I mentioned earlier that two people went after Attorney General Spitzer in the April 12, 2002, edition of the Wall Street Journal after the court order resulting from Spitzer’s investigation was issued. The second individual remains nameless because he or she was writing in an unsigned editorial.
The editorial was entitled, “Buying and Selling,” and focused on the specifics of Henry Blodget’s case (described earlier).
Unlike Glassman’s column, which dealt with the question of analysts’
talent, the editorial addressed the issue of analysts’truthfulness. If I read it right, the editorialist more or less concludes that truthfulness is unimpor- READING(ORIGNORING) ANALYSTS’ RECOMMENDATIONS 177
tant. On the subject of Blodget’s disingenuousness—my word choice, and a kind one—the writer commented, “Big surprise.”
Well, it was a surprise for many observers, including many investors who had placed their trust in Blodget and others like him. Brokerage houses offer their clients a double service—trading securities on their behalf and advising them in the process. New York’s General Business Law, Section 352 (1), defines fraud as, among other things, “any device, scheme or arti- fice to defraud or obtain money by means of any false pretense, represen- tation or promise. . . .” When a brokerage house defrauds its clients, that is a big surprise—or should be.
Comments such as the Wall Street Journal’s “Big surprise” have the same general odor as Enron’s public utterances “before the fall.” They are a mixture of arrogance, smugness, and condescension. The offending party offends, the public reacts with indignation, and the business community shrugs its shoulders: “We all knew that!” My own sense is that although the Wall Street Journal’s editorial writers may not yet recognize it, we have col- lectively crossed an ethical Rubicon. When enough individual investors have enough money in the game—a state we are in today despite a large-scale flight from the markets—a new ethical norm comes into play. There is no doubt in my mind that business—and business ethics—will have to change.
Too optimistic? Maybe. However, in May 2002, Merrill Lynch & Co.
settled the charges resulting from the State of New York’s findings that it had misled investors with its research. It agreed to pay $100 million to New York and several other states. According to the agreement, analysts would no longer be paid directly from investment banking revenues. In addition, Merrill Lynch would create a committee to monitor analysts’ research and recommendations, and it also would monitor electronic communications between investment banking and research analysts.
No, it is not clear that Merrill Lynch got the point entirely. In its state- ment, the firm expressed its regret that “there were instances in which cer- tain of our Internet sector research analysts expressed views that at certain points may have appeared inconsistent with Merrill Lynch’s published rec- ommendations.” This is at least a little bit backwards, the way I read it. How- ever, I still hold out hope that Merrill Lynch and its industry colleagues—under threat of $100 million judgments—will eventually get the horse before the cart.
LESSONS FOR THE INVESTOR
Who is working for whom? At least until the Enron wake-up call, research analysts with investment banks were essentially salesper- sons for the bank.
Two things can go wrong with the analysis.Your analyst may or may not get it right. Even if he or she gets it right, the analysis may not make it past interested parties elsewhere at the brokerage house.
(This latter problem may be on the wane in light of some houses’
highly publicized woes.)
Analysts tend to be good in good times and bad in bad times.It is like the old joke about banks: They only lend you money when you don’t need it. When times get rough, you should get more skep- tical about optimistic analyses. They are probably wrong.
Consider an independent.Independent researchers can be found through the following Web sites:
www.investars.com www.thomsonfn.com www.starmine.com www.jaywalkinc.com
We are going to win ultimately. I believe that the widespread involvement of basically decent people in the publicly regulated markets eventually will force an improvement in ethical standards within those markets and in the various industries that surround them.
READING(ORIGNORING) ANALYSTS’ RECOMMENDATIONS 179
The Perils of Cliffs
Once upon a time, a company named Enron was a utility of sorts. It owned pipelines, and fuels flowed through them. It thought of itself as a utility and more or less behaved like one.
Then, in August 1999, Enron started trading contracts on future deliv- ery of energy. A psychological shift accompanied the strategic shift. Enron began thinking of itself as a financialcompany. This was gratifying because it meant the company had moved into the fast lane—where the drama, excitement, and money were. Goodbye to the plodding old days of being a regulated utility; hello to the “Big Time.”
One of the most successful divisions of Enron, it turns out, was a hedge fund called ECT Investments. “The hedge fund, the brainchild of Enron’s former chief executive officer, Jeffrey Skilling, did quite well,” according to a report in the Wall Street Journal, “averaging annual returns of more than 20 percent after it was launched in 1996. In that period, the Dow Jones Industrial Average had returns of 11 percent. The hedge fund’s gains amounted to as much as 8 percent of Enron’s overall earnings in recent years. . . .”1
However, the transformation to a financial company also meant that Enron became susceptible to all the fragilities to which financial compa- nies are vulnerable. One of the most pernicious of these is the confidence factor:How much confidence do your clients and shareholders have in you today? How much will they have tomorrow? Absent a Three Mile Island–type disaster, the confidence factor does not vary much for a utility.
However, it bounces all over the place for a high-flying financial company,
181
13
C H A P T E R
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
especially if the main financial product that the company is trading in is its own stock.
The business depended in large part on the stock being constantly on the rise—or at least not losing value. The reason was leverage, which has the unpleasant capacity to go from positive to negative overnight. Enron was perched on the edge of what Standard & Poor’s calls a “credit cliff,”
meaning that any drop in its credit rating would materialize in a deteriora- tion of its debt, leading in no time to a further downgrading. Although Enron’s financial health was an exercise in brinkmanship, what actually brought it down in just over 6 weeks was little more than a glitch, which on its own merits should have been survivable. The rest, as its former chief executive officer (CEO) would say, was only a “run on the bank.”
Thus the point of this chapter is to help you, the investor, understand and recognize a credit cliff, as well as its equally daunting sibling, a rating cliff. I am confident that when you spot a company living on these cliffs, you will decide to stay away.