When a Wall Street analyst puts a buy recommendation on a company, he means ‘it’s okay to be in the passive, low-risk, low-payoff dividend reinvestment plan,’ explains a sardonic financial glossary recently offered by Brill’s Content. Hold actually means sell, and on those rare occasions when a sell appears in brokerage house research, ‘the company is most likely already in Chapter 11.’
This is not far from the conventional Wall Street wisdom that analysts are generally reluctant to issue sell recommendations, especially for firms that might generate future investment banking business. So, of the nearly 6,000 stocks tracked by First Call, a mere 0.8 percent garner a sell recommendation; 66 percent have strong buy or buy recommendations, while the remainder are holds.
Swiss cheese
‘The Chinese Wall has definitely broken down at an increasing number of firms,’ notes Chuck Hill, First Call’s research director. Originally denoting the separation of sensitive banking information from a brokerage firm’s research side, the term ‘Chinese Wall’ now also commonly refers to pressure on the analysts from the banking side to favor institutional clients, or potential clients. In these cases it’s more a question of peering through or over the wall.
‘It’s Swiss cheese,’ admits one research director, while a Wall Street veteran describes it laughingly as ‘six inches high.’ A London-based fund manager says simply, ‘When I hear of a downgrade or upgrade, my only question is Why? What’s the analyst’s motive?’
Research departments of brokerage houses spend billions of dollars a year on security analysts, in the firm conviction that whatever else it does, good research can make money for their investment clients. But there are increasing questions about the credibility of the research reports they are producing.
Even though most Street-wise investors have long ago learned – in the words of one old hand – ‘to just accept the contamination from the investment banking business as a given,’ a smoking-gun Morgan Stanley memo hit the pages of the Wall Street Journal with quite a bang in 1990.
‘Our objective is to have a zero failure rate on this subject and to adopt a policy, fully understood by the entire firm, including the research department,’ wrote Clayton Rohrbach III, then Morgan’s head of equity capital markets, ‘that we do not make negative or controversial comments about our clients as a matter of sound business practice. Furthermore, as we have discussed, any opinion changes or investment conclusion which may be viewed negatively by our clients need to be monitored through Jeff Sine as CFD (corporate finance department) operations officer.’
Morgan Stanley insisted that the memo had never actually been adopted but, according to the Journal, analysts who chose to question the firm’s directives either quit, were fired or were forced into different jobs.
Pressure points
Since then, pressure on analysts to be positive has not only intensified, but has started coming from a lot of different directions at once. The bankers, needless to say, continue to pursue their own interests, and increasingly it is the corporate finance business that pays analysts’ salaries and bonuses.
‘Research is a loss leader at brokerage houses,’ notes J Anthony Boeckh, head of Montreal-based Bank Credit Analyst Research Group, a firm that has been providing independent research for 50 years, and is now being used more often by investors burned by brokerage house optimism.
One international fund manager points to the recent Wall Street enthusiasm for the bonds of a troubled Indonesian pulp and paper company as a prime example of the disconnect between reality and underwriting fees. ‘It’s a horrible story: they’ve taken a lot of hostages, there’s debt of $8 bn, yet all these people continue to recommend their bonds even as they get weaker,’ he gripes. The fund manager adds: ‘I don’t see them running to put these bonds in their personal accounts.’
At the bulge-bracket brokerages firms, many research heads freely admit the pressures, but they contend that these can be successfully negotiated. ‘There is always going to be the possibility of conflicts between a research opinion and a corporate relationship, but obviously the relationship has to be managed to show the value of independent research,’ notes Charles Scott, Morgan Stanley Dean Witter’s director of European research. ‘Our bankers understand that the analyst’s franchise is key to his usefulness.’
Albert Richards, head of European research at Salomon Smith Barney, takes a similar line. ‘The reality is that the conflict exists every place in the world,’ he asserts. ‘You can’t deny it’s there. The only difference you will find is how aggressively the integrity of the research department is managed.’
At Salomon, Richards says, the analyst is told the investment banker cannot complain about what is said about a particular company, but only about how it is said. ‘To say, We disagree with management strategy, is one thing,’ he points out. ‘But it’s different to say, They are a bunch of idiots.’
Driving deals
Though all major firms are seen as equally culpable, Goldman Sachs is often singled out for special mention. ‘The deal-driven quality of their research really turns me off,’ says one fund manager. Robert Morris, Goldman’s co-head of global research, says in his firm’s defense, ‘To a large degree, the impression that we are cheerleaders is related to the fact that we have a very large deal flow – it’s a spill-over effect.’ And, he maintains, the firm tends not to do deals the relevant analyst cannot support; moreover, the analyst must set price targets and defend his decisions in a disciplined investment environment.
Some firms pride themselves on the difference between their research and that which is provided by the giant brokerages. ‘It is no secret that some of these big global American houses are, shall we say, very careful about what they write on corporate stocks. We, however, have a policy of preserving analysts’ integrity,’ says Michael Crawshaw, head of research at Schroder Securities in London. ‘They write what they believe to be true even on corporate advisory stocks, and they do not manipulate their views for the purposes of securing capital market mandates.’
Marc Mayer, head of research at Sanford C Bernstein, is convinced of the power of an independent view. ‘I think it’s unique to Bernstein that whatever forecast we carry, whatever rating we assign, it really is the independent view of the analysts,’ he claims. ‘While we do participate in syndicates – we’re not entirely uninvolved – we don’t originate, and that’s the crucial difference.’
