Wall Street Prophets
Public Unaware Of Conflict Of Interest For Stock Analysts
Their Wall Street Firms Often Take Companies Public
And Have Stake In Very Firms They Report On
Jan. 30, 2001
(CBS) If you're like many people you lost a lot of money in the stock market lately whether you traded yourself or just watched your 401(k) dwindle.
A lot of that money was lost following the advice of Wall Street stock analysts, the experts who work for big brokerage houses. Think of them as the prophets of Wall Street. They analyze a company, look into the future and recommend whether to buy the stock.
So how did so many get it wrong? Many investors don't realize that some high-profile analysts and their firms stood to make a fortune on stocks they recommended. A lot of their advice was tailored to make them rich, not you, as Correspondent Scott Pelley reports.
"I don't know frankly how some of these analysts live with themselves," says former analyst Tom Brown. "I couldn't get up in the morning and look in the mirror and know that I just caused somebody to lose 50 percent of their retirement money because I exaggerated and lied. And that's exactly what I saw at DLJ."
Forty-two-year-old Brown worked at the Wall Street firm Donaldson, Lufkin & Jenrette for seven years. He was a top banking analyst with a reputation for blunt honesty. Brown says he recalls a DLJ meeting where an analyst explained their job was to make the stocks they represented look good.
"The line was, 'You have to understand; forgive me, Father, for I have sinned,'" Brown says. "You were going to have to go back to the sales force after having lied to them and tell them that you were wrong."
If there is pressure to lie, it stems from a very simple conflict of interest. Wall Street's brokerage houses make 70 percent of their profits from what's called investment banking: raising money for companies that need cash.
For example, when Amazon needs money, it goes to its broker, Merrill Lynch. And Merrill Lynch offers Amazon stock for sale.
The higher the price, the more the brokerage makes. Now imagine what the analyst is going to tell the public about stock his or her firm wants to sell.
"They really are cheerleaders," Brown says, noting even if analysts cover a company that's not a client of the firm, it could be a potential client. "So the investment banking group wants you to be wildly bullish about everybody."
So if there's bad news about a stock, you're not likely to hear it from the analysts. A 1999 study from Dartmouth College and Cornell University says analysts showed "significant evidence of bias" when they recommend stocks handled by their firm. The study points to an internal company memo from brokerage house Morgan Stanley that tells analysts, "We do not make negative or controversial comments about our clients." Morgan has disavowed that memo.
Recently, though, Morgan Stanley made millions in fees raising money for Priceline. Morgan's analyst, Mary Meeker, recommended buying Priceline's stock at $134 a share.
When it fell to $78, she repeated her buy recommendation. And she kept recommending Priceline as it fell to less than $3.
Are analysts free to be critical of clients of their firms?
"I don't think analysts are so free since I was fired for being critical of, not only clients, but potential clients," Brown says.
Brown was very critical "in the 1995 to 1998 time frame of the mergers and acquisitions activity that was taking place among the largest banks," he says.
"I frankly thought they were paying too much and that they were using unrealistic assumptions and that shareholders were going to be hurt," he declares.
Brown says he was fired because those banks he criticized stopped doing business with DLJ. The company told 60 Minutes II that Brown was fired because of "his persistent inability to operate effectively within a team infrastructure." DLJ insisted there is a separation between investment banking and analysts, and said its analysts are encouraged to be candid.
Brokerage firms say analysts disclose their conflicts of interest in every research report they write. (It's those paragraphs of small print, at the bottom of the page.) Disclosures like these are not good enough for Arthur Levitt, chairman of the Securities and Exchange Commission, in charge of enforcing the law on Wall Street.
"I think the analyst has a responsibility to reveal a conflict of interest. And that's something that the commission is urging upon the stock exchange...to see to it that their rules are changed in a way which will force the analysts to reveal conflicts," Levitt says.
"There's got to be much greater disclosure of the kinds of conflicts that are part of today's market." Adds Levitt: "I'd say it's less than moral."
One result of these conflicts was the inflation of so-called target prices, analysts' predictions of how high a stock would go. In the wildly speculative Internet market, analysts set inflated targets with no connection to a company's real worth.
The setting of target prices has "been a practice as long as we've had analysts," Levitt says. "If investors are prepared to take that at face value, they have to be prepared for the consequences," Levitt says.
