The recent media and public outrage over conflicts of interest between analysts, investment bankers and their respective clients has captured the headlines in the past year. A record $1.4 billionfine was slapped on ten of Wall Street�s largest houses recently because of the duel roles that analysts played in helping to lure in banking clients. While simultaneously recommending shares ofthese banking clients in public, these analysts had numerous doubts about these companies as uncovered in their private documents and emails. Further conflicts grew out of the analysts� and theirfirms� allocation of �hot IPO�s� to executives of these same banking clients so that they could make a quick profit during the go-go days of the late nineties. With the impending investigations intoanalyst practices as well as the large fines placed on the ten firms, we must ask ourselves- will any of this change the research practices at major Wall Street houses?
My gut reaction to this question is an emphatic �no!� During this period of intense scrutiny by regulatory bodies of the practices of analysts, things may change in the short-run. Indeed, much as a speeding driver will slow down to the speed limit when he spots a police officer, the firms will clean up their practices at least temporarily to show that they are really changing. The regulators have recently picked up the pace of their investigations in response to a public outcry and pressure from politicians. However, the main problem here is not the intensity of the investigations by the regulatory bodies as some in the media have suggested, but the pervasive attitude of the Wall Street executives themselves. There has been no public acknowledgement of wrong-doing or apologies to all of the millions of small investors that were screwed by the faulty research practices. One Wall Street executive even bragged in a press conference about how his firm paid one of the smallest fines, and thus was �less guilty� than the rest. Another firm hyped up an initial public offering in ways similar to the late nineties just three days after the fines were imposed. To them, the problem was not what they were doing, but rather, that they got caught.
Putting several analysts and executives in jail for a few years and imposing large fines will put a temporary scare into some of the firms, and force some kind of change to their practices. The ultimate problem inherent with research at major Wall Street firms will not be solved however. Within a matter of months or a couple of years, these firms will have a vested interest in going back to their old habits after the vice-grip of the regulatory bodies loosens again. For these firms, investing is a �transactions� business. It is in their best interest, to persuade investors to make transactions- that is when these firms get paid. Getting people to move money, whether it be from rapid trading (where they can rack up commissions) or from doing large investment banking deals (where the firms can rack up fees), Wall Street is a �transactions� business. Unless analysts are held accountable for their recommendations, no regulatory bodies will have much impact on the practices most firms� employ. It will remain in the best interests of the firms to have their analysts change their recommendations on a stock every month so that they can generate more commissions through investors trading on those recommendations. Once the regulatory bodies get off their backs, it also will once again be favorable to write positive recommendations about the firm�s investment banking clients to generate more business. This is how Wall Street gets paid- moving money.
How do we put an end to these research practices? It would be very simple. Regulators must force the firms to put together a model portfolio of $100,000, and then track the portfolio through the years. This portfolio must be updated daily and prominently displayed in every office, publication and web site that the firm has. That is all it would take!
Let me explain. First of all, the $100,000 size was used because it is probably an amount that represents the typical small investor- the same type of investor that got burned the most in the recent bubble. Now many of you reading this may be asking the same question that I often do: �why isn�t this done already, doesn�t anyone track the stock picks of analysts?� Aside from the Wall Street Journal�s monthly feature which pitted analysts� picks against those picked through random dart-throwing, as well as several other random publications that have similar stock market games, there is no coordinated effort to really track a firm�s research department. There are the annual awards that go to the top analysts in different industries and quarterly features in the Wall Street Journal about how the various firms fared in their picks (usually this embarrassing to the firms, as most do not beat the S&P 500). However, no one really monitors these picks over the course of many years to see if investors are truly better off listening to these gurus over an investing lifetime.
