Wednesday, October 25, 2006

How to make Wall Street Analysts Relevant

They are a highly sought after group of commentators on CNBC and the business press: Wall Street Analysts. Often, they have impeccable educational pedigrees and years of experience at bulge bracket investment banks. A major business story in BusinessWeek, Barron's, and the WSJ almost always has a couple of quotations reserved for an analyst who covers one of the companies under the microscope.

Back in the halcyon days of the late '90s, these curious creatures even broke into the ranks of business celebrities -- almost as famous as the entrepreneurs and managers they covered. Mary Meeker of Morgan Stanley was trumpeted as the "Queen of the Net" for her coverage of the Internet space. Henry Blodget (pictured above) made the audacious prediction that Amazon would hit $400 (and it did shortly thereafter), allowing him to ditch the house of Oppenheimer for the more luxurious digs of Merrill Lynch. And Jack Grubman of Citi was the telco czar -- for a time.

Of course, we all know what happened next. Only Mary Meeker came out of that mess with her dignity in tact. The telco and internet analysts saw their importance dim, as the industries they covered waned. Yet, for some inexplicable reason, analysts remain "go to" people for the business media.

Turn on CNBC during the trading day and you're bound to see an analyst (or two on a split screen) helping us digest the numbers for Company A's most recent quarter. Presumably, the media goes to these people because: who better to comment on a company than someone who is paid to study it? Their employers (the investment banks) are only too happy to put them out there to chat, as a little publicity never hurt anyone.

Yet, here's a basic question: who among us has ever garnered an insight from one of these talking heads? They are prone to regurgitating back the most recent numbers for the given company. If the numbers hit or surpassed, they shower praise; if they missed, they identify that some problems exist. But, too often, the commentary is reporting facts, rather than strategic insight.

For example, in the Spring of 2005, Google had a blow-out quarter. Jordan Rohan, an RBC analyst, who gets attention because he covers Google and never shies away from a media interview, grudingly acknowledged their success this way: "Google's defying the logic of growth companies." About a year later, Google's stock took a hit, after it mistakenly posted financial projections on its website. The company has resisted giving Wall Street analysts guidance. Jordan disapproved, saying: "We believe Google management is creating unnecessary volatility by refusing to issue financial targets." Additionally, he complained that management's capital spending was "unfathomably high." After Google's most recent blow-out quarter, Rohan struck a congratulatory tone: "This is an eye-opening and refreshing quarter for Google investors."

What's wrong with this synopsis?

  1. Analysts, unlike the companies they cover, rarely are accountable for what they previously write. No one ever goes back and studies whether their ability to predict the future actually panned out.
  2. Analysts are chronic rear-view mirror drivers. These are bright Harvard MBAs. Yet, I am less interested in what has happened to a company compared to what will happen. I can read the press release or listen to the conference call. Where is the insight into what will happen down the road?
  3. How many original ideas do you recall hearing from analysts? The kinds of thoughts that made you stop and rethink how a space was developing? I frankly can't think of any. I can think of outlandish price targets -- but few singular thoughts.
  4. Analysts' insights are free to all who watch CNBC and, therefore, worthless. Free information is a commodity. For these analysts and their companies, the name of the game is publicity for the investment banking team. Have you ever noticed you never see analysts from hedge funds on CNBC? Why? Their intelligence is valuable and their firms will not easily part with this.

So, what are some solutions for the problem of more talking head analysts on CNBC? Here are a few modest suggestions for how to make Wall Street Analysts more relevant to market observers:

  1. Hire McKinsey/Bain/BCG strategy consultants (or others with a similar Strategy bent) as Analysts. A big problem with analysts is that they are too analytical. It would be much more interesting to hear comments or read reports from those with a background on saying what the latest results mean for the future and how well the company is strategically positioned.
  2. Track Analyst Performance and report it. While Institutional Investor magazine and others do analyst ranking, what's missing is analyst accountability. Big business periodicals should track analyst predictions and then show how they actually did. If someone is perenially a poor performer, there's probably a better profession for him/her. As Dr. Demming, the grandfather of Quality, said, 'you can't improve something, if you don't measure it.'
  3. Reward Analyst Creativity. There should be the equivalent of a Pulitzer Prize for Wall Street research. In the meantime, compensation should also follow original ideas that help banking clients make money. If you don't pay for it, you won't see it. The creativity should also drive more publicity for the firm.

