In February the SEC, NYSE and NASD finally moved to sever the interests of sell-side analysts and investment bankers.
Any conflict of interest is fraught with tension. When it comes to sell-side analysts, the companies they analyze and the institutions they work for, the subject is so sensitive that few of the headliners from this Wall Street circus will acquiesce to being quoted - at least by name.
Until recently the superstars of the market, sell-side analysts have fallen on hard times. The first slips in confidence started in the late 1990s, when many companies that had so recently gone public amidst sell-side hype hit a cash crunch. 'There was real pressure to go public, and many companies were floated far too early,' says one early stage investor. 'Most were still a long way from being cash flow positive, and it became clear that future revenue predictions had been vastly exaggerated. To complete their business plans, these companies would need to raise new capital, and that meant either debt or dilution, an idea that left investors highly unimpressed.'
From mid-1998 until the end of 2000, many central banks, particularly the Fed, tried to prevent overheating by gradually hiking interest rates. That left some companies stretched to pay the coupon on their floating-rate bonds, and smaller, heavily indebted companies that were unable to raise more cash began to seek bankruptcy protection. Their creditors - often other companies in similarly cash constrained circumstances - saw their own revenue projections fall apart. The house of cards had begun to collapse, and disgruntled investors quickly found a scapegoat. They had been misled by sell-side analysts and their rosy projections of huge revenues and share price appreciation.
In the case of initial public offerings, legal eagles had been deferring part of their fees in exchange for company stock, which would almost invariably go skywards immediately after the companies went public.
As for the banks, they were falling over themselves to win the business of these upstarts and the large fees from their offerings. And if the big banks were willing to put their name to these IPOs, surely they had to be good investments?
One banker at JP Morgan admits, 'When an investment house underwrites an IPO, it is effectively giving investors some degree of assurance regarding the legitimacy of the company and its business. Yes, the known risks should be listed in the company's prospectus, but with so many of the dot-coms now seeking bankruptcy protection from their creditors, it calls into question the effectiveness of the underwriting process.'
An executive at a large UK venture capital firm claims that many banks based their analyses on the due diligence carried out by early stage investors and that often their own research was not thorough enough when bringing companies to market. 'Worse still,' he affirms, 'some were so keen to jump on the IPO bandwagon that they chose to ignore the fact that many of the companies taken to market would not make a profit for a long, long time, if ever.'
Lawrence Mitchell, a law professor at George Washington University, sums it up well in his book, Corporate Irresponsibility: America's Newest Export: '[Wall Street analysts] are in the business of pushing the stock their firms underwrite or would like to underwrite. As a result of that they tend to be sloppy and careless.'
Then there are the underhand tactics of IPO allocation, which have just been affirmed in a dramatic way. In January, Credit Suisse First Boston paid $100 mn to the SEC and the NASD to settle charges of kickbacks in the allocation of IPO shares, including the red hot IPOs of Linux providers Red Hat and VA Linux and optical networker Corvis (all of which are now trading at a tiny fraction of their IPO price). The settlement terms allowed CSFB to admit to technical violations while denying fraud.
In the words of Melvyn Weiss, the New York lawyer who headed the committee prosecuting the case, 'CSFB would not have agreed to pay $100 mn, or indeed suspended and fired some of the executives involved in the IPOs, if it had not been at least partially at fault.'
And Dan Ackman writes in Forbes magazine, 'The payment [could be a drop in the ocean since it] will encourage private litigants who are suing CSFB and a number of the bank's competitors.' There are currently around 1,000 lawsuits on the go, involving some 300 IPOs and 45 securities firms.
Potential conflicts
At the heart of the sell side's conflict of interest is the relationship between investment banking and brokerage trading. How does a company select a bank for raising capital or any other transaction? It's unlikely to choose one whose analysts have a low opinion of the company. In the go-go 1990s, with trading commissions cut to the bone and investment bankers high on the hog, the pressure was on the sell side to cultivate cozy relationships with companies. As Aram Fuchs, CEO of the independent equity house FertileMind.net, puts it, 'Research became subservient to the interests of investment banking clients.'
Surely, though, sell-side analysts who constantly overstate their case should find very few takers for their research. According to the conventional wisdom at Zacks, it is in the interests of company management to provide conservative figures, because nothing is as damaging to a company's share price as a downward revision of its expected earnings. With so much of senior management's income derived from share price performance, they should try to provide accurate information to sell-side analysts, choosing to err on the side of caution rather than to overstate their case. The same goes for sell-side analysts: their main aim is to provide buy and strong buy recommendations that will outperform the market, ensuring their research is better received by institutional investors.
The options option
But are growth projections usually conservative? In the case of company management's projections, one pension fund manager at Scottish Widows maintains that they're often not. In recent years, the time senior executives managers remain at any one company has decreased dramatically, and each new role is typically accompanied by generous share option packages. 'Executive stock options now account for some 13 percent of the market in terms of outstanding shares,' Mitchell finds.
