Financial Analysts: Writing Research That Benefits Their Employers and Themselves
In a disclosure likely to send ripples (of laughter that is) through the investment community, the Securities and Exchange Commission said recently that the independence of Wall Street research analysts may be compromised when they profit personally by buying stock in companies they cover. The SEC and Congress are supposedly conducting widespread probes into a litany of analyst practices. It seems that financial analysts may be biased in their coverage of companies and the public may have been misled by their tainted advice.
Investors have lost billions, even trillions; the retirement dreams of most Americans have been squashed or delayed. Many feel the pain of their losses, yet few are talking about it. Everyone is looking for someone to blame. It was analysts that fueled public demand for stocks, pushing prices higher and higher. Now class action lawsuits are being filed against analysts and their employers for their bullish recommendations. The full extent of the damage is still unknown. We have just experienced the largest evaporation of wealth in modern history. What does the industry have to say for itself?
The Association for Investment Management and Research, the 50,000 member lobby group for financial analysts and portfolio managers, which occasionally portrays itself as an "investor advocate," has conceded to Congress that rules to fix analyst conflicts may be needed. You may recall this venerable association publicly disputed our allegations in 1998 that personal trading abuses were rampant throughout the money management industry. Apparently AIMR has some reason to believe its financial analyst members aren't quite as immune to the temptations of personal gain as its portfolio manager membership. More likely, AIMR's modus operandi is to issue a blanket defense of its membership for as long as plausible and, once buried under an avalanche of embarrassing public disclosures, gracefully concede there may be problems. Since 1990, AIMR has never publicly disciplined any member for violating its ethics mandate that analysts "maintain independence and objectivity in making investment recommendations." The NYSE, NASD and SIA are also conducting their own reviews of analyst practices.
Is it possible that the SEC, AIMR, NASD, SIA, NYSE and Congress were all unaware that stock analysts are influenced by their firms' underwriting and trading efforts, as well as personally profiting from their recommendations?
Of course not. It is commonly known that analysts' so-called "research" is riddled with conflicts of interest. The investing public should be outraged that the SEC, including its vocal acting Chairwoman, is acting surprised. If she and the agency didn't know about these analyst practices, they should have. Have they been hiding their heads in the sand? The reality is that the SEC has long known about these abuses but has permitted them to continue. Powerful Wall Street investment banking and proprietary trading firms, all NASD, NYSE and SIA members, have always used "research" to further their own pecuniary interests, to the detriment of investors. Ironically, much of the current criticism is being directed against the analysts themselves. Attention has been focused upon the relatively insignificant amounts that analysts have been able to squirrel away by buying and selling stocks personally before they issue a recommendation. In our opinion, this is all too convenient and misdirected. It's not surprising that several large Wall Street firms have recently volunteered to establish ethical prohibitions on their analysts' ownership of covered stocks. It's a meaningless concession that doesn't cost these firms anything.
Since 1998, we have written many articles concerning the pervasiveness of personal trading abuses in the money management and securities business. See Hidden Crimes; Too Many Secrets: How Money Managers Hide Illegalities From Investors, August 2000. Personal trading violations by mutual fund portfolio managers and other money managers occur daily. Our review of SEC deficiency letters of money managers indicates that personal trading violations affect about 25% of money managers. These abuses often result in substantial, quantifiable harm to investors.
We know the SEC is aware of the front-running and other personal trading abuses by money managers because the Commission writes the very deficiency letters we review on behalf of clients. The SEC publicly maintains that personal trading by fund managers is not widespread yet it resists efforts to make the results of its examinations of money managers available to the public. The agency has testified that the Freedom of Information Act should not require public disclosure of examination results. See: No Freedom Of Information When It Comes to Money Managers, November 2000.
We are no fans of research analysts that personally profit at the expense of investors. But the conflicts of interest affecting Wall Street investment research run far deeper than the chump change a few self-dealing analysts pocket. For purposes of educating the SEC, AIMR, NYSE, NASD, SIA, and Congress on the realities of Wall Street's investment research, we offer the following simplified analysis. Most especially, we hope that investors, once they understand the nature of this so-called research will be less likely to be harmed by analysts' recommendations.
Securities firms that provide investment research incur the cost of employing analysts to produce that research. The question then becomes, how can analysts earn their keep? If an analyst were to write a recommendation regarding, for example, Dell and investors indicated when they placed their order for Dell that they were trading as a result of the analyst's recommendation, then it would be a fairly simple matter. Those trades would be credited to the analyst and he would be correspondingly compensated to some degree. Executives of securities firms have tried to implement such a compensation model but it doesn't work well. Investors don't routinely say why they're buying Dell when they place an order. Or they may read an analyst's research report and use a discount broker to execute their trade. Brokers handling customer orders within a firm that employs analysts will claim they brought in the order and deserve credit; conflict ensues between analysts and brokers. At the end of the day, it becomes apparent that you cannot justify the expense of a research department solely in terms of order solicitation. How else can analysts earn their keep?
Firms that employ analysts can purchase, for their own account, securities their analysts are about to recommend. Once a recommendation has been made publicly and the price of a stock rises, firms can sell their holdings of the stock at a nice profit. Firms are required to disclose that they may own the stocks their analysts recommend but, absent specific information regarding the extent of their ownership, this disclosure is useless. If a firm were required to disclose it owned 10 million shares purchased at $10 per share when it issued a recommendation to buy, that would be meaningful disclosure. Don't look for it to ever happen. No regulator will ever propose that securities firms reveal their holdings. If such disclosure were required, most securities firms would close their research operations. Firms that "make a market" in the securities their analysts recommend, generally own the stocks in the normal course of business.
For firms involved in underwriting, the opportunities analysts have to earn their keep are far greater. An analyst can issue favorable recommendations about industry sectors or individual companies, in order to court investment banking clients for the firm. Analysts can also issue bullish reports about stocks of investment banking clients that have recently been taken public to "support" these new issues. On the other hand, analysts can write scathing reviews of companies that have spurned their firms' investment banking group or compete against a client.
We had a technology company come to us some time ago, before the tech bubble burst, with a difficult problem. After having interviewed one investment bank to take it public, it selected another and offered the first firm a co-manager position. Insulted, the first firm declined. An analyst at the firm issued a damning report soon after our client's company went public that caused the stock to plummet 50% in the strong bull market. It was the first "sell" recommendation the analyst had ever written. Under these circumstances there was little we could suggest. It's just the way the game is played, we all agreed.
In summary, the important point for investors to remember is that the analyst owes his primary duty to his company. Forget any assurances you may hear about "Chinese Walls," a legal fiction that was given credibility by its acceptance from the SEC and other regulators. Forget any AIMR ethical mandates of independence and objectivity. There is no effective separation between research, investment banking and trading in securities firms. The analyst is, first and foremost, interested in making money for his firm and keeping his job. It is his firm that pays him, not you. If he can make clients money too, then it's a "win-win" situation. (And you know how rare "win-win" situations are in real life.) Accept that whenever an analyst tells you to "buy," he and his firm probably have already bought and are about to sell.
The more you understand how investment research is used by brokerage firms to make them money, the less likely they are to be making it at your expense. Remember that research provided to investors is not really research at all. It is promotional material related to moving the firm's inventory of securities or strengthening the firm's investment banking franchise.
Setting Standards For The Investment Management Industry