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Bill said...

Ain’t Broke

Mr. Jackson copied and pasted this "How to make Wall Street Analysts Relevant" into a blog in the Wall Street Journal. So, I thought it might be interesting for me to copy and paste my comments on the same Wall Street Journal article here.

On Friday November 10, 2006 a discussion titled, Fixing Wall Street Research was published in the Wall Street Journal On-line. The discussion was about the state of sell-side brokerage research in the post Global Analyst Research Settlement era. In this discussion two students of investment research - Professor John Coffee and Jonathon Boersma, CFA(1) - offered their opinions.

In my mind there are some startling blind spots in this discussion between Professor Coffee and Mr. Boersma. I believe the discussion would have benefited significantly by having a contributor who believes in free markets, and has thought long and hard about the implications of free market economics. The Wall Street Journal article solicited public comment, which is included in a blog appended to the article. I took the opportunity to contribute my thoughts to the public comment blog. Then later I expanded on my comment as follows:

The sky is not falling! High quality investment research is alive and well.

But, before I explain my rational for the above statement, let me say I was critical of The Global Research Analyst Settlement (GRAS) even as it was being cobbled together. Conflicts of interest are a cultural problem in the full service brokerage industry. And the conflicts become most egregious during market bubbles - when investors lose rationality, abandon reason, and pursue unrealistic investment returns. These are the times when institutional investment advisors, knowing better, buy the “line” being espoused by the sell-side, and play along merely to stay in the performance game (you can’t fight the tape). In the long term such bubbles are just “noise”.
(See, reversion to the mean).

The new layer of regulation called the Global Analyst Research Settlement isn’t the prescription for the cure of conflicts of interest in sell-side brokerage research. The better prescription would be to enforce existing regulations designed to control conflicts of interest, and to enforce commercial statutes and criminal law designed to prevent conflicts of interest and to punish fraud. Conflicts of interest and fraudulent behavior will simmer in the background of the full-service brokerage industry until the next frothy market. The Blodgets, Grubmans et al played the game well, and they received their rewards commensurately. But, when the heat was turned-up they were expendable; new salesmen dressed in “analyst suits” will reappear to play pied piper in the early stages of the next irrationally exuberant market bubble, and the cycle will repeat as it has in the past.

Wouldn’t it have been better to severely punish the managers and executives who were, by law, responsible to oversee the analysts and investment bankers, but who instead encouraged and cheered-on conflicted and fraudulent behavior (for their own personal gain)? Wouldn’t it be more effective to punish the guy who approved the bonus checks rewarding conflicted interests and fraudulent analysis? Wouldn’t it be better to punish the guy who approved issuing the million dollar check to the 92nd Street Y? This approach to regulation would set a more lasting example.

The Global Research Analyst Settlement (GRAS) mandated a penalty of 1.4 billion dollars be paid by the 10 brokerage firms the New York State Attorney General’s Office identified as the firms that most egregiously violated the public trust by issuing conflicted and fraudulent research; in Professor Coffee’s words, “the aristocracy of the industry.” This penalty fund was a
mere hiccup in these companies’ combined cash flow. Did the managers and executives of these brokerage firms suffer as significantly as the defrauded investors had? Was the company bonus pool decimated? When a corporation is publicly held who ultimately pays such fines?

The 1.4 billion dollar GRAS pool was set-aside to provide independent unbiased research without incremental cost to investors. The research is to be distributed, for ten years, to the clients of the 10 companies in the settlement. In spite of the 1.4 billion dollar cost of this research effort it continues to be referred to, by some, as “free research”. An advocate of the Efficient Market Hypothesis (EMH) would argue that information that’s available at no incremental cost and is widely disseminated has almost no investment value, since the market rapidly incorporates such information into security pricing. Who benefited from this approach to regulation?

Now, back to my assertion, “The sky is not falling! High quality investment research is alive and well.”

