it would be nice to benefit from that. I mean, I read Blodget made $12 million in his last year at Merrill.''
More Than Callard's Revenue
That was more than Callard's revenue last year, he adds.
Peter Sidoti also plans to cash in on the demand for independent research. Sidoti, a former Drexel Burnham Lambert Inc. researcher, left his job as a small-company stock analyst at Schroder & Co. in 1999 to set up his own firm.
Today, Sidoti & Co., a New York-based firm with 31 analysts, provides research for institutional clients on 200 small, profitable companies overlooked by Wall Street because, he says, they aren't likely to generate big banking deals anytime soon.
Sidoti says he wants to expand the firm's number of analysts by two-thirds in the next two years and triple the number of companies they cover -- while steering clear of doing banking deals.
The trick, he says, is to develop a loyal following of customers such as Blum Capital Partners LP, a San Francisco-based investment firm with $5 billion in assets run by investor Richard Blum.
Blum and other customers are willing to pay as much as $500,000 a year for the firm's research.
Pizza Maker Papa John
So far, Sidoti's results appear to be valuable. His list of stock picks, which includes companies such as pizza maker Papa John's International Inc., Pegasus Solutions Inc. -- an operator of hotel reservation systems -- and retailer Petsmart Inc., returned an average of 15.4 percent during the 12 months ended July 9, according to the firm.
Another firm, Gerson Lehrman Group in New York, charges clients a minimum of $50,000 every six months to put them in touch with independent consultants and industry experts, thereby allowing investors to get specific questions answered and glean insight into health care, technology or energy issues.
``I've found Wall Street analysts and company managers are not the best sources of information,'' says John Raitt, a Gerson Lehrman client and head of research at Harris Associates LP in Chicago, which invests $24.5 billion. ``I need unique and unbiased feedback.''
In mid-June, Raitt considered buying stock in an oil and gas exploration company that appeared undervalued because investors hadn't accounted for certain potentially valuable methane gas reserves in the western U.S.
`Shading the Truth'
``Wall Street isn't objective, because it just wants to sell stocks,'' he says. ``Management is just as bad, always shading the truth to the positive.''
Raitt hired Gerson Lehrman, which pays industry experts such as a former Nevada public utilities regulator as much as $500 an hour to consult with its clients.
``Gerson put me in touch with an expert who did studies and provided me with impartial, objective, evenhanded facts,'' Raitt says. ``That's easily more valuable than a 10- foot-high stack of Wall Street reports.''
Raitt declined to identify the company because as of late June, he was still deciding whether to invest.
In November 2001, Gerson Lehrman surveyed 50 cardiologists in private practice so it could gather insights for a client into a cholesterol-level monitoring device manufactured by Cholestech Corp.
Cost Prohibitive
The findings showed that most cardiologists said they'd never heard of the product and that the ones who had thought the technology was cost prohibitive. The client shorted the stock, which lost half its value from November to March 2002, falling to as low as $10.82 in February from $25. Cholestech shares closed at $9.41 on July 23.
Gerson Lehrman had revenue of $10 million last year, and, says Chief Executive Mark Gerson, 29, sales will likely reach $25 million in 2002. After graduating from Yale Law School, Gerson cofounded the company with Thomas Lehrman, who'd been with Julian Robertson's Tiger Management LLC.
Some of the independent research firms are run by former Wall Street star analysts. One of them is Peter Marcus, who founded World Steel Dynamics in 1999 after 28 years of covering the steel industry at Paine Webber Group Inc. McDep Associates analyzes oil and gas stocks by using a formula developed by its founder, Kurt Wulff, a former Donaldson, Lukfin & Jenrette Inc. analyst.
McDep Ratio
Wulff generates the so-called McDep ratio, which compares a company's market value and debt with the present value of other energy business; McDep stands for market cap and debt to present value.
Beacon Street Research in Atlanta uses a formula that weights sales and earnings along with current assets and liabilities, debt, equity and other factors according to their importance to growth.
The firm doesn't bother consulting the management of companies it's looking at. ``I wouldn't waste my dime calling up a company,'' says President Terry Burke, 57. ``Management either is going to be overly positive or give off false signals. I just stick to their reported numbers.''
Burke, whose entire career has been spent analyzing Companies -- first as an accountant and later as founder of a financial consulting firm -- points to the winter of 2000.
19 of 19 Analysts
Executives at Corning Inc., the world's leading maker of optical fiber for phone and computer networks, were brushing off concerns that fiber demand might slow. Wall Street analysts bought into the company line, and 19 of 19 Wall Street analysts rated the stock a buy.
