Sometimes, it’s the sound of silence that is loudest. As the debacle of Oxford Health’s funny numbers unfolded, the analysts who had been scrutinizing the company did not walk away with any prizes. Why hadn’t they noticed what was happening?
In the last year, the reputation of sell-side analysts as a group has been suffering, as academic studies and articles in magazines from Fortune (October 27, 1997) to Investor Relations (April 1997) point out that analyst reports with ‘sell’ recommendations are rarer than vegetarian Texan cattlemen.
Nelson Publications’ Marcia Boysen tracks the world of sell-side analysts, and reports that ‘independent’ analysts, are clearly in a distinct minority, with over 60 percent of analysts concentrated in the top 30 brokerage firms. But she has seen many analysts go independent to avoid the pressure to ‘publish or perish’. ‘They have to produce since the investment banking division wants to do all these deals and wants the analysts’ work to bring in clients. As soon as a company updates its figures, the analysts are under pressure to produce two-page blurbs whether there’s anything new to add or not.’
Cutting the flow
So what makes an analyst ‘independent’? And what are relationships like between them and the investor relations profession? Many people suggest a perceived need for analysts to stay on the right side of IR departments and managements for fear of cutting off the flow of information, especially in the competitive world of analysis or annihilation described by Boysen. However independent analysts suggest that perception does not always match reality, and that most IR people are highly professional, even in the face of ‘sell’ recommendations. The pressure does indeed seem to come from the competition for underwriting business which easily permeates the Chinese Walls in many of the major brokerage research departments.
The sell/buy quotient in their recommendations is a useful indicator of analyst independence. Chuck Hill, a former sell-side analyst himself, is research director at First Call, which polls analysts on their recommendations using a one-to-five scale, where one is a buy, three a hold and five a sell. He reports that out of a universe of analyst recommendations, only 1 percent are fives and 2 percent are fours, while the other three have around 30 percent, so there is an inherent bias towards the buy end of the scale. The average recommendation is 2.2, a fact that Hill says shows the bias even more.
By contrast, John Eade, president and director of research at independent Argus Research, says, ‘At any time we have more stocks on the sell list than any other Wall Street firm: around 10 percent of our stocks are sells.’
Eade explains the contrast between First Call’s universe of buys and Argus’s 10 percent proportion of sell recommendations: ‘We’re not concerned about underwriting. We don’t have that kind of skew that they get from the investment banking side, so we don’t have to make those kind of recommendations.’
Mixed messages
So what does ‘independent’ mean in this context? Typically, it describes a research firm unconnected to a broker or investment bank. Yet indy analysts still describe themselves as ‘sell-side’ even if they sell no stock, only research. And many independent research houses get soft dollar commissions from brokerage clients, which on the face of it makes them less independent than they claim.
Argus’s primary customers are retail stockbrokers without in-house research departments or money managers who value independence, explains Eade. But he’s quick to point out that providing research to discount brokers does not mean Argus offers bargain basement analysis. ‘We’re a premium service that’s more expensive than other sell-side research because clients actually have to pay for it, compared to most Wall Street research whose cost is recouped from commissions. We have to sell ourselves on our superior service.’ This added value includes seminars and conference calls with brokers and their clients, along with reports customized on different brokers’ letter-heads.
Of course, putting out a greater than usual proportion of ‘sell’ recommendations is not the best way to win the hearts of investor relations officers, but Eade reports that the response is usually highly professional. ‘We see a lot of IR people and senior management. Most treat us just like the other analysts.’ He admits that occasionally analysts with negative opinions may be penalized with lack of access, but this kind of treatment is very rare. More typical is what happened when Eade had a sell recommendation on Woolworth’s a few years ago: the company’s IR officer invited him in to discuss his view. ‘They respect your opinion,’ Eade reports.
He reels off other companies Argus has a sell on whose IR departments respond professionally and positively. However, he points out that reliance only on official company sources should be avoided: ‘Valuable information is gleaned from competitors, suppliers and so on.’
For example, he explains that peripheral information prevented Argus from even starting coverage of Oxford: ‘Our healthcare analyst was a doctor, as was his wife, and he’d mentioned for a long time that Oxford was slow in paying bills,’ which was one reason Argus never covered the company.
IR invisible
David Tice runs his own, eponymous, research firm in Dallas, Texas, and claims to avoid IR departments as much as possible. ‘Rather than interviewing IR and management people, we do our own work. We spend a lot of time looking through 10Ks and 10Qs, press releases, footnotes, and asking questions of competitors.’ He characterizes the traditional IR/analyst relationship as ‘really somewhat incestuous, since often the analyst is too close to management and simply relaying what management is telling them, rather than independently analyzing the company’s prospects. Sometimes we don’t even talk to IR or management,’ he adds proudly.
However, Tice often hears from the IR team after a critical report is published on their company: ‘They might call us, say they disagree, try to convince us we were wrong, and ask us to call in future if we want to write about them again.’
It’s not that Tice is scornful of IR professionals, he says, ‘but IR people are unlikely to tell you business stinks. We’re developing our own opinions, while IROs are usually reporting the company line, and it’s management’s role to be optimistic because they’re in the trenches trying to get things done.’
He is equally forthright on the reasons why firms like his have so many more sell recommendations: ‘Because commissions pay less than investment banking, there’s a great bias for other analysts to be positive toward the companies they cover. Analysts want access to a stream of information from the companies, and they fear that if they’re too negative they’ll be cut off.’
His firm, Tice says, has ‘no investment banking arm, we work only for our clients – money managers – and we try to independently assess companies’ fortunes, to compare our view of the future with Wall Street expectations.’ The payment comes from clients’ annual subscription fee of $10,000, which brings the bimonthly newsletter Behind the Money.
Scales of analysis
Even further along the scale of independence are what could almost be called ‘forensic’ analysts, like John Keefe of Manhattan-based Keefe Worldwide. He left the broker research industry for all the reasons mentioned by Marcia Boysen, seeing the competition for investment banking mandates as the main conflict.
Keefe’s research is commissioned on a report-by-report basis, often paid for with soft dollar commissions. Investors approach him for a report, ‘and my presumption is that they want the highest quality information. It’s more of an individual service: they pay specifically for me, rather than for the department as a whole.’ The key, he says, is to be ‘outside the box, or at least in another box.’ He gives the example of pharmaceutical analysts who get down to the actual chemical analysis of products. ‘They think out of the box of normal analysts, so they complement the Street.’ This microanalysis, he suggests, reverses the normal proportions of traditional researchers who look ‘one third at the company and two thirds at the stock. In many cases the stock and the company are different, and the difference between them,’ he concludes, ‘is investor relations.’
That cynicism may be why many non-independent sell-siders look down on their indy colleagues: ‘They don’t follow the numbers in real time, as most brokers do, so their numbers tend to be stale,’ says an unnamed analyst. ‘They serve a useful service, but just not timely enough.’
John Keefe thinks most institutional investors are attuned to the codes – ‘holds’ instead of ‘sells’ – of the traditional sell-side analyst. But the market for services like his and the research published by other independent analysts suggests that it is not just journalists who are taking a jaundiced view of sell-side equity research. Money managers and individual investors may well be sharing their views and looking to the independents for a closer scrutiny. Hence the wisdom of the IR officers who maintain their professionalism in the face of those provocative independent ‘sell’ reports.
