Rigged Research

Corporate Research E-Letter No. 23, April 2002


by Philip Mattera

START SHREDDING. That was the tongue-in-cheek headline of a recent article in the New York Post about the widening investigation of Wall Street analysts and the brokerage houses that employ them. These professional stock pickers may soon be facing the same kind of legal assault as those other discredited guardians of financial probity: the auditors at Arthur Andersen.

The current offensive against the analysts was initiated by New York Attorney General Eliot Spitzer, who announced in early April that his office had been investigating Merrill Lynch and had obtained copies of internal e-mail messages in which analysts privately disparaged stocks that they were publicly recommending. The messages seemed to document longstanding allegations that stock analysts are routinely pressured by their firms to tout stocks of companies that are investment banking clients.  Using an obscure provision of New York securities law known as the Martin Act, Spitzer charged that Merrill had thus been promoting stocks in an illegal manner. The law had previously been used to shut down so-called boiler room operations -- fly-by-night brokers who sell dubious securities by phone. Spitzer’s move to apply the same statute to mainstream brokerage firms is shaking Wall Street to its core.

Merrill is planning a counterattack against Spitzer that will be led by former New York mayor Rudolph Giuliani. Yet Spitzer does not seem intimidated. He has persuaded a dozen other states to join him in an expanded investigation of stock analyst deceit. Sensing a groundswell, Securities and Exchange Commission Chairman Harvey Pitt announced on April 25 that his agency would launch its own probe into conflicts of interest by Wall Street analysts. The U.S. Justice Department may also get into the act.

The financial community, which has been trying for months to portray the misbehavior brought to light in the Enron/Andersen scandal as an aberration, may have a much harder time handling this broader crisis of legitimacy.


In the old days -- through the 1950s, that is -- researching stocks was something that investors generally did for themselves. That started to change in 1959, when three young Wall Streeters named William Donaldson, Daniel Lufkin and Richard Jenrette began attracting customers to their new brokerage house by publishing detailed analyses of individual stocks. The practice caught on during the bull market of the 1960s, and within a decade, leading analysts were becoming stars of the financial world.

In 1972 Institutional Investor magazine began publishing an annual list of the best analysts, dubbing them the All-America Research Team. Making the list became a huge status symbol for analysts, raising their visibility and their salaries.

Despite their prominence, analysts continued to be nagged by an embarrassing fact: most of them were not very good at what was essentially their main function -- helping investors identify stocks that will outperform the market. Part of the reason is that stock picking is a very difficult exercise, given the multitude of factors -- many of them unpredictable or even irrational -- that determine the course of the market.

What made things even harder for analysts was the kind of relationship they had to maintain with the companies they followed. Until the SEC adopted new disclosure rules in 2000, analysts counted on getting information from companies that was not available to the general public. Maintaining this access meant staying in the good graces of management, which in turn meant avoiding criticism or pessimistic projections. Analysts, in other words, had a structural bias toward optimism that stood in the way of an honest assessment of a company’s prospects.

In an October 1, 1984 article headlined “How Good are Wall Street’s Security Analysts?” Fortune magazine described the case of a one-time high-flying company called Baldwin-United: “Most analysts following the company were chummy with Morley Thompson, the courtly and charming former piano salesman who had built the company into a financial services empire of nearly $4 billion. Wall Streeters on a first-name basis with Thompson accepted without question his explanations of complicated tax shelter deals in the company’s insurance subsidiaries. A Merrill Lynch vice president who strenuously recommended the stock was regularly spotted flying around the country with Thompson in a company jet. In mid 1982, as Baldwin’s earnings and stock price soared, a poll of analysts voted Thompson one of the Top CEOs of the year.” A year later the company was bankrupt.

Intrepid analysts who dared to point out that the emperor’s wardrobe was deficient might very well find themselves out of a job. For example, in 1990 Marvin Roffman, an analyst who followed the gaming industry for the Philadelphia brokerage firm of Janney Montgomery Scott, was fired just days after he questioned the prospects of Donald Trump’s new Atlantic City casino, the Taj Mahal. In the wake of that event, Institutional Investor conducted a survey in which it asked the members of its most recent All-America Research Team if they had ever been pressured by a company to temper a negative opinion: 61 percent of the analysts replied in the affirmative. 


The plight of analysts grew yet worse when brokerage firms sTopped regarding research as a necessary expense and began demanding that analysts do more to help bring in revenue. Traditionally, there was supposed to be a “Chinese Wall” separating the analytical and investment banking functions, but by the 1990s that barrier began to disintegrate. Analysts were expected to use their knowledge of industries to predict which private firms were getting ready to go public and would need an underwriter. They were also pressed to use their relationships with publicly traded companies to be sure that their firm had an inside track when those companies went shopping for an investment banker to assist in acquisitions or new stock issues.

