Who's Paying Your Analyst?

It's easy to be cynical about Wall Street analysts. I've had some back and forth recently with people who believe that a certain analyst covering Elan (NYSE: ELN  ) is dirty because his firm, Lehman Brothers (NYSE: LEH  ) , is doing a debt offering for rival TevaPharmaceutical (Nasdaq: TEVA  ) .

To which I say, certainly there is no depth to which I would automatically doubt that Wall Street would plumb for a few extra dollars, but without specific information, most of these conspiracy theories are just that -- theories. But let me say this: We at The Motley Fool put almost no value into the opinion of Wall Street analysts. We don't consider it contrary, nor do we consider it constructive. This is not to say that we have never found insight from Wall Street analysis. But we don't get excited about what they think about the companies we admire.

The Wall Street problem
But I would like to warn you about a type of analyst that I consider lesser than all the others -- the analyst who is paid by the company she nominally covers. As an example, analysis firm RJ Falkner just released a new report on US Energy (Nasdaq: USEG  ) . The report itself is the usual hokum, and they believe the stock is going to more than double in the next year plus. But take a look at the disclaimer, and you'll see the most important component of the entire report. Naturally, it's in teeny-tiny print: "RJ FALKNER & COMPANY, INC. currently receives a cash retainer of $2,500 per month from U.S. ENERGY CORP. for consulting services and the periodic publication and distribution of research reports on the Company."

The taint of money
This business model is distressingly common. Another "research" outfit, Taglich Brothers, notes on its analyst report of Fountain Powerboat Industries (AMEX: FPB  ) , "The company paid an engagement fee of $5,000 (USD) on May 2005, and upon publication will pay a monthly monetary fee of $1,750 (USD) to Taglich Brothers, Inc., for the creation and dissemination of research reports."

The disclaimers also state that while the companies pay for the coverage, the coverage is solely the opinion of the analyst. That's great, and probably true to a point. But think about analysis paid for by the companies being analyzed: It's a model that almost cannot help but be beset by scandal.

Imagine if Disney paid a movie reviewer. Or a restaurant paid its critics. Both reviews would certainly be tainted.

Stock marketers
As a matter of course, I treat companies that pay for analysis with suspicion. They're marketing their stock, which to my mind is a pretty low thing to do. So Scott Parr, CEO of iCAD (Nasdaq: ICAD  ) , whose company pays RJ Falkner $2,500 per month and who was granted an option to buy 32,000 shares at $2.20, here is your payoff: What you are doing is wrong. Why your board puts up with this type of expenditure is beyond me.

The Foolish bottom line
Neither Tom Gardner nor I would ever knowingly recommend a company that pays outside marketers to hype its stock. A true Hidden Gem wouldn't have to. Buying analysis is a contemptuous use of shareholder capital -- more suited to petty despots than corporate stewards. We much prefer companies like Dawson Geophysical (Nasdaq: DWSN  ) , with management confident enough to let their results speak for themselves. These folks understand that if you build a great company, investors will find you.

The hallelujah chorus is a wasted expense, and it's a sign of insecurity and hucksterism, not competence. We'll stick with looking for the latter. That's where the long-term returns are. To see what we've found so far, click here and be my guest at Motley Fool Hidden Gems free for 30 days. Nothing jumps out as a scarlet letter more than a disclosure that the company paid an analyst for its coverage.

Bill Mann is a Hidden Gems newsletter advisor. He owns shares of Elan, but none of the other companies mentioned in this article. Dawson Geophysical is a Hidden Gems recommendation. The Motley Fool has adisclosure policy.

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