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WALL STREET'S SPIN GAMEStock analysts often have a hidden agendaMeet Thomas K. Brown, 39, a Master of the Universe in bank stocks: 15 years on Wall Street and in eight of the past nine years, the top-ranked analyst of regional banks on the prestigious Institutional Investor All-America Research Team. On Mar. 25, after seven years at Donaldson, Lufkin & Jenrette Inc., Brown was fired. His sin? He was an outspoken critic of banks that had paid heavily to amass huge empires without much to show for it. Says Brown: ''I believed many of the acquisitions are destroying shareholder value.'' Brown's bluntness and independence had become a problem for DLJ, which in recent years has tried to break into investment banking's top ranks. In fact, just hours before Brown's firing, the firm hired a team of two dozen investment bankers to help the firm arrange deals in the financial-services industries. ''I heard from my colleagues that the new investment bankers wanted me out,'' says Brown. ''I was viewed as being negative on mergers and acquisitions.'' Brown, who now runs a bank-stock portfolio for hedge-fund manager Tiger Management Corp., says DLJ offered him $450,000 for a five-year agreement not to talk about the firm. He declined. A DLJ spokeswoman said ex-employees who ask for or get more than the typical two weeks' severance package are always asked to sign a ''nondisparagement'' agreement, a common practice on the Street. As for the dismissal, Research Director Susan L. Decker says it resulted from ''a longstanding and acrimonious conflict with colleagues in the institutional-equities division. It had nothing to do with any other department in DLJ.'' Whatever the reason for the dismissal, Brown's unvarnished analysis will be missed. Indeed, analysts who try to provide an honest and unconflicted opinion are becoming scarcer and scarcer on Wall Street. If there ever was a time when investors could use straight talk, it's now. A runaway bull market glosses over a multitude of analysts' sins. But in today's unforgiving market, probing analysis and intellectual honesty can make the difference between plump profits and gut-wrenching losses. The question for investors is: ''Can you trust your analyst?'' Unfortunately, the answer is not very much. At the major Wall Street houses, which thrive on investment banking, every analyst has a potential conflict of interest. The ''Chinese Wall'' that on paper still separates a firm's analysts from its investment bankers continues to crumble as analysts are encouraged to scout deals. The analyst's firm is either the investment banker for a company he or she is covering--or it's wooing the company for a piece of that juicy revenue stream. A study co-authored by Georgia State University assistant professor Siva Nathan looked at reports on 250 companies by analysts whose firms had investment-banking ties with those companies and an equal number from analysts with no ties. The investment bankers' analysts had 6% higher earnings forecasts and nearly 25% more buy recommendations. ''TRAPLINE.'' Even when a firm isn't big in investment banking, its analysts often pull their punches. They shy from saying things that might anger a company's management, fearing loss of access to executives, company meetings, and earnings ''guidance'' chats--critical to making profit forecasts. By and large, those estimates do little more than parrot the company line. Consider that over the last 20 years, the range of analyst estimates for the average stock has narrowed from 8% to 4%, according to I/B/E/S Inc., which collects and distributes earnings estimates to the Street. That suggests that the analysts are doing less original work and hewing closer to the company source. When earnings disasters hit--Cendant, Oxford Health Plans, or Sunbeam, to name a few--most analysts are as surprised as everyone else. Institutional investors look at the analysts the same way polls show Americans think of members of Congress. Low opinion of most, but high regard for a select few. ''Maybe 20% are intellectually honest,'' says Richard Strong, chairman of Strong Funds, with $32 billion in assets. ''And you assemble a trapline from them and try to replace those as they leave or retire.'' Patrick Adams, who manages $2 billion for Berger Funds, says much of what Wall Street analysts do is of little value to institutional investors, whose in-house analysts nowadays have as much access to companies. ''Few go out and do independent investigations of talking to suppliers, customers, and competitors