FOOL ON THE HILL
How Do Analysts Sleep?

It should have been the "big-freaking-surprise" story of the year, and yet we still find ourselves shocked at the cynicism and self-interest of Wall Street's equity analysts. We have known, and yet not known, that analysts commanded enormous salaries based in no small part on their ability to drive investment banking business to their companies. After the Attorney General of New York's inquiry, we know for sure, and the truth is as bad as we imagined.

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By Bill Mann (TMF Otter)
April 19, 2002

I just got finished reading the entirety of Attorney General of New York Eliot Spitzer's inquiry against Merrill Lynch (NYSE: MER) and its Internet analysts. Since the time that this came out, Spitzer has widened his net to include a host of other brokerage houses, including Morgan Stanley (NYSE: MWD), Salomon Smith Barney, Credit Suisse First Boston, and Goldman Sachs (NYSE: GS).

In this 38-page document, Spitzer quotes dozens of emails from and to the Merrill analysts that not only show sell-side analysts being beholden to investment banking business, but also that they are willing to widely disseminate ratings on stocks that differed drastically from their actual opinions. Of course, Merrill Lynch has claimed that these emails were "taken out of context," insinuating that Spitzer's motivation to press a high-profile case such as this was politically motivated rather than on the actual merits of the case.

Which makes me wonder just what context would neutralize Henry Blodget's admission that there was "nuthin" interesting about GoTo.net -- now called Overture Services (Nasdaq: OVER) -- except for the potential investment banking fees. Or what context would make the statement from Joseph Mazzucco that "the whole idea that we are independent from banking is a big lie..." mean anything else?

But the thing that got me, the item that made my head spin, was this little gem from Kirsten Campbell, another Merrill analyst: "if [this rating] means that we are putting half of merrill retail into this stock because they are out accumulating it then i don't think that's the right thing to do. We are losing people money and i don't like it. john and mary smith are losing their retirement because we don't want [the CFO] of GoTo to be mad at us."

Back in January 2001, I wrote a spoof article in which I "exposed" a pledge that Wall Street analysts had to take. In it was this ditty:

5.  I will retain a rating of "strong buy" on a company like Internet Capital Group (Nasdaq: ICGE) as it slips from $212 to $5 per share, and only then will I decrease it to "buy."

Little did I know how close to the truth I was. Regarding Internet Capital Group, Henry Blodget had this to say in October 2000 in a private email: "This stock is going to 5." "This has been a disaster... there really is no floor to this stock." His public comments? They equated to crickets chirping.

Blodget did not downgrade Internet Capital Group, leaving it at 2-1, the Merrill equivalent of "buy." It now sits somewhere south of a buck.

Actually, we at the Fool have been long stunned that anyone gave Wall Street analysts' opinions and ratings any credibility. In May 2000, Bill Barker (TMF Max) wrote a blistering Fool on the Hill about Henry Blodget, but had this to say for the entire industry: "...the entire method of analyst conversations with companies is designed to purposefully hide the truth from the public...." And yet, people by the scores bought it hook, line, and sinker, and the media is only too glad to assist. CNBC's Maria Bartiromo breathlessly reports every morning what the latest analyst ruminations were, but she never bothers to ask whether these same analysts have had any kind of track record of making good calls in the past, or whether they have any conflicts that needed to be mentioned.

Fine, this is all the American way. "A fool and his money are soon parted," "it would be immoral not to take the money of someone who asks to be ripped off," and all that. The new spin is that those individuals who lost their money on speculative Internet stocks were not so much naive as they were greedy. In other words, they knew there was a scam, but they were under the mistaken impression that they were in on it.

In part, this is true. People were greedy, people did suspend belief, people did take abnormal risks during the boom. But does that AT ALL make it right for someone whose job it is to inform the public of his research to lie? We can play existentialist mumbo-jumbo all we want, we can convince ourselves that people deserved to lose their money, but in the midst of it, Kirsten Campbell at least was sickened by it.

And yet I don't recall hearing of her turning down the massive salary she "earned" for foisting these faulty findings onto the public. Henry Blodget's compensation for 2000 approached $12 million. As a group, Wall Street analysts make insane amounts of money. When P.J. O'Rourke asked one about analyst salaries, he replied honestly: "I can't defend it."

I don't think you need to. If those were the rules, then good on ya. But how do you people sleep at night? Did the fact that the rules required you to lie about your opinion to large amounts of people not gnaw at you? How do you live with yourselves in your big Westchester houses, your palatial Central Park West pads, your ill-gotten riches? You played an officially sanctioned Ponzi scheme -- you drew in new investors for the benefit of those who had already invested. You knew your ratings would influence the gullible, and yet you did it anyway. Did you think about the people who were trusting your opinion? Do you think about them now? The product that Blodget and company was somewhat south of worthless. It was damaging to a whole host of people.

Here's what Spitzer ought to say to analysts: "Your firm generated significant investment banking revenues based in no small part on your ability to "move a stock." That means "to get people to buy it." When these companies did secondary offerings, they were generating dollars based on the price of their stock, the higher the better. Some of that money went to their investment banks, and some of THAT money came to you. So I ask you again -- do you feel that you earned that money, or just tricked people out of it?"

And now suddenly there is a crisis of confidence about the U.S. markets. It seems that we can't trust analysts, we can't trust accountants, and we can't trust companies. And Merrill is outraged?

Well, it seems changes are afoot, as Merrill and the Attorney General have agreed to a settlement that calls for Merrill to disclose both actual and potential conflicts of interest in its analyst reports, and is negotiating on a fine that could reach $100 million. Interestingly enough, the Reuters story I read this morning discussing the negotiations quoted... another analyst. Go figure.

Even if the media is too dim to figure it out, I would hope that the investing public recognizes the fact that analysts DO NOT have their best interests at heart. Take their advice at your own peril.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's favorite flavor of yogurt is "pink." He owns none of the companies mentioned in this article. The Motley Fool is investors writing for investors.