By GRETCHEN MORGENSON
The New York Times
12/31/2000
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." |