Burke's models told a different tale. In the third quarter of 2000, Corning's sales and earnings were up from the previous quarter: 8 percent and 7 percent, respectively.
Still, Burke says, he spotted signs that Corning's business was cooling; its accounts payable had risen to $506.8 million from $445 million in just three months, and its accounts receivable, which had risen 40 percent in the first half of the year, increased just 6.2 percent in the third quarter.
When the future looks dim, Burke says, companies usually extend their accounts payable, pull in their accounts receivable and cut spending to raise cash and pay off debt.
``This is a clear indication of retrenchment and not growth,'' Burke says.
A Sell Signal
And it provided a sell signal. Corning stock traded at an average price of $86 a share, according to Bloomberg analytics, during the third quarter of 2000, when Burke put his sell rating on the shares. Corning shares sold for $3.17 on July 23.
Former American University accounting professor Howard Schilit has been on top of the cottage research industry for years. Schilit started the Center for Financial Research and Analysis in Bethesda, Maryland, with two partners in 1994, mining financial statements for accounting improprieties.
Investors such as Joe Stocke, chief investment officer at StoneRidge Investment Partners in Malvern, Pennsylvania, and Michael Orkin, fund manager at Caldwell & Orkin Inc. in Norcross, Georgia, credit Schilit with being the first to spot problems at MicroStrategy Inc.
$52.5 Million Agreement
Schilit, 50, saw trouble with MicroStrategy's $52.5 million agreement with NCR Corp. back in October 1999. MicroStrategy, a business software maker, had agreed to sell $27.5 million of software and services to NCR, the largest maker of automated teller machines, and at the same time agreed to buy $25 million worth of products from NCR.
MicroStrategy accounted for the transaction by booking $17.5 million of revenue. The company said it had received the payment during the fourth quarter -- even though it had booked it during the third quarter.
That raised a red flag for Schilit, who alerted his customers. MicroStrategy stock soared to as high as $333 in March 2000 from about $40 a share in October 1999 before plummeting. It sold for 48 cents on July 23.
Schilit says he watches for sudden changes in accounting practices, such as recording revenue too soon, boosting revenue with onetime gains or shifting current expenses to a later or earlier period.
Seven Onetime Charges
As recently as May 2002, Schilit slammed 3M Co. for taking seven onetime charges in a row. ``I wasn't an English professor, but my understanding of onetime isn't something that occurs seven times in a row,'' he says.
Today, Schilit has 14 researchers, an office in London and almost 500 clients, including big money managers such as Fidelity Investments and Putnam Investments. He charges a minimum of $3,000 a month -- and as much as $20,000 a month -- for his thrice-weekly reports, bringing in more than $22 million a year in revenue.
He says his business is up 50 percent in the 12 months ended July 9. He's added 10 new clients every month during the past two years, and business really picked up after Enron filed for bankruptcy in December. It doubled in January and quadrupled in February.
Schilit plans to introduce this coming autumn a service that analyzes Asian stocks. ``If Wall Street did what it was supposed to do -- analyze financial statements -- I'd still be teaching class,'' Schilit says. ``Instead, I have a nice, a very nice, business.''
Increasing Clout
Because of their track record, independent researchers like Schilit are demonstrating increasing clout in the marketplace.
Just ask Qualcomm Inc. On Feb. 8, Schilit issued a report stating that the mobile telephone chip maker had booked as revenue $11 million of stock in startup companies. Qualcomm defended its practice, saying it had complied fully with accounting standards.
Investors were spooked. Qualcomm stock dropped as much as 11 percent -- to a two-and-a-half-year low -- within hours of the report's release.
``You can't underestimate what Schilit does,'' says Orkin, a Schilit customer who invests about $500 million for several funds, including the Caldwell & Orkin Market Opportunity Fund. ``It's very cut-and-dried research; it's reading all the numbers and the footnotes. Of course, all analysts should do this, but they don't. All we want is honest analysts, and it's not easy to find them.''
Independent Conclusions
Wall Street researchers used to visit companies, gather their own data and draw independent conclusions. Investors paid for research with trading commissions, buying and selling stocks through the brokerages that generated what they perceived as the sagest advice.
Things started to change after the Big Bang, the day in 1975 when the SEC ruled that brokerage firms could no longer fix trading commissions. The subsequent competition began to drive down the profit margins for trading, and Wall Street started to make more money from new stock and bond sales and mergers.
Today, trading commissions cover only, at most, half of the costs of research for major Wall Street firms, says Sallie Krawcheck, chief executive of Sanford C. Bernstein & Co., a research and brokerage firm that caters to 5,000 institutional clients.
Sanford C. Bernstein, a unit of Alliance Capital Management LP, doesn't do investment banking.