Options are only worth something if the current share price is higher than the options' exercise price, so numerous managers have a very real incentive to overstate their companies' short and long-term earnings prospects. Like early stage venture capitalists, if they can exit while the share price is still in the stratosphere, they can make a handsome profit without worrying too much about any subsequent downward revision of their company's projected earnings. In many cases this is exactly what happened, which is why there are so many dot-com millionaires from companies that are now defunct.
But even at large and well established companies the pressure is on to think short-term. Adds Mitchell, 'Executives and directors now have a direct incentive themselves to maximize short-term profit, exercise their options, sell and get the hell out of there.'
Even so, in order for the extraordinary valuations of the late 1990s and early 2000 to be accepted by investors, management needed the connivance of sell-side analysts. And they got it. In mid-2000, one analyst put a price target of $210 on Ask Jeeves, a web site that seemed like little more than a glorified search engine. With almost 40 mn shares outstanding, that projection would have given the company a valuation of around $8 bn. Its gross revenue in fiscal 1999 was $22 mn - nowhere near cash positive.
There are many other examples. Even as recently as November 2000, Mark Fernandes, VP of equity research at Merrill Lynch, put forward 16 tech stocks in his booklet, Internet Infrastructure Software: Creating Order from Chaos. The twelve-month price targets now seem like science fiction. It will be a long time before even so-called 'rapid growth stocks' are valued based on 100-plus multiples of forward price-to-earnings ratios again.
What's in a recommendation?
Why is it that, at least until very recently, so many analysts seemed so reluctant to issue sell recommendations? This question was put to a number of analysts during the Merrill Lynch Tech Trends conference in London in November 2000.
Of the seven analysts who responded, five gave answers that left the audience none the wiser. Henry Blodget, the investment bank's best known internet bull, answered, 'All our findings can be examined in our reports, but investors also have to read reports, they need to read between the lines.' That's all very well but research reports often come with price targets, which are pretty specific and have very few lines to read between.
Another analyst elaborated on the idea of access to information: 'Analysts are like journalists,' he maintained. 'They have sources of information - the financial officers and management at the companies they analyze. They have to be careful not to be too critical of the companies under review, otherwise the financial officers there might just pull the plug on the flow of information. This would leave the offending analysts at a disadvantage compared to their peers at other institutions who had expressed themselves more prudently.' However, he continued, it was now accepted wisdom that a buy recommendation meant hold, and a hold could actually be considered a sell. Indeed, according to Zacks, 72 percent of brokerage ratings are still strong buy or buy, whereas less than 1 percent are sell ratings.
More art than science
Astute investors know that calculating the value of a company is more art than science. Indeed, during the internet boom, some analysts turned it into an almost entirely abstract art form, since there was little concrete evidence - revenues, positive cash flow, profits - on which to base any kind of valuation.
Generally, however, analysts using traditional valuation techniques and those using more complex methods will base their input on the most concrete data available. This can usually be found in a company's quarterly and yearly reports, which have become far more widely available since the advent of the internet. With a little effort, investors can, and indeed should, carry out their own valuations of the companies in which they wish to invest.
So why do investors place such a high level of faith in the words of stock analysts? Most of the time those analysts may be no better informed than anyone else. A case in point is the collapse of the once mighty Enron. Only two months before Enron filed for chapter 11, 14 analysts considered the stock a strong buy, three rated it a buy, and one a hold. There was not one sell recommendation. After the collapse of the company, RBC Capital Markets came out with a strong sell rating and a price target of $0.
Was this an attempt at sarcasm?
According to Whitney Tilson, founder of Tilson Funds, 'Behind the opacity of Enron's financial statements, much evidence pointing to impending financial doom was there for all to see in the company's 10Q filing in August. But in spite of complaints regarding the company's lack of financial transparency - it was known as the black box among sell-side analysts - analysts continued to tout it as a good investment.'
Here's another example. On October 15, 2001, Goldman Sachs added the US drugstore chain CVS to its 'recommended list' of stocks, which supposedly contains the 'cream' of the bank's numerous strong buy recommendations. When the company released its third quarter report on October 30, the numbers met analysts' reduced estimates, but the company's projections for the fourth quarter were disappointing.
The price plummeted
25 percent and Goldman was quick to downgrade the stock to market perform. By that time, however, investors who had followed Goldman's recommendations had been well and truly stung.
Try it at home: do a simple fundamental analysis on the figures available on October 15, and you'll find that Goldman's original recommendation was perfectly reasonable. But if the analysts at Goldman Sachs did not know of possible problems at the company before they were announced, then it is clear that their own research did not extend beyond what everyone knew anyway. In light of Regulation FD, they and their clients are in the same boat as everyone else. Sell-side analysis today is a case of the blind leading the blind, and reaping fat rewards for it.