And to this day people ask me why I have absolute zero faith in analysts anymore... Almost all of 'em have crossed over to the dark side, or should I say sell-side...
nytimes.com
December 31, 2000
How Did So Many Get It So Wrong?
By GRETCHEN MORGENSON
Of all the rude awakenings
that the bear market in
stocks has brought to investors,
perhaps the most jarring has been
the realization of how woefully
wrong Wall Street's research
analysts have been this year on the
stocks they follow. While the
market sank to its worst
performance in more than a
decade, many of those analysts
kept right on smiling and saying
"buy."
How can so many who are paid so
much to scrutinize companies have
blown it so spectacularly for their
investor customers?
The answer lies in a subtle but
significant change in the way Wall
Street analysts do their work —
and how they are rewarded for it.
That shift, which has brought
riches and stardom to many
securities analysts, has cost
investors billions of dollars in
losses.
The fact is, although brokerage
firm stock gurus are still called
analysts, their day-to- day pursuits
involve much less analysis and
much more salesmanship than ever
before.
"The competition for investing
banking business is so keen that
analysts' sell recommendations on
stocks of banking clients or
potential banking clients are very
rare," said Arthur Levitt, the
chairman of the Securities and
Exchange Commission. "Whether
this is an actual or perceived
conflict, clearly, in the minds of
many institutional buyers,
brokerage firm analysis has
diminished credibility." Robert A.
Olstein, a mutual fund manager
with 32 years of experience
analyzing companies' financial
results, agrees. He said analysts
today are more like racetrack
touts than sharp- penciled
researchers.
"What passes for research on Wall
Street today is shocking to me,"
Mr. Olstein said. "Instead of
providing investors with the kind of
analysis that would have kept them
from marching over the cliff, analysts prodded them forward by inventing
new valuation criteria for stocks that had no basis in reality and no
standards of good practice." (Internet analysts, for example, have cited
visits to a Web site as a reason for optimism. But, Mr. Olstein said,
"Investors can't take page views to the bank.")
No one, of course, can predict what stocks will do tomorrow, much less
next year; but Wall Street's analysts are supposed to help investors judge
the attractiveness of companies' shares. Investors look to analysts to
advise them on whether to buy or sell a stock at its current price, given its
near- term business prospects.
Until the mid-1990's, that is how most analysts approached their work.
Today, there is virtually no such thing as a sell recommendation from
Wall Street analysts. Of the 8,000 recommendations made by analysts
covering the companies in the Standard & Poor's 500-stock index, only
29 now are sells, according to Zacks Investment Research in Chicago.
That's less than one- half of 1 percent. On the other hand, "strong buy"
recommendations number 214.
Analysts have long been known for unrelenting optimism about the
companies they cover. But many investing veterans say that the quality of
Wall Street research has sunk to new lows. That decline, they say, is the
result of shifting economics in the brokerage business that has pushed
many researchers to put their firms' relationships with the companies they
follow ahead of investors.
The commissions charged by Wall Street firms to their institutional and
individual customers for trading stocks are one factor. These fees were
much higher in the 1970's and 1980's, perhaps 10 cents a share on
trades then versus a penny or less now. Because analysts'
recommendations helped generate trades and commissions, research
departments paid for themselves. More important, an analyst who
uncovered a time bomb ticking away within a company's financial
statements and who advised his customers to sell its shares made an
important contribution to his firm in commissions those sales generated.
In short, analysts were rewarded for doing good, hard digging.
But as commissions declined, Wall Street firms looked elsewhere for
ways to cover the costs of research.
The lucrative area of investment banking was an obvious choice. Analysts
soon began going on sales calls for their firms, which were competing for
stock underwritings, debt offerings and other investment banking deals
from corporations. In this world, negative research reports carried a cost,
not a benefit.
The result, money managers say, is that the traditional role of analyst as
adviser to investors has been severely compromised. The increasingly
close relationships analysts have with corporate executives has led many
of them to be gulled by managements intent on keeping up the prices of
their stocks.
"Research analysts have become either touts for their firm's corporate
finance departments or the distribution system for the party line of the
companies they follow," said Stefan D. Abrams, chief investment officer
for asset allocation at the Trust Company of the West in Manhattan. "Not
only are they not doing the research, they have totally lost track of equity
values. And the customer who followed the analyst's advice is paying the
price."
For many investors, that price keeps going up. In the past few months, as
former stock market favorites crashed to earth, many top analysts
remained maddeningly upbeat all the way down.
Consider Mary Meeker, the analyst at Morgan Stanley Dean Witter who
became known as the Queen of the Internet for her prognostications on
e-commerce companies like Amazon.com and Priceline. In 1999, as
Internet stocks soared and new companies were taken public in droves,
Ms. Meeker made $15 million, according to news reports.
Now that Internet stocks are in pieces on the ground, she has become
decidedly less vocal — but no less optimistic. In her reports, she still
rates all 11 Internet stocks she follows as "outperform" even though as a
group they are down an average 83 percent. By comparison, the
Interactive Week Internet index is down 60 percent from its recent peak.
Of the 11 companies Ms. Meeker remains positive on, 8 had securities
underwritten by Morgan Stanley.
