Don't suffocate in blowing smoke of analyst advice
By Jim Gallagher
Here's a number that shows what stock-analyst recommendations are worth.
A year ago, only 0.8 percent of analyst recommendations called for clients to sell a stock, and 74 percent called for buying, according to figures from Thomson Financial/First Call, an analyst-tracking firm in Boston.
The Standard & Poor's 500 index has plunged 20 percent since. Anyone who followed the advice of Wall Street analysts took a bath.
The situation hasn't changed much. Today, "sells" make up 1.5 percent of recommendations, and "buys" make up 65 percent.
A lot of investors have concluded that most stock analysts aren't trustworthy. And the reason isn't simply because they missed the call on the bear market.
Most analysts are ensnared in conflicts of interest. They can't be honest without sinking their company's profits and their paychecks. They might know that a stock is a flea-bitten dog, but they won't tell you to sell it. They'll let you get bitten.
"We do not listen to analyst recommendations," says John Meara, president of Argent Capital Management in St. Louis, which invests $300 million for clients. "We've been jaded. We see the conflicts. They print something in a report so as not to upset company management."
A lot of interest conflicts exist. But the biggest problem is this: At a lot of firms, stock analysts are lap dogs for the investment bankers. The investment bankers bring in the big bucks by raising capital for companies and advising companies on mergers.
If an analyst angers a company, the investment bankers won't land its business. Nothing angers a company like a sell recommendation. Buy ratings make them happy.
China wall
In theory, the Great Wall of China is supposed to stand between stock analysts and the company's investment bankers. The analyst is supposed to give honest advice to a brokerage's clients, regardless of the effect on his firm.
The wall always has been full of holes. But now, it's a pile of rubble.
The Securities and Exchange Commission recently surveyed nine Wall Street firms. Seven of them gave investment bankers a say in analyst bonuses and in hiring analysts. In at least one firm, 90 percent of analyst bonuses depend on investment-banking revenue.
The last decade was a great party for investment bankers. Firms issued stock and experienced a merger frenzy. Meanwhile, discount commissions drove down a company's profit from individual investors.
As a result, the investment bankers became more important to a firm's bottom line. The small investor became less important.
So analyst recommendations became more biased toward the companies that investment bankers wanted to woo.
"Nobody stood up and said, 'Don't do it.' The China wall is coming down little by little," says Jeanine Heller, a former analyst who works as an investor-relations consultant in St. Louis. "It's gotten worse over the past two or three years."
Hopping the wall
Some analysts routinely hop the wall. They help to pitch the companies for investment-banking work, such as issuing new stock. Then, they help the investment bankers to put together the deals.
An unspoken part of the deal is that the analyst will keep a positive recommendation on the stock.
"Certain things are expected. You'll give full coverage of the company, with the implication that we are friends," analyst Juli Niemann says. "They don't want you to do a deal and then have the analyst say, 'Get rid of this stinker.' "
Niemann works for R.T. Jones Capital Equities in Clayton, which doesn't underwrite stock, though she has worked for firms that do.
SEC investigators interviewed several former analysts. "It was well-understood by all these analysts that they were not permitted to issue negative opinions about investment banking clients," the SEC's acting chairwoman, Laura Unger, said in testimony to Congress last month.
Analysts often go further.
When a company does an initial public offering of stock, company executives and certain others often buy in cheap before the stock goes public. Stock analysts sometimes are among the lucky few.
They aren't allowed to sell their stock until a set period after the initial offering. With the period about to expire, analysts might issue "booster shots," buy recommendations designed to keep the price up while the insiders bail out. The SEC found that analysts gave booster shots in 26 of the 97 periods reviewed.
This brings up another conflict. Analysts often own stock in companies on which they report. Is an analyst likely to downgrade a stock he owns?
The SEC found that 16 of 57 analysts reviewed bought stock in a company they later covered, and all the investments were pre-IPOs. Three later traded contrary to recommendations they were giving the public.
To all that, fear sometimes keeps analysts from spanking companies that deserve to be spanked. Companies threaten lawsuits. Their executives could withhold the wink-and-a-nod relationship by which analysts sometimes learn if their earnings projections are on track.
To avoid conflicts, Edward Jones investments in Des Peres told its analysts to sell their stock in companies they follow. Merrill Lynch forbade analysts from buying new stock in such companies, though they can keep what they had.
Business reporters also have failed you. Too often, we quote analysts without noting ties their firms might have to the companies they follow. Too often, we don't try hard enough to find sources who might be neutral.
What to buy?
So, with analysts blowing smoke, how is a small investor supposed to know what stock to buy?
First off, toss out any recommendation from an investment house with ties to the company on which it's reporting.
In their research reports, firms must disclose any investment-banking work done for the company in the past three years, as well as whether the firm owns or makes a market in the stock.
Of course, investment bankers always are shopping for new clients, so analysts are nice to companies, even if they are not customers.
Given all the conflicts, some investors simply knock a notch or two off all recommendations. A "strong buy" translates into "worth a look." A "buy" becomes a "hold," and a "hold" means a "sell."
You might give more weight to brokerage analysts with fewer conflicts. For example, Edward Jones gets less than 2 percent of its revenue from investment banking, mainly through bond offerings and as a secondary underwriter for stock offerings.
That might explain why it feels free to put a sell rating on the auto industry.
Prudential Securities flopped as an investment-banking house. Now that it's backing away from the business, it boasts that its analysts are more free to tattle on stocks. Prudential has a sell rating on 6 percent of the companies it follows.
Finally, you could treat analyst reports the way the jaded professionals do. They ignore the recommendations but read the reports for insight into a company or an industry. "If it's the drug industry, who has drugs coming out of patent?" Meara says.
The nice thing is that the SEC has tightened up considerably on companies that like to whisper in the ears of favored analysts. Anything interesting has to be disclosed to everyone under current rules, and small investors usually can listen in on analyst conference calls.
"By and large, the analysts don't have any more information than what is available to the small investor," says Nasser Arshadi, a finance professor who heads graduate studies at the University of Missouri at St. Louis.
Jim Gallagher\jimgallagher@post-dispatch.com\I like hearing from readers. You can reach me at 314-340-8320, at jimgallagher@post-dispatch.com or at the Post-Dispatch, 900 North Tucker Boulevard, St. Louis, Mo. 63101.
Published in Business on Sunday, August 12, 2001.
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