What would it take for US analysts to regain their credibility
The media has been having a field day with the subject of sell-side credibility – or the lack thereof, to be exact. Some of the attention is a byproduct of the ongoing deflation of net stock valuations, which has led to a great deal of finger-pointing. Not surprisingly, much of the anger is directed at the analysts who recommended the stocks now trading 90 percent below their target prices.
Is it fair that analysts shoulder all the blame? No. And yes, the scarcity of articles taking the media to task for their contribution to the hype game is conspicuous. But fair or not, it's sell-side analysts sitting in the hot seat, as their credibility is called into question by a chorus of disgruntled investment professionals, non-professionals and, of course, journalists. But the accusations go well beyond the dot-com era, calling into question the role of the analyst.
The game
The quantitative side of this story is by now well known: Of the 33,169 buy, sell, and hold recommendations made by stock analysts last year, 125 (or 0.3 percent) were pure sells (see chart). As for accuracy, some accounts have recommendations hitting the mark less than 25 percent of the time. Not exactly a record worth shouting about.
The skepticism that dogs many recommendations often runs just as deep when the call is negative. By the time uber-analyst Henry Blodget of Merrill Lynch lowered his ratings for a number of internet stocks whose valuations had already slumped by 50 percent or more, investors who had watched their nest eggs diminish to pin heads were left wondering if he was merely being ironic.
While some question the sell side for its poor performance and reluctance to be critical, many believe the answer is one of Wall Street's poorest kept secrets: investment banking. In theory, analysts were once kept at arm's length from the investment banking side of the business in order to insulate them from possible conflicts of interest. But with Street firms reaping tremendous windfalls from their investment banking work, analysts are now called upon to help their employers land new deals. And once they do, the urge or need to offer these client companies positive coverage only increases.
'They know where their bread is buttered,' says Faye Landes, a research analyst at Sanford C Bernstein & Company, which focuses on selling research to institutions, rather than advising on mergers or underwriting offerings. Landes herself attracted a good deal of attention this summer when she gave online retailer Amazon.com an extremely rare 'underperform' recommendation.
Jay Nakahara, manager of the $1 bn-plus Invesco GT Technology Fund, agrees. 'Underwriting is very pervasive. Most analysts have underwriting commitments and relationships, and so they play the game.'
That 'game' is the one in which companies guide the analyst community toward a specific growth rate, and the sell-side analysts publish numbers that are usually in line with the guidance. But all the parties involved – the companies, the analysts, and the buy side – know the numbers should be higher.
'The companies play the game, the sell side plays the game, and the buy side plays the game,' Nakahara muses. 'The buy side definitely discounts what the companies are saying. But if you're a sell-side analyst, you say, This is what they're guiding, and we think it's realistic. Because if you were to come out and put out a note that said the company's numbers are 20 percent too low, they may make it more difficult for you to get the information you need. But it doesn't matter if you're telling the buy side the numbers should be 20 percent higher or if you publish it, because the buy side already knows.'
Risk of alienation
For a buy-side manager like Nakahara, being objective – and critical – comes with the territory: he's a slave to performance. For sell-side analysts – at least those without star status – who do decide to strike out and issue critical reports, the results can be disheartening. In the worst case scenario, breaking out from the pack can mean retaliation from the companies that are covered, or even the end of a career.
Take Tom Brown, for instance. In 1998, after 15 years as a top Wall Street analyst, he was fired by Donaldson Lufkin & Jenrette. It was not a case of miserable performance – for eight of his last nine years on the job he had been the top-ranked regional banks analyst on the prestigious Institutional Investor All-America Research Team. According to Brown, DLJ's push into investment banking eroded the firm's emphasis on competing for institutional equity research commission dollars. Instead, analysts focused on pitching deals to the investment banking group, something Brown wasn't willing to do. That he was critical of many of the large acquisitions taking place in the banking sector didn't help.
Instead of going to another sell-side firm 'to do the same thing, just wearing a different uniform,' Brown says, he moved to the buy side, first at Tiger Management, and now at Second Curve Capital, a New York-based investment firm he founded in January 2000. 'It's interesting that the sell side still sets expectation for companies. But that expectation is what the company wants it to be. The sell side creates a model to get to the company's number. It's a system out of whack.'
