The Rittenhouse Review

A Philadelphia Journal of Politics, Finance, Ethics, and Culture

Tuesday, June 11, 2002  

It's Not What You Think

Some of the best commentary on the crisis of confidence in the U.S. equity markets has been appearing in Canada’s National Post. The paper’s string of thoughtful and provocative articles continues today with “Making the Market Safe for More Blodgets” by Steven Maich.

In this article Maich notes that the settlement Merrill Lynch & Co. reached with New York State Attorney General Eliot Spitzer has been criticized for being likely to worsen the faults underlying Wall Street research it is intended to correct.

As widely reported, Merrill Lynch has promised to stop compensating analysts for bringing investment banking business to the firm and has instituted a simpler rating system -- “buy, sell, or hold” -- to be used in its equity analysts’ reports. Most important, the firm’s analysts will be paid partly based on the performance of the stocks they endorse.

The settlement’s critics, using former Internet industry analyst Henry Blodget as their foil, argue that Wall Street analysts would prosper just as well under the attorney general’s proposed rules.

One critic cited by Maich, Boston College Law Professor Lawrence Cunningham, maintains that the “buy, sell, hold” schema “is misleading in that [it] render[s] the complex as far too simple.” He adds that the technology and Internet bubble should have taught the folly of “trying to guess about how the mood swings of the market will treat various companies.”

Blodget ability to assess the market’s mood swings was the key to his success, the critics assert. “It wasn’t that his research was inaccurate, or that companies he touted failed to perform. Many of his key picks skyrocketed,” Maich writes. “When the Internet bull market was raging in the late 1990s, few analysts made more money for their clients than Henry Blodget did.”

Although Maich does not exactly say so, Blodget’s allegedly stellar stock-picking skills stemmed from little more than riding waves of upward momentum that took stocks such as, American Online, and to unjustifiable heights. Having regularly read Blodget’s reports during the period in question, we would agree. If Blodget had a solid grasp of accounting and financial statement analysis, it certainly wasn’t demonstrated in his written work. In our opinion, that was shameless self-aggrandizement (made all the worse by Blodget’s inability to decline interview opportunities) and not, in and of itself, scandalous behavior.

As Maich points out, “The trend was so impressive that pundits openly wondered whether Mr. Blodget was a whiz at recognizing great stocks, or if the market waited to pounce on his next recommendation, making every call a self-fulfilling prophecy.” No doubt the latter in our view. An equity analyst who gets on the squawk box to urge an army of institutional and retail salespeople as large as that of Merrill Lynch to buy a certain stock should be surprised if something other than an increase in the stock price occurred.

It was instead Blodget’s unwillingness to cut his ratings on stocks with poor fundamentals or stocks caught up in a tailspin of downward momentum, or both, that brought disastrous results to the portfolio of some Merrill Lynch clients. The main allegation critics present to Blodget is that he put the firm’s highest priority, namely, attracting and maintaining investment banking and corporate finance business, ahead of the interests of customers reading his reports or catching his sound bites on TV.

“Blodget’s calls usually ignored fundamental analysis of profit and future cash flow potential. His calls were about momentum, market sentiment and market share, all factors that can shift sharply and without warning,” writes Maich.

Frankly, that was a good part of what clients were paying him for. Analysts are expected to recommend stocks that will, not should, trade higher. The most respected analysts in the business do more than that, however. As Professor Cunningham maintains, “Analysts should be helping people understand the internal economics of business. What is the potential to produce additional revenues and profits? What do the margins look like? How able are they to withstand a decline in demand? Can it expand into other markets?”

Wall Street’s Dirty Little Secret

We fully agree with this assessment but would take the argument another step forward by emphasizing that Wall Street research reports in the past were not written or intended for the retail client, i.e., the individual investor.

In an interesting but unnoticed irony, investors who made early money or paper profits in high-flying Internet stocks saw their investments, if one could call them that, undermined by the Internet itself. Companies like Multex Inc. made brokerage reports more readily available to the retail investor, a practice soon adopted by the banks themselves, most of which began distributing their research reports to clients and non-clients either at no cost or for a comparatively modest fee.

However, Multex and the banks did not offer direct access to the analysts who wrote the reports. That remained the province of large institutional investors at investment management firms, pension funds, and insurance companies, those who were paying for the research through trading commissions with the banks and brokers. Analysts and portfolio managers at these firms, the so-called “buy side,” could pick up the phone, call the analyst, and take the discussion far deeper than the superficial level of “strong buy, buy, outperform, accumulate, hold, neutral, underperform, avoid, reduce, and sell.”

It is through conversations like these that a potential investor in a specific stock can sift through shades of meaning; obtain new or more detailed information, statistics, and data; argue a contrary position to determine the strength of the analysts’ convictions; and determine what the analyst truly thinks about the prospects of a specific stock.

And that is the dirty little secret of Wall Street research: Not that investment banking creates a conflict of interest with securities research, but that what an analyst writes in a report and what he or she actually believes can be two different things entirely.

Case in point: Our editor had occasion roughly 18 months ago, while working at Individual Investor magazine, to call upon an analyst at Prudential Securities (now Prudential Financial) to get him to state, for attribution, his opinion about a controversial stock on which he was carrying a “buy” rating. The analyst refused.

It took some prodding, but eventually the analyst conceded, in a moment of refreshing but off-the-record candor, that he did not wish his name to be associated with this particular stock. Among other things, the analyst confirmed our editor’s suspicions that the company’s financial statements were at best based on aggressive interpretations of accounting rules and at worst were deliberately misleading. Instead of talking up the stock, the analyst simply issued the requisite four reports a year summarizing the company’s financial performance during the preceding quarter.

For the record, the company in question subsequently changed its accounting practices and restated past results. Happily, Individual Investor did not recommend the stock, which was then trading for around $20. This morning the stock was quoted at just over $1.

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