to determine what's going on,'' says Adams. He recently hired a market-research firm to ''get something other than what the companies and the analysts are saying.'' And he also contracted with accounting sleuth Howard M. Schilit ''to be the policeman on our portfolio,'' trying to identify companies with accounting-related problems before they blow up. Analysts routinely play up good news and sugarcoat the bad. Positive corporate news--an unexpectedly strong earnings report or successful product launch--may get a recommendation of ''strong buy.'' Bad news gets a ''hold'' or ''neutral''--often a euphemism for ''sell,'' which has all but vanished from the analysts' vocabulary. Even Andrew Shore, the analyst at PaineWebber Inc. who was early to spot inventory problems at Sunbeam Corp., downgraded the stock to only a neutral rating on Apr. 3, and the stock fell 25%, to 34. ''I saw that neutral as a sell,'' says Shore. ''No need to yell 'Fire!' in a crowded theater. I was just trying to be diplomatic.'' Sunbeam is now at 7. OPTIMISTS ABOUND. Today, a mere 1.4% of all analyst recommendations on some 6,000 companies are sells, vs. 67.5% buys and 31.1% holds, according to Zacks Investment Research. It hasn't always been this way (chart, page 154). In mid-1983, for instance, 24.5% of the recommendations were buys, 26.8% sells. But by the end of the '80s, buys outnumbered sells four to one, and by the early 1990s, eight to one. One explanation for the lopsided number of buys is the bull market. Still, the number of buy recommendations has continued to climb over the past 12 months while the average U.S. stock was losing 10% of its value. Investors are bombarded with bullish sound bites and ''strong buy'' and ''outperform'' tips in print and on the air. Analyst recommendations are finding their way online as well. DLJ Direct and Morgan Stanley Dean Witter's Discover Brokerage Direct offer their reports to clients, and soon Charles Schwab & Co.'s Web site will feature research from cs First Boston and Hambrecht & Quist. Investors picking up such tips need to be wary about motives. Official research reports must disclose if the firm is or has been involved in an investment-banking relationship with the company. But news reports of recommendations may not carry such disclaimers. GREENER PASTURES. The war between investment research and investment banking began in the 1980s, but it has heated up in the deal-crazed '90s. The reason is simple: money. Most Wall Street research is pitched to institutional investors who pay the firm about a nickel a share in commissions. But if an analyst spends his time trying to land an initial public offering, the firm can earn 15 to 30 times that amount per share. Merger advisory fees can be sweet as well. And directly or indirectly, some investment-banking fees will find their way back to the analyst's pocket. Wall Street execs admit analysts walk a fine line when they work in both research and investment banking. ''We warn them that if they lose credibility with investors, they're of no use to investment banking either,'' says Mayree Clark, global research director at Morgan Stanley Dean Witter. But what happens when there's a conflict between objective analyses and the demands of investment bankers? ''Conflict?'' asks Brown, the former DLJ analyst. ''There's no conflict. That's been settled. The investment bankers won.'' It's not far from the truth. ''Of all the jobs on Wall Street, the company analyst's role has changed the most in the last five years,'' says Alan Johnson of Johnson Associates, a Wall Street compensation consultant. ''The analyst today is an investment banker in sheep's clothing.'' Equity analysts are a staple of the financial media, BUSINESS WEEK included, and the media doesn't always indicate when an analyst is speaking objectively. On June 8, for instance, Robert B. Albertson, banking analyst for Goldman, Sachs & Co., appeared on both cnbc and on the Nightly Business Report extolling the virtues of the just-announced merger of Wells Fargo & Co. and Norwest Corp. Both shows identified Albertson as a Goldman analyst, but neither said the firm was the investment bank on the deal. Goldman stands to collect about $40 million in fees when the deal closes. But even more questionable is that Albertson appeared on the shows at all. It's common practice on Wall Street to bar analysts from even talking about a company if the firm has an active investment-banking relationship with it. Albertson says his remarks were appropriate and ''not over the line. My customer is the investor, and if I see something