Corporate bankers, of course, are not the only source of potential compulsion. ‘Companies also put pressure on us by telling our analysts We’re not going to answer the phone, if they get negative,’ points out John Hoffmann, Salomon Smith Barney’s director of global equities research. Cutting off access has serious consequences for analysts, since close contact with senior management is seen as providing a competitive edge at a time when everyone has virtually instantaneous access to the same data.
In fact, many investors perceive analysts whose firms have extensive corporate relationships with the companies they cover as being better connected, and as having potentially greater access to information, and they are willing to accept the upward bias in coverage that may result. ‘He’s exceptionally close to all the major players in the industry and I think it makes a real difference,’ says a fund manager to explain why he finds a specific brokerage analyst especially useful.
Companies have recently become even more vigilant about monitoring the perceptions being formed about them by the investment community. Says Salomon Smith Barney’s Hoffmann, ‘Top management is increasingly paid in stock and options, and when their compensation as well as their pride is linked to the stock price, well, they are obviously more sensitive about what anybody says about their company.’ But, adds Richards, Hoffmann’s London colleague, ‘We find that companies are much less sensitive to the issue of negative reports if you give them a chance to rebut.’
Getting mad, getting even
‘I know we get mad at people from time to time,’ says Tom Rice, senior VP and director of investor relations at Fleet Financial Group, ‘especially if we have a sense that someone is grandstanding at our expense, using us as a convenient and colorful example to call attention to themselves. If an analyst is intellectually honest and is conversant with our position and chooses to disagree, we respect that, but if a person is lazy and hasn’t done the work, then we get mad.’
Especially galling, according to Rice, is that while the analyst might change his mind after the company has made an effort to correct any misperceptions, no timely public corrections are offered. ‘I haven’t run into many people who admit to making a mistake,’ contends Rice. ‘People apparently need a fig leaf.’
Some companies are more easily roused to angry action than others, finds Michael Mayo, banking analyst at Credit Suisse First Boston. After he downgraded their stock to ‘hold,’ Mayo was conspicuously disinvited from a Mellon Bank dinner for analysts and, upon making inquiries, was told that he had not been ‘supportive’ enough. ‘Some companies treat you the same no matter what, while some companies cut you off,’ observes Mayo. ‘One bank CEO still won’t talk to me after several years, and what that shows is that he’s putting his own grudge in front of the interests of shareholders.’ In fact, says Mayo, he often finds the individual responses informative in themselves: ‘Some of the most dramatic reactions to our negative research were by companies that had the most to be concerned about, a sign that we were right on the mark.’
In addition to their bankers, and the companies they cover, analysts are also finding themselves under surprising pressure from their research clients. Rather than being interested in receiving an objective report on their holdings, says Lori Applebaum, banking analyst at Goldman Sachs, ‘Investors frequently try to influence our views based on what their own position is.’ Hoffmann concurs: ‘Institutional buy-side clients don’t want us to downgrade stocks they own. We read them saying they want more sell ideas, but when we do it, they kill us.’ Just about everyone, it seems, now has a stake in managing market perceptions upward; as the song says, ‘accentuate the positive, eliminate the negative.’
And why not? When an influential analyst speaks, he or she moves markets. The day Merrill Lynch’s Judah Kraushaar issued a bullish report on the proposed merger of Citicorp and Travelers Group, both stocks immediately shot up 7 percent. ‘A fun day,’ notes Kraushaar.
But it’s not every analyst who has power. Those who are regarded as corporate shills by the investment community can never get this kind of clout – Judah Kraushaar is the top-ranked money center bank analyst in Institutional Investor magazine’s influential poll. Laurie Meisler, who has been in charge of the rankings for 15 years, notes, ‘Certainly fund managers understand the underlying meaning of all the buy-sell-hold signals, but when they choose the top-ranked analysts they increasingly single out independence as a prime factor. So it’s clear they perceive some analysts as more credible than others.’
Star chamber
There is intense competition among brokerage houses for top analysts, since a star will bring in underwriting business, as well as reaping rich personal rewards. When Goldman Sachs, for example, tried to entice the famed telecom tracker Jack Grubman into its fold, Salomon Smith Barney coughed up a compensation package reportedly worth more than $25 mn. (He stayed put.)
With credibility as one of the main star-making ingredients, analysts who sell out might find peace in the short term, but sooner or later, they will likely get blown out. Even as the bankers and companies and fund managers do their best to make analysts pull their punches, if they are perceived to have done so, their star fades, along with their value to everyone concerned. Ironically, the most desirable analysts tend to be those who do not allow themselves to get pushed around.
So, with all of the intense pressure coming at them from all directions, are analysts stressed out and miserable? Well, no. For years, they toiled in relative obscurity, writing reports and making recommendations. Today, the very fact that so many different constituencies are doing their utmost to influence the opinions of analysts testifies to their new-found importance.
‘Analysts are the rock stars of the 1990s,’ contends Salomon Smith Barney’s Richards, and everyone agrees there has never been a better time to be an analyst. They have ridden the raging bull to great power and influence, and the breathtaking pay packages that go along with their new status. But when the market corrects, as it inevitably will, there will be a shake-out. ‘Right now, you slap a buy on everything and you win,’ says Chuck Hill. ‘But when the crunch comes, it will separate the men from the boys. The ones who’ve been getting a free ride during this euphoric atmosphere will take a tumble.’ And so will their clients.
