Wednesday 6th September 2000
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What a dork.
Here are the figures that helped set me right. Of the 234 recommendations made by six top broking firms in their most recent quarterly report, only four were sells. That's less than 2%. Another 10 were "reduce", or the more subtle "underperform" calls, taking the total negative sentiment in the market in the April to June period to 6% (see "Great expectations" table). Buy calls totalled 124 (53%) and holds 97 (41%).
It doesn't take a financial genius to work out these sorts of percentages aren't an accurate reflection of the reality of the market.
And it isn't just in New Zealand. In the US, Zachs Investment Research tracked the 33,169 recommendations made by American brokers in 1999. The result, 11,136 strong buys, 12,415 moderate buys, 9269 neutral recommendations, 224 weak sells and 125 pure sells. As Fortune magazine put it, "The nearly 2200 professional securities analysts on Wall Street, covering some 6000 public companies last year, managed to cough out the word 'sell' a mere 125 times."
Either brokers are en masse optimists, or there's something going on here.
The bottom line (and this isn't new, but the problem's getting worse, not better) is that brokers these days are far more worried about maximising returns from their brothers and sisters in their investment banking operations than doing right for their broking clients. And putting "sell" recommendations on a company's stock sure as hell isn't the best way of drumming up lucrative investment banking business.
This isn't a revolution for the brokers' big institutional clients, who, over the past few years, have learnt to understand the new language of nudge-nudge, wink-wink, hidden nuance, understatement developed by the analysts to get the message across without upsetting their powerful corporate clients (see "Between the lines"). But what about the poor retail punter who didn't get sent the Dictionary of Broker-Speak?
To Unlimited's knowledge no one has yet used the words "immoral" or "deceptive" about this sort of analysts' side-of-the-mouth talk. But it sure pays to understand the pressure broking houses are under to keep their most important customers happy; and the fact is those important customers don't include you. The broking houses are in a hell of a position. On the one hand, faced with $29.95 competition from online brokerages, traditional broking fees are on a downward spiral. On the other hand, the profits from managing floats, issues and other capital raisings are going up and up. It's not unusual for a broking house to cream a 7% to 10% fee from an investment banking transaction, which on a $100 million float isn't small bikkies. And no "buy" from the analysts and brokers means no business.
The phenomenon reached its height in the US during in the pre-April bull market. As the number of IPOs and capital raisings spiralled, many analysts became de facto cheerleaders for companies whose floats their investment arms were promoting. At the bottom of the priorities pile were small investors lured into risky investments by the ra-ra attitude of their advisors. Somewhat late, the US is talking about the possibility of some regulation.
In theory, the structure already exists to prevent these sort of things happening. Much-lauded "Chinese walls" are supposed to separate different parts of a broking house. The reality is these walls are commonly breached, here as much as elsewhere. Although brokers' tip sheets should reach all clients at the same time, for example, analysts are under huge pressure to tell their own sales people of any significant ratings change before they are published. The sales people can then call their major institutional clients, who get a chance to act before - or just as - the knowledge hits the streets.
"We are somewhat cynical about broking house recommendations," says Simon Botherway from fund management company Spicers. "In a perfect world, Chinese walls would result in independent recommendations. But in reality, it appears there is a correlation between a favourable recommendation and banking relationships." Both Spicers and others, like fund managers Axa, use broker research as a starting point, but have their own research people. "We have a system to rank the success of brokers' calls," says Axa's Rob Mercer. "We call it the 'great expectations list'." For Mercer and company, the brokers' tips are the starting point, not the end, for their research.
Investment banking conflict isn't the only issue for analysts. Another one is the level of broking fees. These are paid on both the buy and the sell part of a share transaction, meaning ideally, a firm tries to have clients on both sides of a sale. Often the best way to achieve that is to use positive, rather than negative recommendations. The logic is simple. Put a buy recommendation in your tip sheet and while most clients acting on the tip will buy, it's quite likely another client will read it, disagree, and decide to sell instead. Posting a sell recommendation is likely to bring sellers from your camp but buyers will tend to be clients of another broker - a broker that's expressing a more a positive view on the stock.
"When I first entered the role I naïvely assumed the job of an analyst was to give clients good advice and help them make money. Later I understood you are there to help generate brokerage and the best way to do that is to have buy recommendations," says one high-profile analyst, who funnily enough spoke on the condition of anonymity.
Then there's the issue of analysts putting themselves offside with the very businesses they are writing about. Company executives, aware of their power over the broking houses, aren't slow to show their disapproval of the "wrong" recommendation. An easy way to get back at a recalcitrant analyst is to refuse him (or her) the information needed for the job. Tactics include withdrawing invitations to briefings and refusing to go on roadshows with anyone that doesn't have a buy recommendation. The latter is an increasingly powerful weapon.
"One of the big value-adds a broker can give to his big institutional clients is to get management in front of them," says one analyst. One of the criteria US institutions use to rank broking houses, for example, is how often they are able to bring executives from the companies they are investing in out to meet them.
"So the weighting from brokers is toward buys because they want [these executives] to be their buddies," the analyst says. Some companies are more subtle in the pressure they put on analysts than others. "Brokers frequently have buy recommendations on Sky TV because Sky makes it known that it will only do roadshows and presentations for those 'buy' analysts."
Basically, says straight-shooting analyst Arthur Lim of Ord Minnett, you don't get thanks from anyone (except possibly the odd retail client) for saying nasty things about clients, even if you are right. Lim remembers how, in his early days as an analyst, he put a sell recommendation on a stock on the basis of some new research findings. The company's lawyers were immediately on his back, threatening "injury to [my] financial wellbeing". He was berated by fund managers with positions in the stock, who didn't like the potential ramifications of the sell. Even his own company didn't thank him for his courage - they weren't pleased at having to deal with the lawyers' letters and were worried about the potential damage to future relationships. Oh, and by the way, Lim turned out to be right - the share price plummeted, losing almost half its value in a few months.
Disclosure: Nikki Mandow used to take brokers recommendations at face value
Faced with increasing conflicts between their independent advice, the touchiness of corporates and the demands of the investment banking parts of the business, analysts have learned to speak in a new language in their reports - one that goes as close to the reality of the situation as possible, without upsetting their big clients. All investors have to do is learn the code.
Here are some tips:
(includes strong buy, accumulate, buy an issue)
(includes market perform)
(includes reduce, under perform)
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