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I think Kedrosky is hopelessly out of date, although things might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