I propose that each of the firms be forced to launch a model $100,000 portfolio which tracks all of the moves made by that particular firm�s research staff. All commissions that are applicable shall be charged to the portfolio, and all holdings must be prominently displayed. If a firm issues a downgrade on a stock and the stock falls 5% on the opening of trading the next day, they have to sell the stock at that lower price in their model portfolio exactly like their clients would have to. If the chief strategist in the firm reweights his allocation to stocks up to 75% from 65%, the firm has to publicly announce which stocks they are recommending to buy to achieve this new allocation. They also must purchase them at the prevailing price at that moment with all applicable commissions, just like the typical small investor. I am quite confident that with all of the changes that a typical Wall Street house makes, the model portfolio would get �nickeled and dimed� to death with excess transaction expenses. It would be more than fair to say that this model portfolio would probably undergo at least 100 changes during the course of a year. If you average $50 per trade in commissions (I think most houses would probably charge even more), your trading expenses would be $5,000 for a year, or 5%. This alone would be a tremendous hurdle for the trigger-happy firms of Wall Street to overcome in this model portfolio.
In addition to the small expenses adding up to cut into your return, it must be pointed out that the practices of the analysts themselves would lead to subpar results. I do not have substantive evidence that analysts downgrade stocks their firm is trying to buy, while upgrading stocks that the firm�s trading desk wants to sell. I am not a regulator looking closely at these practices. However, how else could you explain some of the pathetic stock picks that we have seen over the past few years? This problem goes far beyond the last second downgradings that prominent analysts made on stocks like WorldCom and Enron right before they plunged into bankruptcy. This is a problem that happens every day in the market much more subtlety.
I will illustrate my point by asking a simple question: if you wanted to buy a particular stock but hadn�t yet, would you recommend that stock to the world so you could pay a higher price, or would you �downgrade� the stock so you could pay a lower price? Likewise, if you already owned a stock, would you be more inclined to recommend it to everyone, or say that the products the company makes are faulty? Common sense tells us that we wouldn�t want to tell the world to buy a stock at $30 when we are trying to buy it at $25. It would be much more advantageous to write a negative report about the company so the stock may fall down to our $25 price. The reverse incentives exist for a company we already own stock in that we are looking to sell at a higher price. All Wall Street firms have trading desks that buy and sell large quantities of stock. Given this fact, where do you think the best interests of the firms and their analysts are?
To cite two specific examples that I can recall in the past year (both stocks that neither my fund nor myself owns or has any ties with), I will point out the analyst recommendation histories of AFC Enterprises and BJ�s Wholesale Club. These are two old favorites that I mentioned in my last article �Measuring Risk� as well. BJ�s Wholesale Club traded above $40 per share and as high as $57 throughout most of 2001 and 2002. During that period, the analysts covering the stock wrote glowing recommendations, and not one had a rating below �buy.� As the stock price began to collapse, several analysts lowered their ratings from �strong buy� to �buy� in late 2002. The first hint of Wall Street worries came on August 21, 2002 when one analyst lowered the rating to a �hold� (in Wall Street language, that�s a �sell�). Unfortunately this came after the stock was down over 50% from its all-time high. When the stock made its final descent down to a little under $10 per share, downgrades were abundant. One firm that had been recommending the stock since January 10, 2002 (when the stock was at $44.36) downgraded the stock on March 13, 2003 to a �hold� as the stock closed at $9.38.
Fast forward to the recommendations that exist as I write this article. There is not one analyst recommending the stock as a buy as it trades at $15. Perhaps this is a good recommendation going forward, as margins and profitability have been cut a great deal for this company. Nonetheless, the average price target over the next 6-12 months on the stock is $21. This begs the question: how is the stock a �hold� or a �sell� if it is expected to return 40% over the next 6-12 months? What is this telling you? Either the analyst doesn�t really believe in his projection of $21, or there are other factors at work here. Perhaps the trading desk is looking to buy more of the stock now, as it appears to be a buyout candidate for either Wal-Mart or Costco. Further, perhaps the analysts and their firms know the details of these negotiations, and they know the firm could profit from owning some shares. This couldn�t happen, could it?
