Like Clockwork, Red Hat, Net2Phone and Others Jump 25 Days After Their IPOs

Everyone seems to benefit, at least in the short term, from research built on a decidedly shaky foundation.
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The examples are many. Shares of

Red Hat

(RHAT)

jumped 27% last Tuesday, just a day before

Goldman Sachs

issued a bullish report on the company's prospects. Shares of

Net2Phone

(NTOP)

jumped 32% after

Deutsche Banc Alex. Brown

rated the company a buy on Aug. 24. A

Credit Suisse First Boston

analyst called

Tumbleweed Communications

(TMWD)

a buy, and the stock jumped 14% in a day.

Analysts move stocks.

In the tautological logic of Wall Street, the prediction of good things to come leads, invariably, to good things -- at least in the short term. And the surest of those sure bets is that stocks will jump with the release of post-IPO research.

Here's the deal: The

Securities and Exchange Commission

prohibits investment banks who underwrite an initial public offering from issuing research reports for 25 days after the IPO. When those reports finally come out, they're almost universally laudatory and almost religiously lead to a quick pop in share price. But should they?

Money Can Buy You Love
Shares of Red Hat pop after a glowing research
note from underwriter Goldman Sachs.

Source: Baseline

Obviously, these reports are far from objective. The analysts who write them work for investment banks who've been paid millions in fees to bring a company public. In fact, these days research analysts are actively involved in pitching investment banking business. The star analysts wait in lobbies to meet company management; investment bankers are sometimes just along for the ride. As they compete to bring hot companies public, star analysts and their shameless, uncritical research become a deal-winning asset. "What do you expect us to do?" asks one analyst with an East Coast investment bank "We're sell-side analysts: We sell things." Positive research from an underwriter is more than a lead-pipe cinch -- it's often an implicit part of the deal itself.

"It's incredible to me that anyone would be surprised that this research is positive," says Seth Tobias, whose

Circle-T Partners

hedge fund has been heavily involved in this year's spate of Internet offerings. "But this trade still works, over and over again."

For anyone interested in an Internet business -- or any business for that matter -- analyst research is fascinating reading. OK, it'll never make

The New Yorker

, but within these 20-some-page reports is a pithy overview of the company, an assessment of the market opportunity and overview of the critical numbers affecting company growth. But these business models are where the real insight begins, or ends, with so many of these analysts.

"There aren't just a lot of rookie daytraders out there," says Tom Courtney, managing director and senior Internet retail analyst with

Banc of America Securities

. "There are a lot of rookie analysts and they're not doing thorough research. You have to look for detailed work. Do they have a five-line model or a fifty-line model?" he asks, referring to the spreadsheets that replicate a business model.

"Some firms say 'fourth-quarter sales will be up.' But we build a model showing how many customers there are, how many there will be and how much those customers will be spending. You can disagree with our assumptions, but at least you can see how we arrived at them."

But the most notable aspect of these reports is the most ironic: the buy, sell or hold rating on the cover. This call generates the most attention, but it's a deep Wall Street code. Sell is as rare as underpriced Silicon Valley real estate and buy is more of a tepid compliment than a call to action. More importantly, the self-serving motivation of the "analysts" who write these reports is transparent -- but ignored by many investors.

Institutional traders tend to ignore such research, but in recent years, daytraders have been piling on these stocks when the reports come out. The bulletin boards on

Raging Bull

and

Yahoo! Finance

are full of gleeful shock -- shock! -- when the reports come out with their buy headlines. And the rest of the Street is starting to take notice, because if a stock moves up, a stock moves up and there's the opportunity for a quick profit. It's a self-fullfilling opportunity to be sure, but it's proving to be profitable for all market participants.

Analyst David Readerman of

Thomas Weisel Partners

includes a calendar of upcoming research dates in his weekly research report. And some money managers say big-time professional investors are cornering these stocks and using those research dates to drive up the share price, hoping they can sell at a later date when nobody is watching.

"I think retail drives these trades," says Tobias. "But some small hedge funds are starting to play these for a pop."

And so, as it goes, it goes. The meaningless positive research gives way to meaningless positive moves into new trading territory. But you might not want to be around when the market figures out there is no true support to these paper tigers.