July 30, 2001
Manager's Journal
We're All Analysts Now
By Andy Kessler. Mr. Kessler, a former technology analyst at Morgan Stanley and PaineWebber, is a partner in Velocity Capital Management in Palo Alto, Calif.
To save on legal expenses, Merrill Lynch recently settled an arbitration case brought by Debasis Kanjilal, a New York pediatrician who lost $500,000 investing in Infospace, an Internet stock recommended by star analyst Henry Blodget. The claim was that Mr. Blodget's buy rating was a conflict of interest because Merrill Lynch, his employer, was selling a company to Infospace and needed to keep the stock up. Now every Tom, Dick and Fidelity will want similar reparations from the Internet wars.
Say goodbye to analysts. The Securities and Exchange Commission's Regulation Full Disclosure has already wiped out much of their value, and they're set for a beating at tomorrow's congressional hearing on conflict of interest.
Analysts are now a real liability. No, not their compensation -- it's their potential mistakes. Paying back the $500 billion loss of market cap in Cisco alone would wipe out Wall Street's capital, as virtually every firm recommended that stock.
How did we come to this? Wall Street used to be such a cozy place -- 75-cent-per- share commissions, analysts shuttling around town in limos to meet big company managers.
In 1972, Institutional Investor magazine first compiled a list of All-American Research Analysts from a poll of big money managers. Hardly anyone paid attention. But in the mid-1970s, the Big Bang hit, ending fixed commissions. Small investors could move in and out of stocks for 1/2, then 1/4, soon 1/8 of a cent a share. Trading, now cheaper, became more fast and furious, and analysts were in greater demand to track what was hot and what was not.
Barton Biggs put together the first all-star analyst team at Morgan Stanley in the late 1970s -- folks like Ben Rosen, who later founded Compaq. Mr. Biggs paid them astronomical salaries rumored to be in the six figures. Then the bull market hit in the summer of 1982. The pace of initial public offerings quickened. A tech bubble based on the personal computer played out in 1983 and 1984. Analysts were rapidly hired to follow software, biotech and a host of new industries.
In the annual polls, money managers voted for analysts who called them, so analysts were commanded to make 100 phone calls a month. As an analyst back then, I learned quickly that getting ranked in the polls was leverage: You helped your own firm's overall ranking, but other firms who wanted to move up in the rankings then courted you. I once was really impressed when I met the number three coal analyst, only later to find out that there were only three coal analysts.
In addition, the higher you ranked in the poll, the easier it was for your firm to win initial public offering pitches, what is known as the "bake off" or "beauty contest." And then, in a strange circle, the more quality companies your firm did banking business with, the higher you would get ranked in the poll.
Make phone calls, get ranked, do deals. Who had time to analyze?
Plus there still was a cozy relationship with companies. When I started as an analyst, I used to sit glued at my desk and watch for an announcement, really one sentence, on Intel's earnings. I would quickly dial Jim Jarrett, Intel's investor relations guy (they now have a whole department). His secretary would pick up, take my number and say, "Mr. Kessler, you are the first one to call." How cool to be 25 and have someone call you Mr. Kessler. Ten minutes later, Jim would call and I would try to keep him on the line for 30-45 minutes, knowing all my competitors were pacing, waiting for his call back. Then I would hang up and quickly call every top institution to tell them my spin on the quarter.
Faxes and e-mail and conference calls killed off that game, and soon everyone had the spin, so analysts needed other reasons to call institutions. Rarely was it anything analytical. I backed into the only thing I could figure out, which was long-run trends, and very few clients cared. But long-term thinking came into vogue in the last three years, merely to justify already lofty valuations. In 2001, we're back to short-term analysis again.
Analysts naturally turn themselves into self-promoting machines. Their incentive is a once-a-year bonus. The formula is simple: phone calls=votes=ranking=investment banking business=big bonus. Eventually CNBC appearances and magazine covers replaced phone calls.
On Wall Street, you only have your reputation. Once you have it, you'll do anything not to lose it. Especially if you are what is known as the "axe" in a stock, when a change in your body language can send the stock down five points. Pavlovianly, you can't stop recommending it. You'd think it would be easy to say buy a stock at $5 and sell it at $100, but it is next to impossible, figuring all the heat you'd get if it goes to $200.
But that shouldn't matter to the general public anyway, since institutions are the analysts' clients. They're smart and up to speed and could care less if you say "buy, hold or sell." They just want to know why. Analysts' reports that say, "As expected, the company beat our previously lowered but higher than consensus earnings expectations" just don't add a lot. In reality, institutions use analysts to take a pulse, figure out what most people are thinking, and then decide which side of it they believe in.
As for the gold chain crowd, their investment needs are now serviced by chat rooms manned by 15-year-olds and online trading. Wall Street's help is long gone, although someone forgot to tell Dr. Kanjilal, the pediatrician.
So as ambulance chasers get in line for their buyoffs, are Henry Blodget at Merrill Lynch, Mary Meeker at Morgan Stanley and Jack Grubman at Salomon sinister figures, perpetrating ruin on unsuspecting retirement accounts? Worse, are they incompetent fools recommending stocks that only go down?
Hardly. They are smart, savvy people at the top of a game that is changing, most likely to their exclusion. Is there an investment banking conflict? They wouldn't be stars without it, and no one likes to bite the hand that feeds them.
The Securities and Exchange Commission was formed to fix the problems of the 1920s, and I suspect it will overreact to the problems of the 1990s. The agency is only one or two regulations away from completely neutering the analyst trade. Will we see warning labels about second-hand stock tips and investing while pregnant?
But with or without the SEC's help, analysts are becoming obsolete. Money managers do their own work, and the public will have to as well. With the democratization of financial markets, we are all analysts now. Everyone must take charge of their money, must analyze their employer, heck, even local industry and the neighborhoods they buy into. Perhaps this is disturbing, but it is inevitable.
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