Analysts' Plea of Ignorance Undermines Market
By Jerry Knight
The Washington Post
Monday, March 4, 2002
Page E01
After watching Wall Street securities analysts testify about their work on Enron Corp. last week, it's hard to imagine why any Washington investor would ever pay attention to an analysts' report again.
We are not corrupted by conflicts of interest, insisted the highly paid investment experts from J.P. Morgan Chase & Co., Salomon Smith Barney Inc., Credit Suisse First Boston Corp. and Lehman Brothers Inc.
Yes, our firms made millions of dollars doing business with Enron, but that is not why we kept telling investors to buy Enron stock -- even after the Securities and Exchange Commission started investigating the company.
"I believed in the company's business model and believed in the company's management," said Raymond C. Niles of Salomon Smith Barney.
No, we did not feel pressured to be nice to Enron. "I have complete freedom with respect to the recommendations that I make," said Anatol Feygin of J.P. Morgan Chase.
Besides, agreed Feygin, Niles and their two cohorts, Enron lied to us.
Great defense, guys. Pleading incompetence. Not guilty by reason of inanity.
Investors who look to Wall Street for advice on which stocks to buy would have found it more credible if the analysts had simply admitted what everybody in the business knows: securities analysts are in bed with their company's clients.
And not their brokerage clients.
Small investors are routinely led astray by analysts at Wall Street firms, firms who make most of their money from the very companies the analysts are supposed to independently evaluate.
The "buy" recommendations for Enron were just the latest insult to investors by the wonderful people who brought you the tech bubble, the telecommunications bust-out and all those fabulous Internet stocks.
After losing so much money by listening to Wall Street's exuberant irrationality, investors are in danger of losing something even more precious -- their faith in the stock market.
The market -- indeed the nation -- can't afford to let that happen.
The other danger now is that Congress will try to do something about it, since the Enron analyst hearings last week produced no evidence that Wall Street is enlightened enough to act in its own self-interest.
News reports on the hearings focused on the Nixonian defenses offered by the four witnesses from Wall Street brokerage firms that were advising their clients to buy Enron stock until just a few days before the company filed the biggest bankruptcy proceeding in history.
But there were five witnesses at the table. The odd man out offered more valuable insights into the Enron case than any of the men from Wall Street.
That's what he gets paid for. He is Howard Schilit, head of the Center for Financial Research & Analysis in Rockville. A former American University accounting professor, Schilit and his team of analysts specialize in poring over corporate financial reports and spotting danger signals.
Schilit sells his services to institutional investors -- mutual funds, pension pools, money managers and the like. They use the information as an early warning system and to spot trends.
In an interview after Wednesday's hearing, Schilit said he had not looked at Enron's financial reports until he was invited to testify and was amazed by what he found while doing his homework.
"I spent less than one hour the night before the hearing looking at the company's financial reports and I had three pages filled with warnings," he said.
"Was there evidence of fraud?" he asks rhetorically. "No. Was there evidence they were headed for bankruptcy? No. But was there enough for any decent analyst to ask questions? Absolutely."
Among the things that set off Schilit's alarms were references to non-cash sales and related-party transactions. In one six-month period, Enron's sales to "related parties" were more than $1 billion, he noted. In one quarter the company reported profits of $325 million, of which $264 million came from related parties. Enron frequently reported multimillion-dollar transactions in which it said it earned "profits" but never actually received any cash.
If those were danger signals to Wall Street, there's no sign of it in the research reports published on Enron. And the analysts who testified last week didn't mention smelling any smoke.
Nor were the majority of analysts as shocked as Schilit to see Enron executives getting loans from the company and selling huge amounts of their company stock. Both once were red flags, but not any more.
"I came away from that session absolutely astonished," Schilit said. He said he found it hard to believe the analysts had even read Enron's financial reports.
Even giving them credit for looking at the numbers, it's clear they did not look beyond the financial reports and ask the tough questions that investors would expect a professional stock evaluator to ask.
As Schilit put it: "My immediate read on it was: What does the word analyst mean? One assumes that you analyze."
The four analysts who volunteered to be pilloried by the Senate committee -- and others who refused to show up unless they were subpoenaed -- have put themselves in a position where they cannot defend themselves against charges of incompetence.
Better to be judged dumb than dishonest seems to be their strategy, since their failure is so obvious. It must be a terribly humiliating position for people at the top of their profession.
But not just the Enron analysts are playing dumb as a defense.
That was the excuse of the analysts who put their firms' clients into flaky Internet stocks and now-dead dot-coms. It's the plea of the analysts who told their clients to invest in Global Crossing, the telecommunications giant that recently joined so many of its rivals in bankruptcy court.
Pointing out that everybody else was wrong as well may enable analysts to avoid feeling guilty about their individual failings, but it undercuts the credibility of their entire profession, and ultimately the securities industry.
A perverse kind of peer pressure socializes analysts into defending any company whose finances come into question from the media or a watchdog like Schilit. Often as not, the counterattack comes not from the company itself, but from some analyst who has long recommended clients invest in the company.
It happened to me several years ago when I reported complaints from students and possible abuses of federal loan programs at now-defunct Computer Learning Centers. Analysts were as aggressive as the company in their defense and some continued to recommend CLC stock long after state and federal regulators began the crackdown that put the company out of business.
It happened to Schilit when he advised his clients of potential problems at MicroStrategy Inc. "Within 24 hours, Merrill Lynch wrote a report defending the company point by point and telling the readers to ignore everything we said." MicroStrategy stock, of course, has fallen from $313 a share to under $3.
Unfortunately most individual investors can't afford the kind of independent financial analysis that Schilit provides. Signing up for his service costs $35,000 a year. An institution can save that much on a single tip, but it's as big as the entire portfolio of many Washington investors.
Some independent investment advisory firms do sell reports on companies to individual investors, but Schilit doubts that selling securities research at retail could be a viable business. Most Wall Street firms give away analyst research to their retail investors. Their revenue comes from persuading investors to buy stocks, not giving them good advice, which goes a long way toward explaining things.
At last week's hearing, lawmakers suggested Congress might demand that Wall Street firms spin their research divisions off into separate companies, so analysts would no longer be tempted to toady up to companies who were investment banking clients.
That seems unrealistic. Investment bankers need research. It's nonsensical to prohibit them from doing it themselves and demand they buy it from somebody else.
And if the banking side of a Wall Street firm isn't going to bankroll the research, who will? Brokerage firms can't charge retail customers for research or try to finance research costs out of commission revenue. The firms with big networks of branches are already losing small investors to discount brokers.
One way to end the conflict of interest between investment bankers and their analyst colleagues would be to change the way analysts are compensated. Instead of being paid for attracting banking clients for the firm, analysts ought to be paid for the long-term performance of the stocks they pick for investors. They shouldn't get bonuses because the stocks they touted last year did well. Their bonus should be held up until those stocks have turned in a track record of two, three or five years.
As Fed Chairman Alan Greenspan suggested a few years ago, compensation based on stock market performance has to be judged in the context of the overall market. During a bull run when the market goes up 40 percent in one year, only people who beat the market deserve a bonus.
Their are undoubtedly many other things that could be done to restore investors' confidence in Wall Street analysts. Congress stands ready to prescribe remedies, but that is not the best solution. Wall Street prides itself on the innovations fostered by the United States' free markets. The challenge now is whether Wall Street can be innovative enough to clean up its own act.
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