Efficient markets price goods “at the margin”. Valuation information (research) is very rapidly reflected in the price of the entire float of a security in a few trades, or merely by changes to the bid-and-ask quoted for the security. The value of new information, or research, is highly dependent on the ability to maintain the exclusivity of the new information and to act on it without providing “clues” to the market. As long as “transactors” can discover value discrepancies and capitalize on them they will bear the cost of research that produces an excess return over the cost of the research. (See,

After the GRAS small company research has probably suffered most because, prior to the GRAS, small company research was subsidized by full-service brokers who were using this research to build a marketing case for IPO’s and for secondary public offerings of small company stocks. Another consideration, full service brokers make principal markets in small company stocks, so they have a vested interest and profit incentive in small company research and in publishing “puff pieces” on stocks in which they make a market. Also to be considered, the institutionalization of the markets makes it more difficult for any significant number of “transactors” to add significant incremental value to large portfolios using small capitalization stocks because accumulating positions of any significant size in small capitalization, or illiquid, stocks has significant market impact. The market impact of a few transactions (either purchases or sales) in such stocks rapidly influences accurate revaluation, and can cause short term distortions, in the security price (ask Peter Lynch). Over time investors will not pay for research they can’t use profitably!

An advocate of free markets and the Efficient Market Hypothesis (EMH) would point out that the idea of “ranking” sell-side analysts based on the consistency and predictive quality of their recommendations has popular appeal, but such rankings have little practical value for investors. If the market is relatively efficient, all available information is reflected in the price of a security with stunning speed, and it’s very difficult to become an owner of a recommended security before its price reflects the new information. It’s very difficult to capitalize on new information.(2)

Ranking sell-side analysts should be likened to a beauty contest. As in a beauty contest, the benefit of winning goes to the contestant, and to some lesser degree to her current boyfriend or husband. In the case of ranked sell-side analysts the benefit goes to the analyst, and to a greater degree the analyst’s employer (to the degree the employer can market the analyst’s reputation). A less abstract way of looking at this might be, can I add Angelina Jolie to my personal portfolio without unreasonable expense? Consider Joe DiMaggio’s experience with Marilyn Monroe.

The Global Research Analyst Settlement has focused attention on the conflicts of interest in the full-service brokerage industry. Worrying about a reduction in sell-side investment research is like worrying there isn’t enough advertising advocating the benefits of smoking cigarettes. If investors and regulators continue to focus on the potential for conflicts of interest and fraud in the full-service brokerage industry, over time the market for valuable research will reach equilibrium, and investors will benefit from the reduction in valuation “noise” created by full-service brokers’ marketing hyperbole. (Markets have a natural tendency to revert to the mean).

In closing I will also take issue with Professor Coffee’s statement: “The brokerage side of the firm will subsidize security research to a lesser degree in order to generate commissions, but only for high market-capitalization stocks that are likely to generate commissions, thus leaving a dark, research-free desert below that level. From this perspective, the most serious public policy issue is how to subsidize securities research without thereby distorting it.” (Italics added for emphasis)

My issue: Research is not a public good. Subsidizing the investment research industry is not a public policy issue. Any effort to turn the cost of research into a public expense, to subsidize the cost of research – or to socialize those costs - will merely increase the overhead and reduce the efficiency of research provision, and thereby negatively affect the net value of research. A free market will allocate resources to the discovery of the fair value for securities to the extent that the expense required for discovery yields a net benefit the discoverer. The market can determine the level of research necessary to properly value securities, bureaucrats can’t.

(1)In general I would argue that a CFA is not intellectually prepared to argue the first question about the value of investment research. The Chartered Financial Analyst (CFA) designation signals a very strong belief in the value of investment research. Research is a CFA’s bread-and-butter. Chartered Financial Analysts create their own investment research and they also use investment research created by others to make investment decisions and to propose investment recommendations. The process of obtaining a CFA designation screens out research skeptics - just as surely as seminary screens out atheists. The proliferation of investment research, and the universal assumption that research is valuable, is job security for CFA’s. The more research available, the greater the demand for CFA’s; the CFA is, presumably, uniquely qualified to differentiate good research from inferior research.

Rather than assuming the CFA designation is pivotal to good investment performance, a more realistic evaluation of the CFA designation might come from comparing the investment performance statistics of a large population of CFA qualified advisors’ portfolios to a broad securities index for a period of ten years. I have seen “proxies” for such performance evaluation. These proxies support interesting conclusions.

