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Stock analysts' dirty little secret
It's not that analysts have lost their integrity. It's that they never had it to begin with -- and everyone in the industry knew it. Maybe the brokerages should fire them all.
By Jon D. Markman
Upgrade, downgrade, reiterate, initiate. The vocabulary of stock research analysts entered the vernacular of the late 1990s via televised financial news with the invasive force of a bad jingle you cant get out of your head. No sooner was the word up or down breathed over the airwaves did a stock move in the intended direction like notes in a capitalist arpeggio, as newly empowered private investors pressed the buy and "sell" keys in online brokerage accounts nationwide.
Now that the work of analysts is on the verge of being retroactively criminalized by the Securities and Exchange Commission and New Yorks attorney general, however, its time to reveal the industrys dirtiest little secret. And its not that brokerage analysts were on the take from investment bankers or the agents of Satan.
The real skinny is that virtually no one who matters in the investment industry -- which is to say, portfolio managers at large pension, mutual and hedge funds -- ever took nine-tenths of research reports seriously. Only the public did. As I explained in my book in 1999 (see link at left), analysts at the major brokerages for years have been looked down upon by institutional investors as sales support staff, a pack of kids with fancy college degrees who provided little more than PR material for the retail brokerage and investment banking teams. If they were called promoters rather than analysts, the public would have had a better idea of their role in the retail investment ecosystem. The funds have their own, unbiased, independent staff analysts who never made public pronouncements.
Bear market in integrity
Bret Rekas, a hedge fund manager in Minneapolis whose misspent youth included a stint as a technology analyst at Robertson Stephens, is one pro who therefore cant understand why the government has only this year determined that the system was rigged against consumers. Whatll they discover next, he wonders. That professional wrestling is fake? That recipes never turn out as good in your kitchen as they do in the color photos of Bon Appetit?
Rekas says that the real purpose of research on the Street has always been to provide a veneer of intellectual respectability to a sales endeavor that otherwise might not be considered much more lofty than the retailing of shoes, cars or potted plants. It probably wont sound like a great revelation now to contend that research reports still serve largely as patter for brokers hitting up retail clients on the phone for commissionable trades on shares their firms have in inventory, rather than serving as an exercise in fact-finding. To a brokerage, a top-gun analyst isnt one with the most brains, but rather one who can both communicate a companys sex appeal to the sales staff and engender lust among the public in TV appearances. Publish or perish is the mandate in most research departments; the goal is to say something, anything, as often as possible to encourage consumers to ring the register by making a trade -- preferably on margin.
If brokerages will no longer be allowed to pay for their research staff with money made from investment banking, as the SEC proposed last week, then you have to wonder if any will keep their analysts. Since they are a cost center, not a money maker, it may ultimately make no sense for Merrill Lynch (MER, news, msgs) or Bear Stearns (BSC, news, msgs) to keep several hundred analysts on the dole. Indeed, it could be a tremendous catalyst for the broken-down brokerage stocks if one of the top firms were to remorsefully announce it will pink-slip its whole profit-draining analyst crew. As it stands now, one industry expert has estimated that the investigation into Merrills research misdeeds could cost the firm up to $2 billion -- $1 billion in settlement fees, lost business of $500 million and civil-suit damages of $420 million. That would far surpass the $600 million tab that killed off Drexel Burnham Lambert following junk-bond investigations in the late 1980s.
What would be lost except for the stain of lies? Certainly little of value. One of the reasons the market has not responded to an uptick in the economy as heartily as I had expected is that there is a bear market in integrity. If stock consumers cant find help in discriminating between the good and the damned, its natural that they would simply abstain. In the absence of Merrill or Bear Stearns analysts, the slack would be taken up by independent Wall Street firms whose analysts are respected for their brainpower, not just good looks and writing styles.
Companies such as Sanford Bernstein, whose researchers are typically the first ones mentioned by fund managers when asked for a credible source of stock analysis. Or International Strategy and Investment Group, whose daily economic reports are considered by many pros one of their few must-reads every morning. Or CreditSights, which provides excellent independent corporate and sovereign debt research.
David Hendler, a former Credit Suisse First Boston equities analyst who now covers financial companies at CreditSights, said that the best analysts at brokerages will get sick of the game. Fed up at the lack of support from their managers against the corrupt demands of investment bankers and sales staff, they will leave and form their own research shops. The result could be a return to the 1960s and 70s, when boutique research firms flourished. If you dont pay for your research, you wont get unbiased research, Hendler said. If you want good ideas, youve got to pay for them.
