Several disturbing stories in the media have resonated with me lately, and when Mary Meeker showed up on the cover of Fortune with the caption "Can we ever trust Wall Street again?," that did it.
Once labeled the "Queen of the Net," Meeker rose to prominence as an Internet analyst for Morgan Stanley, made millions for her firm and herself (reportedly $15 million in 1999) and now is clinging to the buy recommendations of dozens of struggling Internet companies that she helped take public. No matter, she's rich and her firm is richer thanks to her deals. She was just doing her job, she says. Maybe so, but what exactly is her job?
The title of analyst implies Meeker is analyzing companies. OK. Maybe. The problem is that today's sell-side analysts are part analyst, part cheerleader, and part dealmaker. Meeker clearly got carried away with the cheerleader and dealmaker parts and has lost credibility as an analyst. It's not uncommon.
My personal experience with sell-side analysts is -- how shall I put this -- tainted. (Click the link on my name above for a better understanding.) In my previous life as a corporate financial analyst who worked with sell-side analysts, I discovered that analysts rely way too much on corporate guidance and not enough on true research. The further immersed in the financial markets I get, the more this truth turns up. It's not like this is a secret. The guys on CNBC's Squawk Box are constantly satirizing about the insightfulness (or lack thereof) of Wall Street's Wise. And Fortune must run a story every month that tells tales of shoddy analysis or biased analyst reports.
Some would argue that having research and investment banking in the same firm is necessary because the hefty I-banking fees support the analysts' salaries. Without other revenue, the thinking goes, I-banks could not support their research departments. Hogwash! The truth is that those research departments have become extensions of client PR departments. Too many analysts are just cheerleaders.
So, if you can't trust the analysts to provide objective company analysis, who can you trust? To answer that, we must first define analyst. I'll try to limit my snide comments. There are two kinds of analysts. Buy-side and sell-side.
Buy-side analysts typically work for money management firms like hedge funds, mutual fund companies, or boutique investment advisors. They research stocks (and all sorts of other investment opportunities) with one goal in mind: Make money off their research. When they make the right call, the firm and its clients, to whom it sells its research and advice, prosper. That's the goal -- make money. These firms and their analysts are paid well for their objective analysis.
Sell-side analysts, also known as Wall Street analysts, work for investment banks with brokerage divisions. They usually have a field of expertise such as airlines or software companies and evaluate companies within their respective fields. They (supposedly) understand the inner workings of these companies and (supposedly) have elaborate financial models from which earnings estimates and valuation arguments and "buy," "sell," and "hold" recommendations are based on.
The big difference between buy-side and sell-side analysts is motivation. Buy-siders are single-minded in purpose -- make money based on research. They are motivated to be objective. Sell-siders, on the other hand, are torn between honestly evaluating companies and bringing in new investment banking business. In order to bring in the business, you have to pucker up to the companies needing I-banking work.
It's just like negotiating with your wife. Tell her she looks pretty in that dress and she's more likely to smile upon your Sunday golf outing with your buddies. Tell her what you really think -- that dress makes her look a little frumpy -- and you're not gonna get out of the house till July -- July 2002! Write a report about the promising opportunities of a company and that company is more likely to choose your firm when it comes time to issue debt or make a secondary offering.
Underwriting -- when I-banks raise capital for corporations -- fees are astronomical (an initial public offering can cost as much as 7% of the capital raised) and they easily trump revenues from research products. Therein lies the problem. I can think of a few choice words that describe the process better, but I'm pretty sure my editors would cut them [we would!], so use your imagination.
Brokers confuse the situation even more for sell-siders. Brokers want the hot stocks with large trading volume to have strong recommendations from the analysts. It helps them sell stocks, which generates commissions. If analysts are down on a company, the brokers can't push that stock to retail and institutional investors and commissions suffer.
Independent research firms do exist. Sure, their analysts don't make the coin that sell-side analysts do but at least they can maintain integrity. The Chinese wall that supposedly exists between banking relationships and sell-side research analysts is as solid as rice paper.
In all fairness, some sell-side analysts actually manage to balance integrity with the pressure to recommend certain companies, but as is obvious from the shameful lack of "sell" ratings, most just play the game. Just last month, J.P. Morgan got caught with its pants down when an internal memo mandating that analysts get feedback from its investment bankers and corporate clients prior to changing stock recommendations got out. There is no mistaking that message: If your analysis could damage our I-banking relationship, bury it.
Fortune also profiled the uglier side of this quid pro quo game in an article about Credit Suisse First Boston banking analyst Mike Mayo. In a nutshell, Mayo lost his job with the firm because he downgraded the entire banking industry, thereby threatening CSFB's I-banking relationships. I applaud Mr. Mayo (and Prudential Securities for picking him up), but unless we revamp this quixotic system, I'll stick to trusting an unbiased source -- my own research.
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Todd Lebor is not married, although he does pretend to know what it is like to have a nagging wife. It's a security mechanism. Todd's other holdings can be found online along with the Fool's complete disclosure policy. The Motley Fool is investors writing for investors.