For example Amazon was selling for about $275 a share when a little-known analyst, Henry Blodgett, predicted it would go to $400 - even though Amazon had never made a profit. Amazon did go to $400 and beyond.
Amazon's backer, Merrill Lynch, responded by replacing its pessimistic Amazon analyst. His replacement? Henry Blodgett. While this was great for Blodgett, it proved not so good for investors, many of whom got soaked when Amazon's value fell 75 percent.
Blodgett has said his prediction was based on sound analysis using new ways to measure a company's performance. Wall Street coined a new verb: to "blodgett" a stock.
Former Internet analyst Lise Buyer says experienced hands on Wall Street couldn't make sense of soaring target prices.
"Those of us who've been in the business for a while looked at the wild targets that people were putting out there, and our jaws dropped," says Buyer. "And then we watched the stocks follow suit."
"The market that we had over the past couple of years: Amazon went to 400 because Henry said it would," Buyer says. "It was analysts proclaiming what the stock would do, not analyzing what the businesses said they would do."
One of the differences during the latest stock market frenzy was the success of cable business channels. The shows needed guests; so the analysts became TV stars.
Many appear on CNBC's Squawk Box, hosted by Mark Haines. After a stock was recommended by a guest, he says, "I'd look down at the quote machine, and all of a sudden it had jumped five bucks or 10 bucks."
Thousands, new to investing, were watching the analysts with no idea that a conflict of interest might exist on the stocks they were recommending. CNBC now requires its guests reveal conflicts of interest before they appear.
"When CNBC started 10 years ago, it had a relatively small audience that was almost entirely professional," Haines says. "There was no need to point out these relationships because our viewers knew about them."
"As the audience broadened, more and more and more people were coming to this not knowing the rules," he says.
One of the rules that many analysts live by is never say "sell," because that would drive down the price of the stock. Currently there are about 8,000 analyst stock recommendations, according to Zacks Investment Research, and only 29 sells. That's less than one half of 1 percent.
"You rarely see sell," Buyer says. "It angers management; it doesn't help institutional investing clients....So what you say is, 'We're downgrading this to a 'hold' and believe it promising for those with a three- to five-year investment horizon,' which, for those in the know, means, 'See ya.'"
Not even a company's imminent collapse could force analysts to say sell. Much of Pets.com's financing was raised by Merrill Lynch. Merrill made millions. Merrill's analyst Henry Blodgett made a buy recommendation at $16. When it fell to $7, Blodgett said "buy" again. Again a "buy" at $2 and again at $1.69. When it hit $1.43 a share, Blodgett told investors to "accumulate." Pets.com was recently kicked off the stock exchange.
Investors may have lost a fortune, but last year Blodgett and Meeker were paid about $15 million each. Both analysts declined requests for interviews.
Merrill Lynch, Blodgett's firm, did send 60 Minutes II an email saying its analysts "make independent recommendations based upon their best judgments."
Mary Meeker at Morgan Stanley sent a statement saying, in part, "We maintain a strict separation of the (investment) banking and research functions within the firm. Our research is objective and has a long-term focus."
Buyer, the former Internet analyst, defends most of her former colleagues. She says some analysts work for firms without investment banking clients, and others can take the heat.
Haines notes, however, that investors ignored warnings before the Nasdaq's dramatic drop, even when there were clear indications a company was vulnerable.
"We would invite on the CEOs, and we would interview them, and we would say, 'Do you have any patents?' And they would say 'No.' 'Well, would it be hard for me to go into business to compete with you?' And they'd say 'no,'" Haines says.
"'Do you have any cash?' 'No.' And I'd look down, and the stock would be up $40," observes Haines.
"You would point out the risks; you would point out how crazy it was. There was a mania going on out there where people were just throwing money," Haines adds.
And Haines says investors didn't seem to listen when he pointed out analysts' conflicts of interest on the air. "It was put in their face, and they pulled the lever on the slot machine anyway."
Last year Tom Brown started his own investment company. He decided to leave the analyst game because there's too much pressure to be dishonest, he says. DLJ offered him the usual severance deal, but he rejected it because it required him to keep quiet.
"DLJ offered me $400,000 to not say anything," Brown says. "And I decided in August of '98 that it was worth more for my pride to be able to shout it from the mountaintop that something was wrong, and tell them to keep the $400,000."
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