Ms. Meeker declined to comment for this article. But Ray O'Rourke, a
Morgan Stanley Dean Witter spokesman, defended the star analyst,
saying that her picks had been made for the long term. Moreover, he
said, Ms. Meeker warned investors last March that Internet stocks were
volatile.
Asked about Ms. Meeker's record and whether her nonstop optimism
had anything to do with the fact that most of the companies had engaged
Morgan Stanley as an investment bank, Mr. O'Rourke said: "It is what it
is. But you shouldn't be surprised necessarily to see `outperforms' on the
companies, because we've been very vigorous on the companies we've
chosen to bring public."
Anthony Noto, at Goldman, Sachs, is another Internet-stocks analyst
who remained upbeat on shares that were trading at a fraction of their
former values. On Dec. 18, he lowered the ratings to "market performer"
on four of the nine stocks he follows, including the Webvan Group, an
Internet grocer; Ashford.com and eToys, two troubled e-tailers, and
PlanetRX.com, an online resource for medical products that was in
danger of being delisted by the Nasdaq stock market.
The companies were downgraded after they had dropped on average
98.2 percent during the previous 52 weeks. By contrast, the Nasdaq is
down 39.3 percent this year.
Of the nine stocks Mr. Noto follows, seven had stock offerings
underwritten by Goldman, Sachs.
"Our research is driven by fundamental analysis and is not influenced by
anything else," Mr. Noto said. He went on to explain that the companies
he followed had their stock prices drop last spring not because their
operations were failing, but because market psychology had changed. He
downgraded the stocks much later because only then had it become clear
through his research that the companies' results were deteriorating. "In
hindsight," he said, "we should have lowered our ratings sooner. We
regret that."
Faces are also red — or should be — at Salomon Smith Barney. Jack
Grubman, the highest-paid analyst at the firm and, perhaps on Wall
Street, reportedly made $20 million last year in his job covering the
telecommunications industry. Investors who have followed his picks have
not done as well.
Mr. Grubman began to advise caution on the 11 smallish telecom
companies he covers in the so-called competitive local exchange carriers
sector only two months ago, after the stocks in the group had already lost
77 percent of their value. All 11 had securities underwritten by Salomon.
Mr. Grubman declined to comment. But in an article in Business Week
last May, he scoffed at the idea that his help peddling investment banking
services to corporations put him in conflict with his firm's investor
customers. "What used to be a conflict is now a synergy," Mr. Grubman
was quoted as saying.
Investors in Rhythms NetConnections, a high-speed local access data
provider that Mr. Grubman has favored the last 21 months, may feel
otherwise. The meteoric rise and crushing fall of the company's shares
neatly illustrates how much money investors can lose by following the
advice of conflicted analysts.
Rhythms NetConnections was not much of a company back in April
1999 when its shares were offered to the public at $21 each in a deal
managed by Salomon Smith Barney and Merrill Lynch. But it quickly
became a monster stock, soaring to $111.50 during one trading day. Its
closing high was $93.13 on April 13, 1999.
At its peak, the company's market value was $8.9 billion, even though its
revenues for the prior year had been $528,000 and in two years as a
private company, it had racked up $39 million in losses. Before it issued
shares, the company's capital consisted of $158.3 million in borrowings.
Today, Rhythms NetConnections trades at $1.13 a share, giving it a
market value of $89 million. Some $8.81 billion in value has vanished.
As those billions were vaporizing, one of Wall Street's most powerful
analysts following the stock, Mr. Grubman, and two analysts at Merrill
Lynch recommended the company to investors. At Merrill, Mark Kastan
recommended the company until he left the firm in 1999; Kenneth
Hoexter picked up coverage in May when the stock was $21.
After its initial offering and with the analysts recommending the stock,
Rhythms was able to tap the equity and debt markets for $870 million, in
four underwritings led by Merrill and Salomon. Fees earned by the two
firms on the company's stock offerings alone totaled $3.8 million.
Meanwhile, top management and directors at Rhythms NetConnections
were selling almost a million shares, reaping $26.4 million.
On Oct. 18, when the stock was at $2.81, Mr. Hoexter cut his rating on
Rhythms from a "near-term buy" to "near-term neutral." Mr. Grubman
did not temper his enthusiasm for the stock until Dec. 5, when its shares
closed below $1 for the first time. He reduced his rating to neutral.
Mr. Hoexter said he remained high on Rhythms for so long because it
continued to meet his near-term estimates. "To us, it wasn't so visible that
there was something wrong at the company," he said.
But Mitch Zacks, vice president of Zacks Investment Research in
Chicago, questioned the claims of analysts who said they did not see the
freight train bearing down on them. "It's not that they're oblivious to things
getting worse," he said. "But the way an analyst can get fired is to
damage an existing investment banking relationship with a company or
sour a future investment banking relationship. The way you do that as an
analyst is coming out and telling people to sell a stock."
And it is not just a company's management that analysts must worry
about angering. They must also weigh what their negativity would mean
to the portfolios of the venture capitalists that send their firms companies
to take public. If an analyst advises investors to sell a stock that its
venture capitalists still own a stake in — and they often hold such shares
for years — the likelihood of getting future deals from those people will
be slim.