From there it was a short step to transforming analysts into salesmen, whose main job was to tout stocks of companies with which their firm already had an investment banking relationship. Analysts once advised investors to buy certain stocks and sell others. By the end of the 1990s sell recommendations were virtually extinct. Of the 8,000 analyst recommendations covering companies in the Standard & Poor’s 500 stock index collected by Zacks Investment Research in late 2000, only 29 were sells.

Excessive bullishness on the part of analysts reached its height during the dot.com mania of the late 1990s. Analysts such as Mary Meeker of Morgan Stanley Dean Witter, who became known as the Queen of the Internet, helped push the stock prices of “new economy” companies such as Amazon.com to stratospheric heights. Many of these analysts remained upbeat even when the bubble began to burst. On December 31, 2000 the New York Times published an article on the dot.com fiasco accompanied by a cartoon depicting an analyst guiding investors onto a “DotComConCo Suspension of Disbelief Bridge,” which could be seen collapsing in the distance.


Last year saw the beginning of a backlash against analyst hucksterism -- or at least a public relations effort to make it appear Wall Street was cleaning up its act. Prudential Securities conspicuously hired analyst Mike Mayo, who had earlier been fired by Credit Suisse First Boston for downgrading bank stocks, as part of a ballyhooed plan to provide unbiased research. The Securities Industry Association published a set of voluntary “best practices” guidelines, including requirements that analysts disclose their holdings in companies they cover and that brokerage houses end the practice of linking analyst salaries to the amount of investment banking business generated by those companies. Although the industry rushed to embrace the guidelines, some observers were not impressed. Alan Abelson of Barron’s wrote that they were “the equivalent of those familiar signs in restaurant bathrooms adjuring all employees to wash their hands before leaving.”

To ward off stricter controls being discussed in Congress, Merrill Lynch announced in July 2001 that it would bar its analysts from buying shares of the companies they cover. Observers pointed out that this still did not address the pressure on analysts to use reports to attract investment banking business. As an officer at one institutional investor commented to the New York Times about the Merrill move, “This policy, while some sort of noble gesture, doesn’t get to that issue.”

Wall Street’s attempt at self-transformation was forgotten with the eruption of the Enron scandal. Stock analysts were taken to task for failing to detect the energy company’s legerdemain. At a Senate hearing in February, four prominent analysts made a feeble attempt to defend themselves, lamenting that they could not be held responsible for reaching invalid conclusions when the company deliberately lied to them. Maybe so, but the real question surrounding the hearing was whether Enron analysts, most of whom continued to tout the stock as the company headed for bankruptcy, were deliberately lying to their research clients in order to avoid alienating a company that generated millions of dollars in fees for their employers.



After reading the above, one might be tempted to conclude that analyst reports are not worth reading. Although such reports are not worthy of the reverence in which they were once held, they can still be a useful source of information. Knowing which analysts follow which companies is essential to corporate campaigners seeking to influence the way in which a target company is regarded by Wall Street. Here are the key information sources:

Nelson Information <www.nelsoninformation.com> publishes Nelson’s Directory of Investment Research, which lists the analysts who cover each of about 19,000 public companies throughout the world. It is available in larger reference libraries and online via Lexis-Nexis.

Institutional Investor magazine still publishes its All-America Research Team feature each year in its October issue. Other business publications have followed suit with their own analyst rankings. The Wall Street Journal began publishing an annual “Best on the Street” during the 1990s, and Fortune launched its All-Stars analysts list in 2000.

At one time, analyst reports were given away for free by brokerage houses. Once firms started restricting their circulation as a cost-saving measure, a company called Business Research Corp. realized there was a market to be exploited. Beginning in the mid-1980s it began selling access to electronic versions of these reports via a service called Investext <www.investext.com>. Now owned by Thomson Financial, Investext distributes the reports of hundreds of brokerage houses at rather exorbitant prices. Some university library systems provide access to the service to students and faculty. Lexis-Nexis also contains Investext, but its collection is not a complete as the version distributed directly by Thomson Financial.

A less expensive though less comprehensive source of analyst reports is Multex <www.multex.com>, which is available via Dow Jones News Retrieval or various stock websites (where you use a credit card to pay).

Zacks Investment Research <www.zacks.com> and Thomson Financial/First Call <www.firstcall.com> track earnings estimates by analysts.