A123 Illustrates Perils of Wall Street Research

Editor's note: This is the second part of Rick Pearson's look on investing in Chinese small-cap stocks. Here is Part 1.

Supposedly "objective" third-party research should be viewed with a healthy degree of skepticism. Wall Street investment banks have an irreparable conflict of interest when it comes to providing research, due to the connection with generating sales and trading volumes as well as investment banking revenue.

For a good example, look at A123 Systems(AONE). The company did a roughly $1 billion IPO in 2009 despite the fact that it has never made a profit and in fact has negative gross margins. Not since the blazing days of the Internet boom have I seen a more deserving candidate for a "strong sell" recommendation. And yet how many Wall Street banks initiated coverage with a sell rating? None that I could see.

To be viewed with even greater caution is the "company sponsored" variety of research. There are a number of small firms that will produce detailed research and a sky-high price target. These firms are paid by the company to produce a positive report for investors. The payment typically includes lots of stock warrants, so the research writer has a strong incentive to see the share price go as high as possible. Before I even read any research report from anyone, I always skip to the bottom portion to see if the company paid to have the research produced, and then I evaluate it accordingly.

The simple fact that companies pay to have someone do research on them is not always a bad reflection on the company. The reality is that major investment banks, for obvious reasons, do not have an incentive to devote resources to these small companies, even in cases in which the upside in the share price may be tremendous. As a result, small companies often have no alternative but to pay for it themselves. In any event, I often refer to these types of reports as a source of condensed, well-formatted and easy-to-read information, which is typically just a summary of the SEC filings . But I largely ignore their share-price targets, and I deeply discount their financial forecasts.

Always Rely on Multiple Data Points

Lastly, articles like these should serve as "one data point among many," and should certainly not be seen as the most important data point. But, you may say, "what if the price jumps and I miss it?" My answer is that if a stock looks like it could potentially deliver a return of several hundred percent, then missing the first few percent is not such a big deal. Even if a stock jumps 30%-40% on that day, you will then have another 17.5 hours until the market reopens the next day, which is plenty of time to do some in-depth research and bracket your expectations on buy and sell price targets. You may pay a higher price, but you will also know for certain that you are paying the right price.

At the time of publication, Pearson had no positions in stocks mentioned.

The author can be reached at [e-mail].

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