Changing rules
For all its flaws, the current system that supports the relationship between investment banking firms, analysts, and companies has arguably created the strongest equity market in the world. The difference today is that individual investors have poured into that market. And as more people own stocks, their appetite for information has grown dramatically. As a result, the media has become equally focused on Wall Street, making celebrities out of stock pickers.
But perhaps the most explosive new force – the fuel being thrown on the fire – is technology, which has enabled virtually anyone with a phone line, a computer, or even a cable hookup to receive news on a real-time basis. The resulting feeding frenzy for information has led to an incredibly short-term focus, and that has made it more difficult for the system to work to everyone's advantage. 'This whole whisper circuit is distasteful, but unfortunately it's a fact of life. The companies object to it, asking Why do we have to be so conservative with our projections? – we beat the projections and the stocks still don't go up. But it's one of the prices you pay for having stocks at tremendous multiples,' says Nakahara.
Regulation FD
One indisputably important factor that may influence the relationship between analysts, companies, and even investment banks is the SEC's new disclosure rule, Regulation FD, which mandates that companies broadly disseminate material information. But whether it's a good thing – for analysts' independence or for anyone else – is open to debate.
'I think the situation will have to change because of the fair disclosure rule,' says Brown. 'Analysts will have to be doing their work on their own. Companies may give guidance and still come out and guide the consensus, but they will no longer be able to leak that information selectively to analysts. For some analysts, it will become obvious they can't think without the company.'
'Quite frankly, I think some analysts are going to find themselves having lots of time to go back to school, and I won't feel sympathetic,' adds Frances Stone, a former Wall Street analyst now working as a consultant and money manager.
However, to the critics of Reg FD, and there are many, the cons of the new rule outweigh the potential pros. The chief concern: Reg FD will trigger a chill, rather than broadening the flow of information, as companies clamp down on information in order to avoid any possibility of selective disclosure.
Mike Caccese, senior VP and general counsel of the Association of Investment Management & Research, is one such critic. 'Our viewpoint is that in its final form, Reg FD is still flawed. While the SEC did listen to some aspects of the industry – lower level managers can freely speak to analysts – it didn't address our final concern which is, How do you define materiality? So it creates uncertainty, which means it will slow the flow of information.'
Back to basics
But Stone disagrees that analysts will suffer from the new rule. To her, it is the reversal of a disturbing practice of selective disclosure. 'Companies will have to be more outspoken. They'll have to release to the public, rather than have a private conversation that no one hears about. And frankly I think that's good. Fewer people will be cut off from the information. As for losing access to information, aside from visiting the company, 99 percent of the information is available to the public already. It's a question of doing the work. If analysts are out there doing the job they should be doing – talking to suppliers, customers, and so forth – they'll have all the information they need. They'll do a better job.'
Beyond selective disclosure, Reg FD theoretically makes it more difficult for companies to retaliate against critical analysts. And this should help many of the smaller, independent research firms, like Sanford & Bernstein, that may not enjoy the access of their larger peers.
Ultimately, critics say the future of the game depends on the institutional investors who continue to favor the powerful Wall Street firms. And no one is suggesting the conflicts of interest that arise from the investment banking side of the business are going to disappear. But if there is any advantage that sell-side analysts enjoy due to their investment banking ties, that too may prove less valuable given Reg FD. 'Banking relationships may help some analysts get better information, at least theoretically, but this may become moot once Reg FD is implemented,' Landes observes.
Postscript: On September 22, computer-chip maker Intel lost roughly $90 bn of market cap after announcing sales would fall short of estimates in the current quarter. Many professionals believe more companies will surprise the market as they clamp down on guidance due to Reg FD. The downside: the potential for more volatility. But Intel's stumble did prompt the once unthinkable: a number of sell-side analysts apologized for not doing a better job.
In the January 2001 issue of Investor Relations, Ian Sax will study the question of sell-side credibility in Europe.