(2)Other evidence that might be used to support the contention that no individual knows more than “the market” and that markets rapidly reflect all available information, is provided by sophisticated analytical tools used by investment advisors to analyze “insider trading”. The investment returns of corporate executives and board members (classified as insiders) do not demonstrate enough consistency of excess returns, trading in the securities of the companies they are insiders at, to add significant return premium to a diversified investment portfolio.

Eric Jackson said...

Hi Bill:

Your comment was good there and is good here.


Dr. Eric

Steve said...

You can't address this question without considering the business model for equity research, which has been in flux since the SEC settlement and the relationship between investment banking and research became highly regulated. How do investment bank equity research analysts continue to justify their existence? Alternatively, if you really know how to call stocks, why not move to a hedge fund where you participate in the upside rather than "provide insight" to clients who drive commissions by trading on your advice. The reason why the bulk of research that the general public sees is so disposable is because the research analyst's job has slowly been transformed into calling the quarter (a market-moving event whose timing can be easily predicted) for their clients ahead of the event. The better analysts generate hypotheses on stock investments - the less good ones try to identify "story" stocks to generate trading volumes on the brokerage side of the house.
Researching private companies who may be potential acquisition targets for growth has also fallen by the wayside.

Eric Jackson said...

Thanks, Steve.

I think you're right. I'm not sure there is hope. Anyone good will migrate to hedge funds. That's been the complaint for mutual funds too.

I'm not sure if my suggested changes will make a difference because of the business model issue that you point out.



Bill said...

Hedge funds are the shiny new toy of Wall Street. By adding leverage and other risky portfolio strategies they generate a wider dispersion of performance returns. The winners reap greater returns and the loosers reap more significant losses.

Hedge fund managers charge more fees, and in a zero sum game over the long run the managers will be the only risk adjusted benefactors.

Hedge funds worked when they were only a small segment with highly skilled management (Steinhart, Roberts, Rainwater). The model is not adaptable to a multitude of hopeful players. The brilliant scion managers with eager friends and family as clients will disappoint as surely as Long Term Capital did.

Prepare for the disappointment.

Eric Jackson said...

Hi Bill:

I don't think it's right that all hedge funds will fail. Certainly, as more rush in, the failure rate will go up. But, if you bet wisely on the right manager, you should do well.

Just aping a hedge fund strategy that has been successful for others is likely a recipe for tears though.

I prefer the activist hedge fund managers. They take a position, understand the levers that can be manipulated, and then exit. If they're right, they can be very successful. Ralph Whitworth has done very well with this approach. Carl Ichan has had more of a mixed result (although his TWX play seems a little more compelling these days than it did at first... Blockbuster hasn't worked out for him thus far).

One of the problems for these fund managers though is that they are victims of their own success. It is much harder to put $6B (or more) to work than $1B. Not as easy to move in and out when you're an elephant. Still, the better managers will do extremely well, and their investors are unlikely to complain.



Bill said...

Dr. Jackson:

I agree. Not all hedge funds will fail, AND I never said ALL hedge funds would fail.

But, I do believe over time a majority (more than 51%) of the current batch (estimated in excess of 3,000 hedge funds will fail, and as they fail the true believers will always point to the “survivors” as proof that the model works.

“Survivorship Bias” has always been the call to devotion for the hopeful. But, over time "The Survivors" become a very small group, and their followers become a cult.

In the past mutual fund complexes found a way to sweep their laggard managers’ portfolios into the complexes' excess-performer funds, and thereby hold-on to assets while they blend historical excess returns and the promise the benefits of firing a “looser manager”. They gave the losing manager’s clients’ hope.

But, under the hedge fund structure, “hot” hedge funds have little motivation to dilute their performance by melding underperformers with the STARS. For most hedge funds, merging underperformers would require the re-negotiation of client contracts…. With the current lock-ups this ain’t gonna happen!

A word to the wise, when you hire an investment advisor, the riskiest decision you make is hiring the investment advisor.

If this post seems odd, or a bit alien to you. do a key word search on: Survivorship Bias.

Eric Jackson said...

Not odd at all, Bill. Very true about Survivorship Bias. I expect that a thinning out of hedge funds should happen over the next 3 - 4 years. We'll see.

Thanks for the post,