$10 Billion in Fees
During the 1990s, fueled by the Internet boom, Wall Street firms earned $10 billion in fees, raising a quarter of a trillion dollars in taking 1,300 companies public, according to Bloomberg analytics. Research played a pivotal role in helping banks snare more business.
``Research does a lot of really good things for investment banking,'' says Goldman Sachs Vice Chairman Robert Steel. ``Sometimes we get the initial public offering because analysts get to the company first; sometimes we turn business down because analysts tell us it's not a good company.''
Wall Street ramped up, hiring hordes of analysts. In 1988, Donaldson, Lufkin & Jenrette -- which Credit Suisse First Boston acquired for $13.4 billion in 2000 -- had 32 analysts.
Now, Credit Suisse has more than 280, according to its Web site. Some firms are far larger: Morgan Stanley employs more than 500 analysts today, and Merrill Lynch has about 800.
The Top Five
For big securities firms and some analysts, that expenditure has paid off. Last year, the top five underwriters issued 73 percent of all U.S. stock offerings compared with 45 percent in 1994.
At Merrill Lynch, Internet analyst Blodget either helped pitch deals, market offerings or write research reports for 52 investment banking transactions -- one a week, on average -- from December 1999 to November 2000, according to documents released in the New York attorney general's investigation into Merrill.
Merrill earned $115 million in fees from those deals. Blodget's contract got ripped up and replaced with a much sweeter deal: His guaranteed minimum cash bonus increased to $12 million for 2001 from $3 million in 1999, according to documents released by Spitzer.
Some analysts say their work was swayed heavily by investment banking concerns.
`Fed Up With the Games'
``I was fed up with the games on Wall Street, being told I could not cover companies in my coverage universe because of investment banking relationships,'' says Gary Craft, who left Deutsche Bank AG's Deutsche Banc Alex. Brown unit last year.
Craft says his bosses told him he was prohibited from covering certain companies if they believed he was going to write a negative report. In other cases, he says, he was told a company should have a positive rating.
In November, Craft opened Financial DNA, a San Francisco-based independent research firm that specializes in financial technology companies and markets.
Christine Cortezi, a spokeswoman at Deutsche Bank Securities, declined to comment about Craft's allegations. At Financial DNA, Craft and his team of three analysts avoid ratings altogether.
Instead, they analyze market conditions and a company's performance to determine long-term trends.
Too Optimistic
In early June, Craft issued a report saying Wall Street's estimates for First Data Corp. were too optimistic because increased competition and price gouging in the international money-wiring market would hurt its Western Union division.
Craft predicted a 10 percent growth rate instead of the 15-20 percent that Wall Street analysts were predicting. ``We're not saying buy or sell the stock,'' he says. ``We're giving you our analysis of the long-term growth rate.''
New York Attorney General Spitzer homed in earlier this year on the close ties between bankers and researchers.
In court papers filed in April 2002, he accused Merrill analysts of being ``quasi-investment bankers for the companies at issue, often initiating, continuing and/or manipulating research coverage for the purpose of attracting and keeping investment banking clients.''
Spitzer released e-mails in which analysts such as Blodget, who quit Merrill in November 2001, had privately disparaged companies they were simultaneously recommending to investors.
Banking Relationships
The e-mails also indicated that banking relationships influenced Merrill's ratings.
As part of Merrill's settlement with New York, investment bankers will no longer have a say in analysts' compensation. The agreement stopped short of barring analysts from joining bankers when they solicit business from potential clients.
``I don't think the settlement changes the way Wall Street operates or eliminates the inherent conflict of interest,'' says Bruce Simon, who oversees $18 billion as chief investment officer at Glenmede Trust Co.
Nor is the $100 million fine likely to change Merrill's behavior, says William Federman, an Oklahoma City attorney who's representing former Merrill brokers and clients in a class-action lawsuit against the firm.
Postage Stamps
The $100 million is less than one-third of what Merrill spent on office supplies and postage stamps last year, according to its most recent annual report.
Federman says his clients alone have claims totaling $28 million, or more than a quarter of the settlement amount. ``One hundred million dollars is nothing,'' Federman says. ``It lets the brokerage firms make an economic analysis of the cost of doing business this way.''
Seasoned investors say they're skeptical about whether Spitzer's campaign will change much on Wall Street. Orlando, the Value Line Asset Management investment officer, says no scandal, no fine, no battery of investigations is going to free Wall Street's research from its more lucrative businesses.
``I'm going to continue to look at all reports from Wall Street with a jaundiced eye,'' he says. Orlando adds that he's also quite sure his attitude won't stop Wall Street from bombarding him with e-mails about the latest hot stock tip. |
