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Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Verastem and the Broken Wall Street Research Model

Stocks in this article: VSTM PFE NVS LLY GSK

NEW YORK ( TheStreet) -- Wall Street research is separate from investment banking. Sell-side analysts spend their days analyzing companies and counseling investors on which stocks to buy and sell, while their investment banking colleagues, oblivious to what the analysts might be writing or saying, raise money and negotiate deals for those same companies.

Just kidding.

Experienced investors understand that, despite regulatory overhauls, Wall Street research is still fundamentally flawed and rife with conflicts. Investment bankers always win, which is why investors who rely heavily on sell-side research and don't do independent work too often lose.

In January, Boston-based Verastem (VSTM) raised $59 million in an initial public offering led by UBS and Leerink Swann, with Rodman & Renshaw, Lazard, and Oppenheimer lending secondary support. Biotech IPOs are relatively rare these days, but Verastem's offering was even more unusual and risky because the company's drug development program is based on research into cancer stem cells still in preclinical stages. Verastem won't initiate Phase 1 studies, which test a drug's safety in humans, until next year. Proof-of-concept efficacy data will not available until late 2014 at the earliest.

Biotech companies with drugs in much later stages of clinical development find it difficult to go public today, yet here was Verastem, with nary a single patient exposed to any of its drugs, selling 5.5 million shares to the public at $10 per share.

Forty days later, the minimum time period allowed by law, sell-side analysts from all five of the investment banks which took Verastem public issued glowing reports with buy ratings and price targets 50% to 100% above the current share price.

Coincidence? Not likely.

The truth is that major investment banks are still hopelessly biased in favor of the companies with which they do business. Analysts working for those investment banks, therefore, have strong inducements to issue bullish research.

The Verastem IPO, while modest, still generated $4.4 million in banking fees. To partake in the lucrative business of raising capital, a bank can't alienate management with even the risk of a negative review.

I'm going to dissect the Verastem research report issued by UBS for two reasons. First, UBS is by far the highest-profile bank in the Verastem syndicate (a term for the group of banks that orchestrates an IPO.) Second, the analyst who wrote the report, Matthew Roden, is a smart guy who often does quality work and has made good calls in the past. My complaint isn't with Roden per se, but rather with the "reformed" research-investment banking system that still creates misaligned incentives.

Before I demolish Roden's Verastem research (nothing personal, Matt), a bit of background on Verastem plus an explanation of how a professional investor values development-stage drug candidates.

Verastem was founded on the belief that most currently marketed anti-cancer drugs have little efficacy against cancer stem cells (CSCs), a progenitor subgroup of cells that some scientists believe fuel metastases and tumor regrowth.

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