The Pitfall of relying on ‘Experts’:

Society places a high reliance on so-called financial experts to make projections into the future.  Experts are most often wrong – and when they are right, their forecasts are only accurate for the short term.  When an expert is asked for a projection – they are in effect attempting to read the future.  The information gathering is complex, to say the least.

The number of possible outcomes, when thousands of factors interact in the marketplace, is infinite. It is simply too difficult (more like impossible) to interpret the data and present a precise estimate.

A contrarian investor simply believes that analysts cannot predict the future and therefore will not have accurate forecasts.

Experts also demand as much information as possible to assist them in their decision making.  The more information an analyst has, the more confident the analyst is.  With more information available, the analyst should make better decisions but this is not the case. More information requires more human judgment and interpretation.  More information leads to greater expert confidence. This confidence leads analysts to optimism; hence- optimistic forecasts and up-beat company analysis.  Ultimately, this results in forecasting errors.  Not too smart to follow this path.

As can be seen in the article, “Analyst in Name only”, there is tremendous career pressure on analysts.  Analysts are not judged on the accuracy of their forecasts, but judged on the amount of business and commission a firm can gain.  Sure, an analyst can tell a great story about a company and its future prospects. The problem is that this story is more often based on fiction, than reality.

Analyst in Name Only

NEW YORK - Of all the rude awakenings that the bear market in stocks has brought to investors, perhaps the most jarring has been the realization of how woefully wrong Wall Street's research analysts have been this year on the stocks they follow.

While the market sank to its worst performance in more than a decade, many of them kept right on smiling and saying "buy."

How can so many who are paid so much to scrutinize companies have blown it so spectacularly for their investor customers?

The answer lies in a subtle but significant change in the way Wall Street analysts do their work -- and how they are rewarded for it.  That shift, which has brought riches and stardom to many securities analysts, has cost investors billions of dollars in losses.

The fact is, although brokerage firm stock gurus are still called analysts, their day-to-day pursuits involve much less analysis and much more salesmanship than ever before.

"The competition for investing banking business is so keen that analysts' 'sell' recommendations on stocks of banking clients or potential banking clients are very rare," said Arthur Levitt, the chairman of the U.S. Securities and Exchange Commission.

"Whether this is an actual or perceived conflict, clearly, in the minds of many institutional buyers, brokerage firm analysis has diminished credibility."

Robert Olstein, a mutual fund manager with 32 years of experience analysing companies' financial results, agrees.  He said analysts today are more like racetrack touts than sharp-pencilled researchers.

"What passes for research on Wall Street today is shocking to me,” Mr. Olstein said.

"Instead of providing investors with the kind of analysis that would have kept them from marching over the cliff, analysts prodded them forward by inventing new valuation criteria for stocks that had no basis in reality and no standards of good practice."

(Internet analysts, for example, have cited visits to a Web site as a reason for optimism.  But, Mr. Olstein said, "Investors can't take page views to the bank.")

No one, of course, can predict what stocks will do tomorrow, much less next year.  But Wall Street's analysts are supposed to help investors judge the attractiveness of companies' shares.

Investors look to analysts to advise them on whether to buy or sell a stock at its current price, given its near-term business prospects.

Until the mid-1990s, that is how most analysts approached their work.  Today, there is virtually no such thing as a "sell" recommendation from Wall Street analysts.

Of the 8,000 recommendations made by analysts covering the companies in the Standard & Poor's 500 index, only 29 now are "sells," according to Zacks Investment Research in Chicago.  That's less than half of 1%.

On the other hand, "strong buy" recommendations number 214.

Analysts have long been known for unrelenting optimism about the companies they cover.  But many investing veterans say that the quality of Wall Street research has sunk to new lows.  That decline, they say, is the result of shifting economies in the brokerage business that has pushed many researchers to put their firms' relationships with the companies they follow ahead of investors.

The commissions charged by Wall Street firms to their institutional and individual customers for trading stocks are one factor.  These fees were much higher in the 1970s and 1980s, as much as US 10 cents a share on trades then, versus a penny or less now.

Because analysts' recommendations helped generate trades and commissions, research departments paid for themselves.

More important, an analyst who uncovered a time bomb ticking away within a company's financial statements and who advised his customers to sell its shares made an important contribution to his firm in the commissions those sales generated.  In short, analysts were rewarded for doing good, hard digging.

But as commissions declined, Wall Street firms looked elsewhere for ways to cover the costs of research.

The lucrative area of investment banking was an obvious choice.  Analysts soon began going on sales calls for their firms, which were competing for stock underwritings, debt offerings and other investment banking deals from corporations.  In this world, negative research reports carried a cost, not a benefit.

The result, money managers say, is that the traditional role of analyst as advisor to investors has been severely compromised.  The increasingly close relationships analysts have with corporate executives has led many of them to be gulled by managements intent on keeping the prices of their stocks up.

"Research analysts have become either touts for their firm's corporate finance departments or the distribution system for the party line of the companies they follow," said Stefan Abrams, chief investment officer for asset allocation at Trust Co. of the West in Manhattan.  "Not only are they not doing the research, they have totally lost track of equity values.  And the customer who followed the analyst's advice is paying the price."

For many investors, that price keeps going up.  In the past few months, as former stock market favorites crashed to earth, many top analysts remained maddeningly upbeat all the way down.

Consider Mary Meeker, the analyst at Morgan Stanley Dean Witter who became known as the Queen of the lnternet for her prognostications on e-commerce companies like Amazon.com and Priceline.  In 1999, as Internet stocks soared and new companies were taken public in droves, Ms. Meeker made US$15-million, according to press reports.

