March 6, 2002
This week several Wall Street financial analysts were grilled on why they were so reluctant to change their ratings on Enron even as the stock plunged from $80 to less than a dollar in a single year. The larger issue, are analysts biased to the buy side because Wall Street makes its big money from banking fees rather than stock commissions, also was explored.
Certainly, something other than reasonable analysis must explain why so many strong recommendations for Enron stock persisted even as its stock collapsed. As a former director of a brokerage firm, I believe that analysts try to develop analytical models. However, they know that their stature and possible future employment will depend upon how much business they can bring to the company.
This usually means that they seek "popular" stocks or hidden gems. Most commissions are motivated by buyers (although there is a sell on every transaction). Banking business, such as the distribution of new bond or stock issues, almost always depends upon distribution, which means the ability of the brokerage to find buyers for the issue.
Not surprisingly, analysts are seeking potential buys. Furthermore, analysts will get grief (not from management but from the sales force) if they lower a rating. After all, the broker will need to explain to the customer why that issue the customer was hoping would recover no longer is worthy. A few of those conversations and the broker will lose the customer.
I was hoping that as the brokerage business became more asset management and less transaction based, this natural bias to the buy side would vanish. Apparently, it has not.
First, the shift to asset management (where the customer pays a fee based on the size of assets) is not as rapid as I had hoped. Discount brokerage services, where transactions costs are pushed down to paperwork costs, have stymied this adjustment.
Second, many brokerage firms mistakenly believe that their banking business is more profitable than it really is. No question, that million dollar fee for a $20 million new issue can make a year for the person who arranged the deal. However, the costs of discovering and landing those deals must include the cost of deals that fell through.
One analysis I have seen indicated that the returns to banking for smaller brokerage firms is only about a third of the returns to institutional fixed investment in those same firms over time. The "lottery effect" of dreaming of the big deal clouds our minds to the weekly costs of being in the game.
In institutional investing, the broker may be managing the investment portfolios of small financial institutions. The broker may actually be initiating transactions to help the client meet corporate objectives or improve their risk/reward performance.
When was the last time your broker called to suggest a transaction because your portfolio was overbalanced or no longer conformed to your stated objectives? This happens all the time in the profitable institutional fixed investment departments.
Should one be surprised to learn that bond analysts are more likely to spot problems at companies than stock analysts? Bond analysts know that if credit risks increase, brokers must recommend selling bonds that no longer comply with the investment criteria of their customers.
Third, most stock brokers are trained to distribute issues and gather assets rather than manage assets. They assume that customers manage their own accounts. Indeed, many have no idea what the complete holdings and objectives of their customers are. If you cannot manage, why should I pay you a fee for doing so?
Needless to say, if the brokers are transacting rather than managing, they want stories to sell. Analysts are naturally drawn to supporting those stories. Remember, the broker can call all clients to suggest a buy. Only the ones who own a security need to be called to suggest a sell. And that conversation usually is not as pleasant.
Pension programs and mutual funds made the same errors as brokerage houses did in buying and holding Enron securities. Why did they rely upon the analysts rather than do their own research? Again, the customers' search for low management fees may preclude the research we assume exists in these areas.
In the end, analysts should report discrepancies from their forecasts and explain why they occurred. An unexplained drop in stock values needs to be explained (as so many analysts failed to do with Enron). These should be included in research reports. Indeed, I would require that from any analysts I supervised.
Also, I would require that analysts review their calls from two and three years ago and indicate whether they are still buys, holds, or should be sold. After all, investors probably still hold previously recommended issues.
But the customers must also take some blame for Enron research failures. We get what we pay for. By demanding cost reductions we may have biased research. Indeed, how many brokerage firms are responding to Enron research problems by beefing up their research?