What are stock analysts for?

Stock analysts, the CNBC superstars of the go-go 90s, have been back in the news of late. Henry Blodget, Merrill Lynch's star internet analyst, said one thing in internal emails and another in public reports, bringing down a $100 million fine on his firm. And Jack Grubman, Salomon Smith Barney's telecoms analyst, has recently quit his $20 million-a-year job, but still faces lawsuits alleging, most recently, that he upgraded his rating on AT&T only so that his firm could get a lucrative underwriting deal from the telecoms giant.

The general problem with such people, from the point of view of Eliott Spitzer or Gretchen Morgenson, is that they're duplicitous hyprocrites, who purport to be giving advice to investors on which stocks to buy when in fact they're just buttering up their firms' potential clients.

Spitzer, New York's ambitious attorney general, has received glowing press and is now better placed than ever for his forthcoming run for governor. Morgenson has already got her Pulitzer. It's easy to see why analyst-bashing is so popular right now: as greedy investors look at the ruined state of their stock portfolios, they love anybody who says that someone other than themselves is to blame.

Among people long familiar with Wall Street, however, the shock was not at the behaviour of the rogue analysts, but rather at the way in which the fearless press (not to mention the Pulitzer committee) was lapping it all up. After all, it was common knowledge during the boom that these analysts were earning tens of millions of dollars a year: where did people suppose that money was coming from?

I was set to thinking along these lines after reading a piece by former analyst Paul Kedrosky in the National Post. Stock analysts purport to be stock pickers, he says, but in fact they're not: if they were good at picking stocks, they'd be picking stocks rather than analysing them. Kedrosky claims that the purpose of stock analysts is to provide essentially a set of fresh eyes for institutional investors: maybe they'll see something the fund-manager missed, or come up with an interesting new angle. The actual rating - buy, sell, hold - is, on this view, irrelevant.

I think Kedrosky is hopelessly out of date, although things might be swinging back in that general direction. For one thing, ratings upgrades and downgrades do move stock prices, so they can't be quite as irrelevant as Kedrosky says. For another, Kedrosky seems stuck in the old world of financial markets, where companies just went ahead and did their thing, analysts analysed, and investors arrived at a collective decision for the value of the company. There were no feedback loops: a company's fundamentals were reflected in its stock price, but the stock price itself was not one of those fundamentals.

Most importantly, in the old days, stock analysts were modestly paid, mainly because they produced no revenue for their firm. The only way they could justify their existence at all was by invoking the honour of institutional investors, who apparently felt duty-bound to use Bank X's trading desk to buy or sell any stock which they were dealing in as a result of Bank X's research. Whether that was actually the case or not nobody knew, and in any event the marginal increase in brokerage commissions which the average analyst brought in was never enough to justify a seven-figure salary.

It was obvious, then, when analysts started becoming superstars and bringing home seven figures monthly as opposed to annually, that something significant had changed. And it was obvious, too, what that change was: the primary audience for analysts' research was no longer institutional investors, but rather the very companies they were covering. A hot analyst like Blodget or Grubman could create a buzz around a company, which would keep investors concentrating on the rising share price rather than asking awkward questions.

WorldCom was a prime example. It was generally considered a Bernie Ebbers story: iconoclastic CEO, through sheer force of personality, single-handedly shakes up the fusty US telecommunications industry and creates hundreds of billions of dollars of value in the process. But in fact it was just as much a Jack Grubman story: every time Ebbers bought another company, Grubman would put out a bullish research note, and the market capitalisation of WorldCom would increase by more than the price Ebbers was paying. Ergo, all WorldCom's acquisitions were successful. It was quite a nice little virtuous cycle while it lasted: super-charged revenue growth drove up the stock price and p/e ratio; a super-charged stock price gave Ebbers a highly valuable currency with which to make further acquisitions; and the fast pace of acquisitions drove the company's revenue growth.

All this was dependent on Grubman and his fellow telecoms analysts: it was they who never pointed out that WorldCom wasn't actually adding any value to the companies it bought, and that it made no sense to behave as though any company automatically doubled in value the minute it got bought out by the Ebbers machine. There was a good reason for them not pointing this out: while neither of the companies concerned got much in the way of bottom-line value out of the mergers, the banks who advised WorldCom on its acquisitions made hundreds of millions of dollars in M&A fees. (They got nearly as much out of underwriting WorldCom's ever-increasing debt issuance, as well.)

So there was never any doubt where Grubman's $20 million a year was coming from: it was trickle-down from the deals he was incessantly pushing, and the fees they generated for Salomon Smith Barney. Ebbers and Grubman needed each other, and both profited handsomely from the relationship. Investors signed on for the ride because while it was working it worked for them, too. If you followed Jack's picks, you'd make a lot of money. In the bubble years, stock prices often rose simply because they were rising, and not for any fundamental reason; the Grubmans of this world were there to reverse-engineer some sort of vaguely plausible rationale for the behaviour of an irrationally exuberant market.

So now we see why Michael Armstrong, the CEO of AT&T, would put pressure onto his friend Sandy Weill, the CEO of Citigroup, to get Grubman to upgrade his company. If Jack Grubman - long a thorn in AT&T's side - were suddenly to upgrade Ma Bell, all three of them could jump onto the ensuing bandwagon and make a lot of money. So Grubman takes another look at the company, suddenly decides he likes what he sees, upgrades it, and - presto! - Citigroup/Salomon Smith Barney gets a $45 million gig underwriting an AT&T spin-off. (A few months later, Grubman changes his mind and downgrades AT&T again, but by that point the money is in Sandy Weill's bank.)

Where Grubman and Blodget tripped up was in believing their own hype too much. For years, there had been a direct correlation between the degree of their own optimism and the degree of their own success. (Blodget made his name by putting a $400 price target on Amazon.com when it was trading at $243; Amazon hit the target less than three weeks later.) So when the market turned sour, they stayed on the bullish side, touting the same old stocks for the same old reasons, but not getting the same old response any more. They should have realised that the party was over, and that every virtuous cycle can turn into a vicious cycle. They should have realised that falling stock prices can be just as self-fulfilling as rising ones, and jumped onto the bearish side of the market. But they had been too optimistic for too long. (It was the fact that they were among the truest of True Believers in the first place that had led to their success.) So individual investors, along with Spitzer and Morgenson, can now blame them for maintaining "buy" ratings all the way down on stocks which lost 99% of their value.

We're now left picking up the pieces, in a world where investment banks are bending over backwards trying to disclose their inevitable conflicts of interest. But no amount of Chinese walls and disclosure statements will ever make analysts trustworthy again. Only when analysts' salaries drop back down to pre-bubble levels, and they're no longer superstars in their own right, will it make any sense to take investment advice from a sell-side institution.

Posted by Felix at 11:32 EST

What are stock analysts for?

Comments

Post a comment

Felix Salmon: Recent posts

Felix's del.icio.us links

Archives