The possibility of earning fees also explains why analysts are loath to
highlight a company's troubles even when it is on the brink of failure. Mr.
Zacks said: "The company could do a restructuring or spin off some
assets," requiring aid from a brokerage firm.
Joanne Tutschek, director of communications for research at Merrill ,
disputed the idea that the firm's analysts work for investment bankers first
and investors second. "Our analysts' credibility in the marketplace is
determined by our institutional and retail investors," she said. "And if an
analyst is not credible, then he loses his franchise. So I don't think an
analyst is going to throw that away for a bad banking deal." She said the
firm's research department was independent.
There is no denying that the business of research has become extremely
lucrative to analysts today and that much of that lucre comes from
banking departments.
According to Joan C. Zimmerman, principal at G. Z. Stephens, an
executive search firm in New York, $10 million was the top pay for star
analysts in 1999, while junior analysts received $350,000 in annual
compensation. This year, the numbers were $15 million for an analyst in a
hot sector and around $500,000 for junior research analysts.
"If a firm wants an analyst who is investment-bank friendly, the type who
will help pitch deals but will also generate ideas and timing on deals, there
is an inevitable return to that analyst," Ms. Zimmerman said. "An analyst
may have fabulous relationships with investors, but if they are not known
to be banker-friendly they will see diminished compensation unless the
research director is very strong and can defend them."
This race explains why many analysts sound more like cheerleaders than
they do researchers. As such, they helped propel stocks to prices never
seen before.
A new practice that has become deplorably common, Wall Street
veterans say, is the use of absurd stock price targets in research reports.
"These price targets fanned the fires of speculation in the market and did
a lot of damage to a lot of people," said Mr. Olstein, the fund manager.
Perhaps the most famous price target put on a stock was $1,000, given
to Qualcomm by Walter P. Piecyk Jr., an analyst at PaineWebber, on
Dec. 29, 1999. It soared 30 percent, to $656, on the news and hit a high
of $717.24, presplit, on Jan. 3. This year, it has been all downhill for the
company's shares, which split 4 for 1. Qualcomm closed at $82.19 on
Friday, 67 percent below Mr. Piecyk's price target.
Mr. Piecyk is no longer at the firm, which was acquired by UBS
Warburg earlier this year. He could not be located for comment.
Outlandish price targets also have proved embarrassing for analysts who
tend to reduce them only well after the stocks are crushed. For instance,
on May 26, when Internet stocks were swooning, Jamie Kiggen, of
Donaldson, Lufkin & Jenrette, issued a note on GoTo.com, rating it a
buy and setting a $160 price target; the stock was then trading at
$15.13. Only in early September did Mr. Kiggen lower his price target.
With the stock trading at $23.31, Mr. Kiggen said he expected it to
reach $80 in the next 12 months. A month later, he reduced the target to
$25. The stock closed at $7.31 on Friday.
Mr. Kiggen, now an analyst at Credit Suisse First Boston, said that the
slowing economy was the surprise that made him ratchet down his targets
for the stock. "Our price targets aren't arbitrary numbers," he said. "In
any early stage company, the inputs into calculating the risk, magnitude
and timing of future cash flows are very unpredictable." But Mr. Kiggen
added that investors also have to take responsibility for their mistakes.
"Using the fact of a price target as a substitute for analysis if you're an
investor is dangerous," he said.
Price targets are just one symptom of the larger malady that permeates
Wall Street research today, according to David Eidelman, a money
manager at Eidelman, Finger & Harris in St. Louis. He also criticizes the
new tendency of analysts to create their own valuation methods to justify
recommending stocks at any price.
"Analysts no longer focus on tangible factors, such as discounted cash
flows, that make a stock worth what it's worth," said Mr. Eidelman, who
headed research departments at two regional brokerage firms in the
1970's. "For instance, analysts have valued internet retailers based on
how many customers they had. This may have nothing to do with
earnings, but since they can't justify buying a stock based on its earnings,
they justify it with some valuation method they invented."
Other money managers cite the focus only on income statements, not
balance sheets, as another flaw in many equity analysts' reports. As
companies loaded up on debt, many analysts were silent on the potential
for difficulties when an operation could not pay its interest costs. Many
companies in the telecommunications sector are now in such straits.
As investors tote up the losses they have suffered at the hands of ebullient
analysts, they may tune out what analysts have to say. A study of
research analysts conducted by Tempest Consultants for Reuters earlier
this year looked at 2,300 analysts working for 228 securities houses. It
concluded that, among fund managers, almost 40 percent spent less time
reading brokerage firm research in the previous 12 months than in 1999.
Jacob Zamansky, a lawyer at Zamansky & Associates who represents
public customers in securities cases in New York, believes analysts will
become the subject of lawsuits brought by investors who lost money on
their picks.
"Lawyers will be examining the conflicts of interest between these
recommendations by analysts and the compensation received by their
firms in investment banking and brokerage fees," Mr. Zamansky said. "It
may well turn out that the analysts pumped up this tech bubble, reaped
huge fees and left the investment public holding the bag."
KJC |