I like, I should be able to say that.'' Albertson says he wasn't part of the investment-banking effort on the merger at Goldman. Should analysts ever wear the hat of the investment banker? Brown says no. For instance, as an analyst, he helped DLJ investment bankers market two secondary offerings for subprime lender Olympic Financial Ltd., now known as Arcadia Financial Ltd. Brown was a bull on the stock anyway but concedes the fact that the equity offerings paid an additional six-figure sum might have affected his judgment. In contrast, there's no direct compensation for a buy recommendation, but analysts are rated by the firm's traders for how much business they generate. ''The difference is, in an underwriting, the analyst has a big incentive to like the company a whole lot more,'' says Brown. These days, Wall Street firms recruit analysts who can land investment-banking clients. ''I got a phone call from a headhunter who was looking for a semiconductor analyst for Prudential Securities,'' says Eliot Glazer of DuPasquier & Co., an independent researcher for institutional clients. ''The first priority was investment banking; the second, investment research.'' A Prudential spokeswoman says ''it doesn't sound right that a headhunter would say that.'' She says the firm believes research and investment banking are complementary businesses. There's no question that an analyst can be a rainmaker. ''Having a top analyst has been essential in bringing in the IPOS,'' says Joan Zimmerman, a headhunter at G.Z. Stephens Inc. Indeed, in most ''bake-offs,'' competitions in which investment banks pitch their services to a potential client, the analyst is a star of the show. That's because a rousing endorsement from a highly ranked analyst is thought to be able to send a fledgling stock into orbit. And the firms play that to the hilt. BUSINESS WEEK has viewed an internal document prepared by a major Wall Street firm to a company planning an IPO. The ''pitch'' stated that the firm's analyst would serve as an ''advocate'' for the company. And it's not only IPOS. A sharp analyst can draw other dealmaking as well. ''If I like a company, we [the firm] try to become its investment banker,'' says technology analyst Michael K. Kwatinetz, who with his 17 analysts and over 120 investment-banking colleagues, recently moved to cs First Boston from Deutsche Securities Inc. ''If you think a company should do something, it's nice when you have an arm of the firm that can try to make that happen,'' he says. Kwatinetz' investment-banking cohorts have arranged acquisitions for Gateway and Hewlett-Packard, an equity offering and divestiture for Micron Technology, and two hedging programs for Dell Computer. Now, six of the eight companies he covers are also investment-banking clients. Only one, Wind River Systems Inc., was a client at the time he started covering it. Not surprisingly, some analysts make more than the dealmakers. And Zimmerman estimates that total cost for equity research has quadrupled in the 1990s--though with Wall Street's slump, 1998 pay levels will likely fall below 1997's. Even if that happens, the dollars are still huge. At the major investment banks, salary, bonus, stock, and options for an Institutional Investor first-team analyst can easily run from $2 million to $5 million, especially in industries like telecom, technology, media, and health care. Even the next tier runs in the $750,000 to $1 million range. Junior analysts still learning the trade can earn $500,000 to $750,000, and for grunts whose work backs up the senior analysts, $250,000 to $400,000 is not unknown. Veteran telecom analyst Jack Grubman recently became the first of his kind to achieve nba-star-like status: Salomon Smith Barney reportedly agreed to a $25 million one-year package to keep the analyst (page 156). Not only are the analysts taking home a bigger piece of Wall Street's pie, but there are more of them. After the 1987 stock market crash, the number of full-time analysts dropped until 1992, when it bottomed at 2,313, according to Nelson Information. But spurred by a bull market and deal mania, the ranks have since swelled to 3,724. And that doesn't include the legions of support staff who now do much of the number crunching, freeing the top analyst to visit companies and clients to push stocks and investment-banking deals. HEATED EXCHANGE. The great fear of the analyst when he or she goes calling on a company is to find the door shut. Roger Lipton of Lipton Financial Services Inc., an independent research boutique, was refused attendance at a 1995 Boston