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I think Kedrosky is hopelessly out of date, although things might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.

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