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Blame the pundits
After the dot bombs, Wall Street has a credibility problem
By Paul Sloan
Henry Blodget is having a really, really bad year. First came the dot-com crash: Blodget, Merrill Lynch's superstar Internet analyst, watched with horror as nearly every stock he had been promoting collapsed last spring. Then there's the Amazon.com problem. Blodget's career took off after he slapped an outrageous but prescient $400 price target on Amazon.com in December 1998, back when its stock was trading at $243. But the Web retailer's shares have since fallen off a cliff. And let's not forget the downgrades. In August, Blodget finally showed some doubt about Internet stocks, slashing his ratings on more than a third of the stocks he covers. The response: Well, to be perfectly frank, there really wasn't one. The stocks barely budged; some even rose.
So much for the stock-picking acumen of Wall Street's top Internet guru, the man Merrill Lynch poached from Oppenheimer for a reported $4 million after his bold Amazon prediction came true in just three weeks. That, of course, was the dawn of the spectacular dot-com stock run-up. But now that the glory days of Internet investing are gone, and the stock market is on track for its worst year since 1994, it's not just Blodget's reputation that's on the line. Where were all the other analysts, critics ask, before Web stocks began their rapid descent? Why has Mary Meeker, the celebrated Internet analyst at Morgan Stanley Dean Witter, downgraded just three stocks in the past three years? And how can it be that even in this lackluster market, "buy" ratings still outnumber "sell" ratings by a ratio of 100 to 1?
Wall Street, in short, has a credibility problem. Its boosterish ways are coming under renewed attack as individual investors learn the hard way that analysts–the pundits who talk up stocks in the papers or on TV–serve many masters. And you, dear reader, are seldom one of them. Worried that self-dealing among research analysts, their investment houses, and their major clients will turn off ordinary investors, the Securities and Exchange Commission has begun taking steps to break up the clubby relationships. Among other things, the SEC is looking for ways to ensure that conflicts of interest are disclosed when analysts tout stocks on TV.
Solid as Jell-O. How did we reach this pass ? Analysts' careers, once tied to the quality of their research, increasingly hinge on their ability to lure new customers. Most spend as much time talking with potential clients as they do researching companies. And as stock pickers, they often act like marketing agents, pushing stocks in which their firms have a stake, or would like one. "People need to realize that these reports and recommendations are advertising," says Kent Womack, finance professor at Dartmouth College's Tuck School of Business. The Street once spoke of the "Chinese wall" between the research and sales arms of a brokerage. But now, says Jeffrey Hooke, an investment banker and author of Security Analysis on Wall Street, that wall "is about as solid as a bowl of Jell-O."
It's not at all uncommon for big-name analysts like Blodget to help bring a company public and promote its stock once it hits the market–sometimes to the detriment of investors. Consider the poor souls who bought shares of Pets.com on Blodget's recommendation. Merrill Lynch took Pets.com public in February at $11 a share. The stock briefly reached $14, before beginning to fall. Then came what Womack calls the "booster shot"–the moment the analyst at the underwriting firm steps forth to urge the public to buy the ailing stock. (This typically occurs 25 days after the IPO, he says, when the SEC-mandated "quiet period" expires.)
True to script, Blodget put out his buy rating on March 8, 27 days after the IPO, predicting Pets.com would shoot up to $16 a share in 12 to 18 months. At the time, the stock was trading at about $7. Blodget's "booster shot" kicked it up as much as 50 percent within a couple of days. But the Blodget effect faded fast. In April, with Pets.com hovering around $2.50, he reiterated his "buy" rating. The stock continued its descent.
That's pretty typical. A recent study by Womack and Cornell University finance Prof. Roni Michaely found that the effect is invariably short lived when an analyst at the underwriting firm touts a stock. The recommendations of brokerages without ties to the company tend to be better–their picks rose an average of 3.5 percent within a year. Stocks recommended by the underwriting firm, by contrast, declined 11.6 percent over the same period.
By the time Blodget lowered his rating in August, Pets.com was trading at about $1.40. Like other faltering dot-com stocks, it's now at risk of getting thrown off the Nasdaq because, now trading at less than a buck, it barely meets the listing requirements. "Obviously you don't want this to happen," Blodget says of the stock's collapse, "but I feel like we were careful" in warning investors of the risks. (Blodget had in fact pointed out that Pets.com was running out of cash, for instance.) He dismisses the notion that his analysis is somehow tainted because of Merrill's banking relationships. "I think the issue of conflict is overblown," he says. ". . . I just feel like the objectivity is there." The downfall for Pets.com, he points out, came with the abrupt reversal in investor sentiment.