Stacks of unread reports
To learn what the pros think of most brokerage research, just visit the office of one and look for the inevitable tall stack of research reports. Chances are it is not on the fund managers desk, ready to be consumed with interest like the sports page or a new gourmet joints take-out menu. It will be next to the wastepaper basket. When I visited the co-manager of a $10 billion trust fund in Manhattan on a Friday afternoon recently, I asked whether the knee-high pile of reports constituted just the rejects from the past week. God no, she said. Thats everything I got today -- you cant get them to stop sending this crap. Its like spam. An ISI report, in contrast, was on her blotter, with yellow highlights and notations in the margins.
Likewise, the manager of a major hedge fund told me this week that he primarily uses Wall Street research reports to determine the consensus view on any given subject, since the analyst system rewards conformity, not independence. He also stacks them up in his office, unread, in piles by subject. The more paper a single topic generates, the more interested he becomes in betting against it.
I have abstained from quoting brokerage analysts for at least a year, though I will interview independent specialists to get up to speed quickly on an industry, such as defense-industry expert Paul Nisbet at JSA Research. But Rekas scoffed at my cynical suggestion that fund managers and analysts might have colluded in the past to pump and dump stocks. Instead, he said, they are competitors in a high-stakes game in which analysts, and ultimately consumers, were played for suckers. Heres an example: Rekas said an analyst might visit a big fund firm like Fidelity or Putnam and pound the table on a stock his firm is trying to flog. If the fund manager wanted to sell a big position in that same stock, he or she might encourage the analyst, creating a positive feedback loop. Then what does the Fidelity fund manager do when the analyst goes back to his office and publishes a report upgrading the stock? Rekas asks rhetorically. Of course, he sells into the euphoria. Nothing illegal there. Its a poker game, and the manager is looking out for his own best interests.
What's to like?
So what does the renegade ex-analyst like these days himself? His fund, Lakeside Bull and Bear, specializes in a market-neutral strategy of being short as many technology stocks as it is long. Hes not particularly bullish on any tech stocks, sensing that they could potentially be out of favor through the rest of the decade, but as long as he has to be long something, he likes Sun Microsystems (SUNW, news, msgs) and Oracle (ORCL, news, msgs) in the single digits.
Unless you think there is going to be an extinction-level event and Sun is going away, at six bucks Im comfortable buying it now, he says, contending that the company has deep management that can survive the recent loss of a couple of top executives, a ton of cash, not much debt and a lock on the high-end UNIX workstation business. Rekas doesnt buy the current argument that Hewlett-Packard (HPQ, news, msgs) is eating Suns lunch in the high-end server business, and he doesnt think low-end servers running Intel (INTC, news, msgs) chips and Microsoft (MSFT, news, msgs) software pose a serious threat on the low end either. Rekas is not expecting the stock to go from $6 to $12 overnight, however, adding with a guilty laugh: Id be happy to see it go from $6 to $9 in the next 18 months.
He doesn't care much for networking equipment stocks such as Cisco Systems (CSCO, news, msgs), but at $8 considers he enterprise software-maker Oracle a reasonable gamble. Its like Sun -- Im not falling in love, but I think theyll survive. They may not be a great growth company for the next few years, but a lot of the risk of extinction has been ground away at this level.
Survival may truly be the name of the game for investors now as they recover from a painful bout of cynicism. Brokerages could hasten the recovery by cleaning house before government bureaucrats or lawmakers do it for them. Until then, its best to pick targets carefully, focusing on companies, as Rekas does, with little debt, prices under $10 but above $5, and annuity-like streams of quarterly revenue from established businesses in little danger of vanishing overnight. Ive already got Sun in the SuperModels portfolio at $8.10, but Ill add Oracle if it retreats to the $7.50 area.
Fine Print
Rekas was the source of good short ideas in this column over the past two years. In 2000, he recommended selling Juniper Networks (JNPR, news, msgs) in the $200s and Siebel Systems (SEBL, news, msgs) in the $80s. He also recommended Apple Computer (AAPL, news, msgs) and Kulicke and Soffa Industries (KLIC, news, msgs) as longs after the terror attacks in September; subsequently they went up 40% and 100%. ... His fund has $14 million in assets. It was up 22% in 2000 and 12% in 2001. ... Small-cap value stocks, which I have written positively about in the past year and a half, could be vulnerable to a sharp correction if investors decide to take advantage of the smash-up in large-cap stocks by bargain hunting with ardor over the next month. For the past few days, the iShare tracking S&P 500/BARRA Growth (IVW, news, msgs) has outperformed the iShare tracking S&P Small Cap 600/BARRA Value (IJS, news, msgs). ... One way to tell that market leadership is in the process of switching between the two would be if IJS were to trade below its 50-day moving average, currently at $95.03, for longer than three or four days. Its not far from that level now.
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to 7jonmail@microsoft.com.
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