. . . . Even Research Comes With Spin . . .
[Should be Re-Titled "Modern Day Anal-ysts are Highly Paid Touts"]
Grade inflation is so rampant on Wall Street that Arthur Levitt, chairman of the Securities and Exchange Commission, has accused analysts of sacrificing quality research to win investment-banking business for their firms.
Tuesday, August 1, 2000
By Miriam Hill
INQUIRER STAFF WRITER
Wall Street executives aren't known for shying away from four-letter words, but there is one you almost never hear from securities analysts: sell.
Almost no analysts recommend selling a stock. Less than 1 percent of 27,000 analysts' research reports on July 31 contained the S word, according to the research company First Call Corp. Two-thirds are rated "buys" or "strong buys." The rest are rated "hold."
Grade inflation is so rampant on Wall Street that Arthur Levitt, chairman of the Securities and Exchange Commission, has accused analysts of sacrificing quality research to win investment-banking business for their firms.
"Analysts have become a fixture on business pitches and investor road shows - doing their bit to market their own firm's underwriting talents and to sell a company's prospects," Levitt said in a recent speech.
"What's more, analysts' compensation is increasingly based on the profitability of their firm's corporate-finance division, and their contribution to the deals to which they are assigned.
"Needless to say, you can see how an analyst who recommends selling a client's stock because it's overvalued would not be terribly popular," Levitt said.
The men and women who recommend stocks for a living have always come under pressure to say nice things about the companies they cover. It smoothes the road with the corporate executives whom analysts need as sources.
Big brokerage firms have always encouraged their analysts to write positive reports to help win investment-banking business. Because investment bankers help corporations issue stock and debt and advise on mergers, positive research makes the deals easier to sell to mutual fund and pension managers and to individual investors.
But there was always a wall between the research and investment-banking departments.
Now, "that Chinese wall has so many holes, it's a piece of Swiss cheese," said Jeffrey C. Hooke, an investment manager in Washington, D.C., and the author of Security Analysis on Wall Street.
It's tempting to blame the apparent ethical deterioration on some broader decline in values. But the reality is that the role of the analyst at big Wall Street firms such as Goldman Sachs Group, Merrill Lynch, and Morgan Stanley Dean Witter & Co., has changed because the brokerage industry has changed. When commissions for buying and selling stocks were fixed, brokerage firms could count on big revenues from that side of the business. That helped pay for the research, said Tom Brown, who was a banking analyst for 15 years and who now runs a hedge fund, Second Curve Capital.
As commission costs were deregulated, discount brokers and then online brokers ate into those profits. At the same time, mergers and public offerings grew dramatically, swelling investment-banking revenues. Stock and debt offerings rose from $316 billion in 1990 to $2.1 trillion last year.
Brown said that when he was an analyst for PaineWebber Inc. and then Donaldson Lufkin & Jenrette Securities Corp., demands for him to spend time trying to win over investment-banking clients grew as the potential revenues did.
"The amount of time that you spent on pure research went down as you were expected to spend more time on the phone talking to clients and meeting with clients and potential clients directly," he said.
Investment-banking clients, he said, wanted to know that the analyst would write positive research that would help sell the stock.
Gradually, analysts' compensation changed. Bonuses were no longer based on the quality of the research or on how well the brokerage arm did. Instead, analysts' bonuses were based on how much investment-banking business they brought in. Each deal was worth $100,000 or more to the analyst, Brown said.
"It paid to exaggerate the positives and perhaps not tell the full story," he said. Brown, who was known for writing tough reports, lost his job at Donaldson Lufkin & Jenrette in March 1998, in part, he said, because investment bankers thought he was not positive enough.
A spokesperson for the firm said: "Our policy is not to comment on former employees."
Accentuating the positives can mean a lot of negatives for individual investors. Misleading research brings losses for investors who base stock purchases on it. Nary an analyst predicted the recent earnings slowdowns at such companies as Xerox Corp., MicroStrategy Inc., Nokia Corp., and Procter & Gamble Co. The earnings problems created millions of dollars in losses for shareholders in those companies.
John Rolfe, coauthor with Peter Troob of the new book Monkey Business: Swinging Through the Wall Street Jungle, about their years as investment bankers at Donaldson Lufkin & Jenrette, said analysts were crucial to winning important deals. Often, the successful firm was the one whose analyst put the highest valuation on the company. The higher the estimate, the more money raised and the greater the value of the stock for shareholders - including company executives.
"There were always fights between bankers and analysts," said Rolfe, a 1995 graduate of the Wharton School. "That's just part of the business. The valuation was usually a compromise, frankly. It depended on the stature of the analyst. If it was a respected analyst with a lot of clout, the analyst usually won. If it was a banker with a lot of clout, the banker usually won."
Even the best-known analysts admit that part of their job is catering to investment-banking clients.
"In the sell-side analyst job, there are four constituencies - institutional clients, retail clients, banking clients, and traders - each of which has different, though not always conflicting, expectations from the analyst," said Henry Blodget, the Internet specialist at Merrill Lynch who is a fixture on television investment shows.
"The best sell-side analysts, therefore, are those that find ways to balance the sometimes conflicting desires of the various constituencies in such a way as to be the most valuable to the widest variety of clients. We try to do this by aiming to do the smartest, deepest, and most useful fundamental analysis in our sector - by knowing our companies and the industry better than anyone else."
He acknowledged that he had never recommended selling a stock. The reason is the high quality of firms that Merrill researches and chooses to do investment-banking business for, he said.
Blodget and other Internet analysts have watched many of their picks melt down in the recent tech-stock slump. Pets.com Inc., an online seller of products for pets best known for the sock puppet on its commercials, for example, closed at $1.59 yesterday, 86 percent below the $11 it sold for in its February initial public offering. The only brokerage firms following Pets.com are those that underwrote the offering. All of them, Merrill included, have buy ratings on the stock.
Aware of the conflicts, money managers say they use analysts' reports for information only. They ignore the actual recommendation and target for the stock price. And if they are running enough money that they represent big trading business, they can find out what an analyst really thinks.
"Recommendations are so driven by these conflicts of interest," said Jeff Wrona, who runs the PBHG Technology and Communications Fund in Wayne. Friendly analysts will tell him whether an investment-banking relationship led to a positive recommendation. But individual investors, Wrona said, don't have that kind of access, so they lose out.
Academics in the last few years have documented the tendency of analysts to be overly bullish on the companies their firms have investment-banking relationships with. Research last year by Patricia Dechow, a professor at the University of Michigan's business school, found that analysts' recommendations became more upbeat at the time of equity offerings. The analysts who work for the firms that are the lead underwriters on the deal are the most optimistic, Dechow said.
And the problem seems to have gotten worse in recent years, according to Kent L. Womack, associate finance professor at Dartmouth College's Amos Tuck School of Business Administration. In the early 1990s, analysts made about six buy recommendations for every sell recommendation. Today, Womack said, the ratio has grown to around 50 to 1.
There is also evidence that analysts, overall, do a good job. A recent study by Brad Barber of the Graduate School of Management at the University of California, Davis, found that stocks receiving strong buy recommendations beat the average stock's return by a healthy 4.13 percentage points a year, suggesting that analysts do identify good stocks.
Does that mean you should listen?
No, said Barber. Buying highly recommended stocks only works if you immediately buy and sell when analysts suggest changes. But that creates such huge commission costs and taxes that it wipes out the higher returns.
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