A second case of unbelievably bad analyst calls comes from the example of AFC Enterprises. This restaurant company that owns Popeye�s Chicken, Church�s Chicken, Cinnabon and Seattle�s Best Coffee traded between $28-$35 per share in early 2002. During this period most Wall Street research staffs rated the stock a �buy� or higher. As the price declined, the firms steadily began lowering their ratings, much like in the case of BJ�s. Right as the stock hit its ultimate low on March 25, 2003, the influx of downgrades came in. One classic case that I tracked was a firm that upgraded the stock to �outperform� on May 21, 2002 when it was trading at $29.46. A week before the ultimate collapse, the firm was savvy enough to downgrade the stock on March 17, 2003 when it was trading at $16.88. They saved their investors a small amount of money for the next few weeks as the stock traded even lower as AFC announced they would have to restate results for 2001 and 2002. However, this came at a cost of 42.7% for those investors that followed these recommendations. How is it that the same firms that were recommending this stock as a �buy� when it was trading between $28-$35 are now recommending it as a �hold� when it trades under $20? I understand the fear with the accounting restatements, as I don�t like to do business with companies that play numbers games like that. However, what I don�t understand in this case is how these shares could be recommended at the higher prices of 2002 when the stock traded at a very high multiple for a restaurant (over 20 times earnings).
It is very easy for me to pick specific cases where analysts went wrong after the fact. I am not trying to say that these guys are bad because they make mistakes. Indeed, I certainly have made my share of mistakes in my past trading and investing career, and I will continue to do so. However, what I do want to point out is the fact that there is a recurring theme when you follow the markets as closely as I do. For instance, why is it that when you watch CNBC and an analyst at a particular firm comes on, he is always recommending a stock that has gone up 100% in the past 6 months? Why is it that a stock gets downgraded after it has fallen 50%? Why was there a shortage of �hold� and �sell� recommendations in the late �90�s when stocks were so overvalued that 50% growth rates couldn�t even justify the prices? Where were the buy recommendations earlier this year in March, when the market bottomed? Isn�t the point to �buy low and sell high?�
Unfortunately for many firms, the point of investing is not performance but generating transactions. Na�ve investors feel panic when a stock price falls. By playing to these fears and downgrading a stock after it falls, the firms can spur action in the small investor by getting them to sell, whether it is in their best interest or not. By hyping a stock that has already risen 100% (and according to the analyst: �is poised to go even higher�), Wall Street can play to small investors� fear of �missing the boat.� Unfortunately, Wall Street and the media has trained us to act emotionally with our investment decision-making. In our society, when it comes to money, it is much easier to get someone to make irrational decisions than rational ones. As Warren Buffett has said in the past: �a fool and his money are soon invited everywhere.� For most investors in the 1990�s, that was quite often to their local stockbroker�s office to make a new trade.
Whatever the reasons for the poor performances of analysts at the major Wall Street houses, something needs to be done. Fines and jail sentences help in the short-term and help some small investors feel vindicated. The only long-run solution that will really work is to make the firms accountable. We must force them to initiate a model portfolio that tracks all of their recommendations. It must be clear and accessible. When you log onto the firm website, it must be prominently displayed. When a representative of the firm speaks on television, he or she should have to address questions about the portfolio. When an account statement gets mailed out to clients, it should include the firm�s �model portfolio.� Everywhere you look, the firm�s results should be posted. No tricks or gimmicks shall be allowed (ie the firm buying stock at the day�s low or selling at the day�s high, excluding commissions, restarting the portfolio or restating past results, etc.). Just clear, concise daily, weekly, monthly, annual and �since inception� results that everyone can understand.
In my estimation, this solution is much cleaner and cheaper than pursuing the years of litigation that we face trying to solve these past conflict of interest problems. The regulatory bodies could hire a small staff to just monitor these model portfolios, and make sure that they are in line with the rules that are proposed. Further, they could enforce a rule that the firms must contact them first to get approval for the changes being made, the price on the transaction, and the commissions to be paid in the model portfolio. I am convinced that the firms will be embarrassed by the results after a period of months or years, and will change their research practices accordingly. Analysts will be forced to place investor interest ahead of their own. They will be more careful and savvy in making their picks and recommendations. In short, they will level the extremely unbalanced playing field for all investors, making the game more fair for everyone.
Christopher Tarrach manages Tarrach Holdings, a hedge fund based in Pennslvania. To learn more about Chris and the funds he managesCLICK HERE.
Disclaimer: Chris Tarrach is the president of Tarrach Holdings. Mr. Tarrach periodically publishes columns expressing his personal views regarding particular securities; securities market conditions, and personal and institutional investing in general, as well as related subjects. Mr. Tarrach’s columns are not intended to constitute investment advice or a recommendation to buy, sell, or hold any security.
