The Myth of Analysts' Best Practices[Fool on the Hill] May 18, 2000

An Investment Opinion

The Myth of Analysts' Best Practices

By Bill Barker (TMF Max)
May 18, 2000

Here in the Fool on the Hill space, we've been keeping our eyes on a new rule proposed by the Securities and Exchange Commission (SEC) regarding the fair disclosure of material information by publicly owned companies. As you may know, public companies are allowed to give material information to Wall Street analysts before they make it known to the public. Wall Street, of course, loves the status quo, and is fighting mightily, though I would say far from valiantly, to stop the SEC from enacting the rule that would erase Wall Street's special privileges and level the playing field. There are now about 4,000 public comments up on the SEC's website, by my estimate nearly 3,000 or so coming from readers of this site.

One that doesn't come from our readers, though, is Merrill Lynch's public comments. Let's take a look at the argument that this Wall Street leader puts forward and the rather persuasive evidence that Merrill Lynch is knowingly misrepresenting the truth of the matter.

In a May 5 letter to the SEC on behalf of Merrill Lynch, Carlos Morales argues that there is really no problem with the current system of companies giving material information to analysts, though there might possibly be some people who are not as highly principled in their actions as the fine, fine employees of Merrill Lynch. What the SEC should really be thinking about, writes Morales, is getting everybody else to act more like the employees of Merrill Lynch:

"We believe that the Commission should give greater thought to identifying best practices with regard to the dissemination of material information and should encourage [companies] and analysts voluntarily to follow these practices. For example, Merrill Lynch requires its analysts uniformly to disseminate their comments to both retail and institutional investors simultaneously. Analysts are not permitted to convey information, or their opinion of that information, to any Merrill Lynch trader, institutional investor or any specific person until the analyst has made such information available to all of Merrill Lynch's clients."

Oh, really?

In an outstanding must-read Washington Post article entitled "Analyst With a Knack for Shaking Up Net Stocks," writer David Streitfeld followed well-known Merrill Internet analyst Henry Blodget around on February 2 -- the day (Nasdaq: AMZN) reported its fourth-quarter earnings for 1999. We learn a number of things about the way analysts operate, among them being that Merrill's analysts do communicate with individual clients before making their comments known publicly. In this particular case, Blodget received a private call from Amazon execs (after the conference call) to update him personally on what his revenue estimates for the next quarter should be. Blodget was then on the phone with a number of clients informing them of his latest thoughts on Amazon, all prior to going public with his comments -- including a raised price target and upgrade -- the next day. As Blodget eloquently noted regarding his upgrade of, he wanted "to differentiate it from all the pieces of [expletive] we have buys on."

I don't really care about Blodget's private discussions when he was apparently under house orders to be quiet, or about his cynical comments regarding his role in a profession that deserves cynical treatment. I don't expect analysts to withhold their thoughts from their richest clients until they can be known to the lumpenproletariat, and if Merrill Lynch wants to misrepresent how the system really works to the SEC, I've no doubt that the SEC commissioners aren't as gullible as Merrill seems to think. The broader issue, which is demonstrated magnificently in the Post article, is that the entire method of analyst conversations with companies is designed to purposefully hide the truth from the public, rather than help reveal it.

In his letter to the SEC, Merrill's Morales states, "Although we applaud the Commission's goal of promoting broad disclosure of material information, we are concerned that the practical effect of Regulation FD will be exactly the opposite: it will discourage many [companies] from disclosing much of the information that now enters the marketplace." The argument here is that the current unfettered interplay between analysts and companies results in a near-perfect distribution of information into the marketplace -- but you simply can't come to a similar conclusion from reading the Post piece. It is quite evident that analysts aren't talking to companies simply to ferret out the most useful information for their clients and convey it to the marketplace -- there's something else at work.

In a particularly telling moment that discusses Blodget's private conversation with Amazon's execs, the article notes:

"The Amazon folks know exactly what Blodget is thinking because he's e-mailed them his financial model -- an extensive breakdown of Amazon's past results and future expectations. 'Feedback is valuable,' the analyst says. 'It's become so important for a company to beat expectations that they want to make sure they don't get out of hand.' Investors also like a company to beat forecasts. As a result, there's a tendency in models to keep expectations modest -- to say that Company X will increase profits by 10 percent. Then the earnings come in, as usual, 20 percent higher. The stock jumps, and everyone but the short sellers are happy. So on stocks such as Amazon, Blodget keeps a private model, too. This one doesn't incorporate feedback from the company. It's more speculative. It's also probably closer to the truth...." (Emphasis added.)

So Blodget is willing to admit that he alters his publicly made comments to serve the companies he covers. He's also willing to admit to one of the most widely read papers in the country that he's perfectly capable of producing an estimate that is closer to the truth with no input from the company than what he actually does produce with guidance from the company.

If this example is representative of the way that analysts work -- and I believe that it is -- then it is not persuasive for Merrill, or any of the other of Wall Street's many, many conflicted brokerages, to argue that their being cut off from special information is a harm to investors. It isn't. Analysts are perfectly capable of producing better analysis without special information from companies than what they choose to produce with the "benefit" of their private communications. In fact, analysts are apparently so cocky about their place in society that they admit on the record that they produce less-than-honest analysis as a more or less mandated part of their job.

As Blodget admits in the article, "There's certainly a tendency to give the company the benefit of the doubt, [but] the best analysts find a way of balancing the needs and wants of their constituencies. It's like being a good politician."

Is that what we really want from analysts? To be like politicians? Is that why we need to preserve their special access to companies -- so that they can agree to change their analysis from the truth to something that the company wants disseminated? Is this the best that Merrill can offer?

Apparently so. It's sad, it's selfish, and it's an intellectually dishonest story that Merrill is putting on the public record.

It's also perfectly predictable.

Related Links:

  • Washington Post, 4/2/00: Analyst With A Knack for Shaking Up Net Stocks
  • Public Comments on SEC Proposed Rule Fair Disclosure and Insider Trading