Telling Congress About the Rigged Research Game
Editor's note: TheStreet.com columnist Adam Lashinsky is testifying today before the House of Representatives Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises. The committee is investigating the quality of equity research and reporting available to the average U.S. investor. We are running Lashinsky's testimony in full and in three parts. This is the first part.
When I first started covering financial news and set out to write about publicly traded companies, I was told to look for sources in Nelson's Directory of Investment Research. All I knew about the "analysts" listed in Nelson's, the pre-Internet Bible on Wall Street coverage, was that the people listed followed the companies I was investigating. If I needed a quote on, say, Caterpillar, I'd flip to the Caterpillar page in Nelson's and start dialing, hoping to find an analyst who'd return my phone call and say something germane on the record.
I knew nothing about the firm where the analyst worked, nothing about the investment-banking ties the analyst may or may not have had, nothing about the difference between a "sell-side" and "buy-side" analyst, and almost nothing about which analysts were better than others. (A star next to an analyst's name meant she was a member of the all-star research team chosen by Institutional Investor magazine, a distinction whose methodology I didn't understand.) All I knew was that an analyst who returned my phone call was more valuable than one who didn't. Nobody explained it to me in any greater detail.
Nobody Explained the Game to the New PlayersIt took me a few years to figure out the answers to these questions. But by the time the tech-stock boom began in the mid-1990s and I was covering tech stocks in Silicon Valley, I did understand. Unfortunately for the individual investor who plunged into the stock market around the same time, nobody bothered explaining these things to him. The average neophyte investor found himself with about the same level of understanding about how the Wall Street research game is played as I had when I was a cub reporter 10 years earlier. Consider the ramifications. An investor seeing "an analyst" plugging a stock on CNBC or in the San Jose Mercury News, where I worked before joining TheStreet.com, had every reason to believe that the analyst in question was a credible source, an objective observer of a company's financial prospects and therefore of its stock-market value. The entry of the confused investor into the stock market wasn't a trivial event, as we know now. Forrester Research estimated that total online brokerage accounts, a decent proxy for individual investors, will grow from 5.3 million accounts in 1998 to 14.3 million in 2002. Another analysis estimates that retail trading accounted for 35% of the total volume on the Nasdaq in 1990 and spiked to nearly 60% in 2000. For the first time in the history of the U.S. capital markets, the amateur investor on Main Street was having as much of an impact on share prices as the professional investor on Wall Street. Old-timers (anyone trained in financial analysis before roughly 1995) decried the lack of attention to fundamentals. But the amateurs, often listening to the respected "analysts" on the tube, made gobs of money as the Nasdaq Composite Index marched from less than 1000 in 1995 to more than 5000 in early 2000. For reference, the composite currently stands at about 2000. Individual investors were justifiably angry that the sources they trusted for their investment advice had served them so poorly. If it's any comfort, individuals didn't fare much worse than professionals, who also believed we had entered a new economy where fundamental value didn't matter.
What the Pros Already KnewSo let's cover briefly what professional investors understood all along and what individuals, with the help of this committee and instruction from the Securities and Exchange Commission, have come to understand. In short, Wall Street analysts by and large are part of the investment banking operation of their firms. They receive a chunk of their compensation based on the corporate finance and M&A advisory fees their colleagues collect. Their part of the bargain is to provide research that makes their firms and themselves prominent without embarrassing either their firms (with research that criticizes a banking client) or themselves (with research that predicts poorly which way stocks will go). Based on my conversations with hundreds of research analysts and institutional investors, there is no doubt that the "game" has become more egregiously abused over time. Two factors have led to this. One is simply the huge uptick in investment banking opportunities during the technology-stock bubble. At the same time, thanks to Big Bang reforms of the 1970s, trading commission fees earned by brokerages have become commoditized. The money isn't in trading when investors pay fractions of a penny to trade a share of stock. The money is in banking, and analysts are part of the banking process. The key to understanding the so-called scandal this committee seeks to investigate is that the game has been well-understood for years. Institutional investors -- analysts and portfolio managers who work for pension funds, mutual funds and sophisticated hedge funds -- long ago stopped relying on equity analysts to help them make buy-sell decisions. These investors know about -- and generally are unbothered by -- the blatant conflicts of interest that exist on Wall Street. When three investment banks underwrite the IPO of a small technology company and 26 days later -- surprise, surprise -- analysts for those three, and only those three, brokerages initiative coverage on the stock, it is obvious to careful observers that a connection exists. This situation doesn't alarm the experienced investor. But nobody told the amateurs who were new to the game. To go to the second part of Lashinsky's testimony, click here.
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