Chicken Inc. investor conference. He had been an early critic and a bear on Boston Chicken, the once-sizzling chain whose stock has since turned to toast. Brown was barred from First Union Corp.'s Charlotte (N.C.) headquarters. He repeatedly clashed with Edward E. Crutchfield, the chairman and CEO. At a First Union analysts' meeting in New York last November, Crutchfield, from the podium, and Brown, from the audience, exchanged heated words. These aren't isolated incidents--and they will continue to happen. Consider a recent survey of Wall Street research, sales, and trading practices conducted by the Tempest Consultants Inc. and sponsored by Reuters Holdings PLC. The survey asked 272 large U.S. companies what their reaction would be to an analyst's sell recommendation. One-third said they would exclude the analyst's firm from investment-banking business, and nearly as many said they would ''reduce communications and reduce access.'' A study of small to midsize companies turned up similar results. It's not just companies that analysts fear to offend. Lipton recalled an analyst who had expressed bearishness about Boston Chicken to him but kept recommending it to clients. Why? ''It turned out that a large mutual-fund company had 5 million shares of the stock, and he feared if he lowered his rating, that fund company would 'come crashing down on him,''' says Lipton. Another analyst, who asked not to be identified, said he angered a major mutual-fund company when he put out a sell on a holding of theirs. ''When you say sell, it's supposed to be a service to a client,'' says the analyst. ''But it was taken as a slap in the face, a challenge to their judgment. They didn't want to hear it.'' Bad news gets blocked by other agendas. Brown was involved in a 1996 effort to find a buyer for Olympic and so was barred from commenting on the stock. Several buyers came, took a look at the books--and backed out. Word leaked out that the deal was in trouble, and the stock started to fall from the mid-20s. Brown says he knew many of his clients were losing money--and couldn't say anything. The company, now Arcadia, was never sold, and trades at around 5 a share. The situation was similar for Josephine Esquivel, the apparel analyst at Morgan Stanley Dean Witter who covers fashion house Donna Karan International. Morgan had been the lead underwriter for Karan's $24-a-share IPO, and Esquivel issued the obligatory ''strong buy'' recommendation a month later and reiterated it several more times. But Karan's stock started to slide within weeks of the IPO--an embarrassment for the underwriters--as the company ran up huge expenses and large losses. In March, 1997, Karan hired Morgan Stanley to unload its beauty-products business. That was tantamount to a gag order, says the analyst. ''I couldn't even change my rating or even an earnings estimate,'' she says. Esquivel was prohibited from commenting on Donna Karan for 15 months. For unbiased evaluations, institutional investors look beyond the major Wall Street firms. Big investors often give high marks to the research efforts of Sanford C. Bernstein & Co., which does no investment banking. They also turn to research boutiques like Lipton's or DuPasquier, the firm with which Glazer is affiliated. ''I'm a dinosaur,'' says Glazer, who, with 30 years of Wall Street experience, remembers the days when equity analysis and investment banking were distinctly different functions. St. Louis-based A.G. Edwards & Sons get high marks for solid research, in part because it's not a major investment bank. ''Putting a sell on a stock is not pretty for me or for the company,'' says Edwards' recreation-industry analyst Timothy Conder, who in mid-July issued an unambiguous sell on Callaway Golf Co. ''But I'll do it if it's right for my clients.'' Conder had lowered the rating to ''reduce'' in early March, arguing that bad weather and the deteriorating economies in Asia would crimp profits. The stock was then at 32. Conder reiterated the rating several times before dropping to a sell at 19. It was a great call: The stock trades around 10. For sure, brokerage firms are not about to break up the money machine that pairs analysts with dealmakers. And analysts are not about to risk offending the companies they cover. Woe to the investor who doesn't keep these two ideas in mind before investing on a stock recommendation.
By Jeffrey M. Laderman in New York, with bureau reports RELATED ITEMS
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Updated Sept. 24, 1998 by bwwebmaster
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