Meeker, whom Barron's dubbed the Queen of the Net last year, is also unapologetic about her dual role as stock analyst and deal maker. When Morgan Stanley's bankers were working on AOL's takeover of Time Warner last January, they summoned her early on a Saturday morning to help sell the deal. Sporting a running suit, the star analyst bicycled across Central Park to attend the meeting. Ultimately, Meeker helped convince Time Warner's board of directors that selling out to AOL was the right thing to do.
Clearly, the days of analysts toiling in obscurity are over. In fact, their media persona has become a crucial part of the job–especially for analysts trying to gain the stature of a Meeker or a Blodget. It's important for their careers that money managers and corporate clients perceive them as prestigious. So while analysts hope to deliver profitable investment advice for the masses, that's often not their priority. "The reason we go on CNBC and talk to the press is that we need to reinforce to our clients that we're influential," says Abhishek Gami, an Internet analyst with William Blair & Co. While Gami is aware of the power his words can have on individual investors, he says, "My job is not to tell the general public what to do." Still, should Gami's on-air analysis move a stock, he won't complain. "The more you move the market, the more companies will be cognizant of you," he says.
That in turn helps land new business, says former Credit Suisse First Boston Internet analyst Lise Buyer. When she was promoting clients on CNBC, Buyer admits that she was also appealing to potential customers. Giving investment advice to viewers, she acknowledges, is not a priority. The irony, she points out, is that Internet stocks were driven mainly by individuals, so "speaking to the public turned out to be very important." Buyer compares the analysts' job with "walking a tightrope while juggling," because you're trying to maintain credibility while keeping all your masters content–the money managers, the corporate clients, the investment bankers. "In general, analysts really try very hard to do the right thing," she says. "To offer the best analysis possible to the most people in a fairly distributed way. Having said that, paying clients get better service and corporate clients get treated with white gloves."
Arthur Levitt, the chairman of the SEC, decries what he calls a "web of dysfunctional relationships" between Wall Street analysts and companies they cover. But any SEC proposal to disclose potential conflicts of interest is likely to run into resistance. Loath to let the government tell them how to handle news, television managers argue that the burden to disclose conflicts should be on the guests–not the news organizations. Analysts, on the other hand, say they're at the mercy of producers, who often boil their interviews down to 15-second sound bites.
Other changes in the system are already underway. On October 23 the SEC will begin forcing companies to disclose stock-moving information to wider audiences, so individual investors can get it at the same time as the pros. While much research is available on the Internet, the best tidbits analysts glean go to their biggest clients first. Jeffrey Bronchick, a fund manager at Reed, Conner & Birdwell, says individual investors are "the last people in the world who should pay one iota of attention to what Wall Street analysts think. They are at the bottom of the food chain."
Some argue that the new regulation will create confusion if companies, fearful of violating the regulation, issue press releases on even the smallest bits of news. But the main concern among analysts is that they'll be cut off from the one-on-one chats with CEOs and top executives that sometimes land them information rival analysts don't have.
All about access. John Coffee, a Columbia University law professor who specializes in securities law, says that's precisely why the regulation will improve the quality of Wall Street analysis. Coffee believes that eliminating private discussions between top CEOs and select analysts will remove one incentive for analysts to issue glowing reports–"saying a stock's a dog obviously won't get you access to a company," he says. But analysts will always feel some pressure to put out positive reports about clients of the investment bankers down the hall.
The backlash against Wall Street is playing out on the Internet. A number of new sites have begun rating the analysts. San Francisco-based StarMine, for instance, just launched a service that uses a huge database of past earnings estimates and stock recommendations to try to sort out which analysts are worth paying attention to. And IDEAglobal.com, a research firm, trumpets the fact that its analysts are not allowed to own stocks.
Ultimately, the chances are slim that a new breed of analyst–one that cares about small investors–will work on Wall Street. Pure research just doesn't pay the bills. But analysts' careers will still rise and fall with the stock market. As they say on the Street, an analyst is only as good as his last call.
That's why Blodget continues to take heat from his recent downgrades. For the first time, Blodget hung "neutral" ratings on two companies, eToys and Barnesandnoble.com. The rating is Merrill Lynch's way of saying "stay clear." Unfortunately for Blodget, both stocks have since soared–eToys up 35 percent, Barnesandnoble.com up 37 percent. Blodget says his goal "wasn't to say here's what the stocks were going to do the next month or two." But it sure would have helped if they had gone the way he predicted. |