Now that lnternet stocks are in pieces on the ground, she has become decidedly less vocal -- but no less optimistic.  In her reports, she still rates all 11 lnternet stocks she follows as "outperform" even though as a group they are down an average 83%.  By comparison, the Interactive Week lnternet index is down 60% from its recent peak.  Of the 11 companies Ms. Meeker remains positive on, eight had securities underwritten by Morgan Stanley.

Ms. Meeker declined to comment for this article.

But Ray O'Rourke, a Morgan Stanley Dean Witter spokesman, defended his star analyst, saying that her picks had been made for the long term.  Moreover, he said, Ms. Meeker warned investors last March that lnternet stocks were volatile.

Asked about Ms. Meeker's record and whether her non-stop optimism had anything to do with the fact that most of the companies had engaged Morgan Stanley as an investment bank, Mr. O'Rourke said: "It is what it is.  But you shouldn't be surprised necessarily to see “outperforms' on the companies, because we’ve been very vigorous on the companies we've chosen to bring public."

Anthony Noto, at Goldman Sachs, is another lnternet stocks analyst who remained upbeat on shares that were trading at a fraction of their former values.  On Dec. 18, he lowered the ratings to "market performer" on four of the nine stocks he follows, including Webvan Group, an lnternet grocer; Ashford.com and Etoys, two troubled e-tailers, and PlanetRX.com, an online resource for medical products that was in danger of being delisted by the Nasdaq Stock Market.

The companies were downgraded after they had dropped on average 98.2% during the previous 52 weeks.

Of the nine stocks Mr. Noto follows, seven had stock offerings underwritten by Goldman Sachs.

"Our research is driven by fundamental analysis and is not influenced by anything else," Mr. Noto said.

He went on to explain that the companies he followed saw their stock prices drop last spring not because their operations were failing, but because market psychology changed.  He downgraded the stocks much later because only then had it become clear through his research that the companies' results were deteriorating.  "In hindsight," he said, "we should have lowered our ratings sooner.  We regret that."

Faces are also red -- or should be -- over at Salomon Smith Barney.  Jack Grubman, the highest-paid analyst at the firm and, perhaps, on Wall Street, reportedly made US$20-million last year in his job covering the telecommunications industry.  Investors who have followed his picks have not done as well.

Mr. Grubman began to advise caution on the 11 smallish telecom companies he covers in the so-called competitive local exchange carriers sector only two months ago, after the stocks in the group had already lost 77% of their value.  All 11 had securities underwritten by Salomon.

Mr. Grubman declined to comment.  But in a BusinessWeek article last May, he scoffed at the idea that his help peddling investment banking services to corporations put him in conflict with his firm’s investor customers.  "What used to be a conflict is now a synergy," Mr. Grubman was quoted as saying.

Investors in Rhythms NetConnections Inc., a high-speed local access data provider that Mr. Grubman has favoured over the past 21 months, may feel otherwise.  The meteoric rise and crushing fall of the company's shares neatly illustrates how much money investors can lose by following the advice of conflicted analysts.

Rhythms NetConnections was not much of a company back in April, 1999 when its shares were offered to the public at US$21 each in a deal managed by Salomon Smith Barney and Merrill Lynch.  But it quickly became a monster stock, soaring to US$111.50 during one trading day. Its closing high was US$93.13 on April 13, 1999.

At its peak, the company's market value was US$8.9-billion, even though its revenues for the prior year had been US$528,000 and in two years as a private company, it had racked up US$39-million in losses.  Before it issued shares, the company's capital consisted of US$158.3-million in borrowings.

Today, Rhythms NetConnections (RTHM/NASDAQ) trades at US$1.25 per share, giving it a market value of US$48.6-million. Some US$8.85-billion in value has vanished.

As those billions were vapourizing, one of Wall Street's most powerful analysts following the stock, Mr. Grubman, and two analysts at Merrill Lynch recommended the company to investors.  At Merrill, Mark Kastan recommended the company until he left the firm in 1999; Kenneth Hoexter picked up coverage in May when the stock was US$21.

After its initial offering and with the analysts recommending the stock, Rhythms was able to tap the equity and debt markets for US$870-million, in four underwritings led by Merrill and Salomon.  Fees earned by the two firms on the company’s stock offerings alone totalled US$3.8-million.

Meanwhile, top management and directors at Rhythms NetConnections were selling almost one million shares, reaping US$26.4-million.

On Oct. 18, when the stock was at US$2.81, Mr. Hoexter cut his rating on Rhythms from a "near-term buy" to "near-term neutral." Mr. Grubman did not temper his enthusiasm for the stock until Dec. 5, when its shares closed below US$1 for the first time.  He reduced his  rating to "neutral."

Mr. Hoexter said he remained high on Rhythms for so long because it continued to meet his near-term estimates.  "To us, it wasn't so visible that there was something wrong at the company," he said.

But Mitch Zacks, vice-president of Zacks Investment Research in Chicago, questioned the claims of analysts who said they did not see the freight train bearing down on them.

"It's not that they're oblivious to things getting worse," he said. "But the way an analyst can get fired is to damage an existing investment banking relationship with a company or sour a future investment banking relationship.  The way you do that as an analyst is coming out and telling people to sell a stock."

And it is not just a company's management that analysts must worry about angering.  They must also weigh what their negativity would mean to the portfolios of the venture capitalists that send their firms companies to take public.

If an analyst advises investors to sell a stock that its venture capitalists still own a stake in -- and they often hold such shares for years -- the likelihood of getting future deals from those people is slim.

Source:  NATIONAL POST ARTICLE  

Tuesday, January 9, 2001