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4. The Loss of the Best Analysts to
the
Sales
Desk,
to
Portfolio
Management, or to Hedge Funds
My fourth argument against the profession is a paradoxical
one: Many of the best security analysts are not paid to
analyze securities. They are often very high-powered
institutional salespeople, or they are promoted to the
prestigious position of portfolio manager.
Brokerage houses known for their research prowess often
send a security analyst to chaperone the regular salesperson
on a call to a financial institution. Institutional investors like
to hear about a new investment idea right from the horse’s
mouth, so the regular salesperson usually sits back and lets
the analyst do the talking. The most articulate analysts find
that their time is spent with institutional clients, not with
financial reports.
During the early 2000s, many analysts were seduced away
from research to take highly compensated positions in
portfolio management or with hedge funds. One of Wall
Street’s best-known analysts, Barton Biggs, left Morgan
Stanley to form his own hedge fund. He writes about the
attractions of his experiences in
Hedgehogging
. It’s far more
exciting, prestigious, and remunerative to “run money” in the
line position of hedge-fund or portfolio manager than only to
advise in the staff position of security analyst. Small wonder
that many of the best-respected security analysts do not
remain long in their jobs.
5. The Conflicts of Interest between
Research and Investment Banking
Departments
The analyst’s goal is to ring as many cash registers as
possible, and the fullest cash registers for the major brokers
are to be found in the investment banking division. It wasn’t
always that way. In the 1970s, before the demise of fixed
commissions and the introduction of “discount” brokerage
firms, the retail brokerage operation paid the tab and analysts
could feel they were really working for their customers—the
retail and institutional investors. But that profit center faded
in importance with competitive commissions, and the only
gold mine left was the underwriting of new issues for new or
existing firms (where fees can run to hundreds of millions of
dollars) and advising firms on borrowing facilities,
restructuring, acquisitions, etc. And so it came to pass that
“ringing the cash registers” meant helping the brokerage firm
obtain and nurture banking clients. And that’s how the
conflicts arose. Analysts’ salaries and bonuses were
determined in part by their role in assisting the underwriting
department. When such business relationships existed, critics
assert, the analyst became nothing more than a tool of the
investment banking division.
One indication of the tight relationship between security
analysts and their investment banking operations has been the
traditional paucity of sell recommendations. There has
always been some bias in the ratio of buy to sell
recommendations, since analysts do not want to offend the
companies they cover. But as investment banking revenues
became the major source of profits for the major brokerage
firms, research analysts were increasingly paid to be bullish
rather than accurate. In one celebrated incident, an analyst
who had the chutzpah to recommend that Trump’s Taj
Mahal bonds should be sold because they were unlikely to
pay their interest was summarily fired by his firm after
threats of legal retaliation from “The Donald” himself. (Later,
the bonds did default.) This is far from an isolated incident.
An analyst from BNP Paribas alleged that he was forced out
of his job after a sell recommendation on Enron. Small wonder
that most analysts have purged their prose of negative
comments that might give offense to current or prospective
investment banking clients. In the 1990s, the ratio of buy to
sell recommendations climbed to 100 to 1, particularly for
brokerage firms with large investment banking businesses.
To be sure, when an analyst says “buy” he may mean
“hold,” and when he says “hold” he probably means this as a
euphemism for “dump this piece of crap as soon as
possible.” But investors should not need a course in
deconstruction
semantics
to
understand
the
recommendations, and most individual investors sadly took
the analysts at their words during the Internet bubble.
There
is
convincing
evidence
that
analyst
recommendations are tainted by the very profitable
investment banking relationships of the brokerage firms.
Several studies have assessed the accuracy of analysts’ stock
selections. Brad Barber of the University of California
studied
the
performance
of
the
“strong
buy”
recommendations of Wall Street analysts and found it nothing
short of “disastrous.” Indeed, the analysts’ strong buy
recommendations underperformed the market as a whole by 3
percent per month, while their sell recommendations
outperformed the markets by 3.8 percent per month. Even
worse, researchers at Dartmouth and Cornell found that stock
recommendations of Wall Street firms without investment
banking relationships did much better than the
recommendations of brokerage firms that were involved in
profitable investment banking relationships with the
companies they covered. A study from Investors.com found
that investors lost over 50 percent when they followed the
advice of an analyst employed by a Wall Street firm that
managed or co-managed the initial public offering of the
recommended stock. Research analysts were basically paid to
tout the stocks of the firm’s underwriting clients. And
analysts lick the hands that feed them.
In 2002, the Attorney General of the State of New York,
Eliot Spitzer, found a smoking gun. While Henry Blodgett
and other analysts at Merrill Lynch were officially
recommending a number of Internet and New Economy
stocks, the same analysts were referring to the stocks
disparagingly in e-mail messages as “junk,” “dogs,” or less
attractive epithets. Merrill did not admit guilt, but it settled
with New York and other states for $100 million. Merrill also
promised certain reforms such as not directly tying analysts’
pay to investment banking revenues, clarifying its stock
recommendations, and better disclosing potential conflicts of
interest. Other firms such as Goldman Sachs and Smith
Barney quickly embraced the Merrill proposals.
The situation today is somewhat improved. Outright
“sell” recommendations have become more common, although
the bias to “buy” advice remains. But the Sarbanes-Oxley
legislation, which followed the scandals associated with the
Internet bubble, made the job of the analyst more difficult by
limiting the extent to which corporate financial officers could
talk to Wall Street analysts. The SEC has promulgated a
policy of “fair disclosure,” whereby any relevant company
information must be made public immediately and thus
disclosed to the whole market. While such a policy can help
make the stock market even more efficient, many disgruntled
security analysts dubbed the situation as one of “no
disclosure.” Security analysts could no longer have early
access to privileged information. Thus, there is no reason to
believe that the recommendations of security analysts will
improve in the future.
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