A financial storm continues to build. Still, most people don't want to be
bothered with the details. With such pretty pie charts predicting fair winds,
they feel secure aboard the "USS Stocks for the Long Term" chanting the "buy
'n' hold" mantra should they ever feel a tinge of concern.
Yet when this modern marvel collides with the iceberg of science and history,
the pain will cause them to begin searching for what went wrong.
Understandably, they want their lives to go on as
normal. Unfortunately, the thinly disguised marketing materials most investors
(and advisers) look to for guidance carry a heavy consequence that will affect
many for the rest of their lives.
I aim to show that to "buy and hold" without an exit strategy is dangerous,
reckless and naive. The "money game" is not a gentlemen's sport. In reality, it
is more like engaging in hand-to-hand combat. If you doubt this and don't
understand how dirty the money game is yet, just save this article and read it
again later. The bear is once again rap-tap-tapping on our chamber door.
But first, I must defuse the "few bad apples" argument. In his book The Pied
Pipers of Wall Street: How Analysts Sell You Down the River, Benjamin
Mark Cole notes that when it comes to Wall Street analysts' recommendations,
the word "sell" is rarely, if ever, heard.
Of 33,169 "buy", "sell"' and
"hold" recommendations made by brokerage analysts in 1999, only 125 were pure
sells. That means just 0.3% of recommendations were "sells", according to data
put together by Zacks Investment Research. There were another 224
recommendations, or 0.7%, that could be interpreted as "sells", such as
rankings with such tepid language as "market under performer". [1]
Or consider the
following. We showed the chart below, originally
from a 2002 copy of The Journal of Psychology and
Financial
Year
Buy and
hold
Sell
Total
calls
1996
96%
4%
29,734
1997
97%
3%
30,350
1998
98%
2%
35,445
1999
97%
3%
37,318
2000
98%
2%
32,633
Averge and
total
97.2%
2.6%
165,480
Markets, in our industry research paper "Riders on
the Storm: Short Selling in Contrary Winds". [2]
If
you're thinking, "Yeah, but surely this all
changed after the crash of 2000 (to 2002)," that'd
be understandable. From 2000 to 2002, the
S&P500 lost 50%, the Nasdaq lost more than
75%, and the Dow lost about 35%. Still, these two
charts (below), produced last September in Alan
Newman's Stock Market Crosscurrents, show that
while insiders sold 6.7 million shares and bought
7,520 shares (a ratio of 929:1),
analysts' sell recommendations came in at only
4%. [3]
So
why would analysts issue so many buy-and-hold
recommendations and so few sell recommendations
while industry insiders flee their
own companies' stocks?
Two words ...
Investment
banking
In May 1975, Wall Street said goodbye to fixed commission rates, regulated by
the New York Stock Exchange, and said hello to the competition. And of course,
this had an unintended effect. While investors won the battle to transact at
lower costs, they lost the war on solid research.
Dr Stephen Koffler reveals the pre-1975 environment he worked in as an analyst
covering the aerospace industry:
We put out two-inch-thick binders on
different industries, which we would work months and months to produce. People
who bought our reports paid us, so to speak, by trading through us. There was
enough profit in that to support an entire research firm.
[4]
Consider this. In 1967, retail commissions accounted for 57% of Merrill Lynch's
total revenues. Investment-banking fees were less than a tenth of that amount.
[5] While the total amount paid in commissions grew with increased retail
participation in the markets, the total percentage declined drastically. A 1997
study by the Securities Industry Association (SIA) revealed that in the 1960s,
when the commissions were fixed, they amounted to about 60% of the industry's
revenues. By 1997, commissions comprised only 16% of revenues. [6]
But Wall Street wasn't about to lose out on the deal. Though Wall Street
widened the spread (between the bid and the ask) and pocketed it to make up for
lost commission revenue, [7] it also found its way into the lucrative world of
investment banking.
As commission revenues have relatively dropped,
brokerage underwriting of stock and bond issues (and attendant revenues) hasn't
just shot through the roof; it's rocketed through the solar system and into
deep space. In the 1960s, the brokerage industry underwrote a little more than
[US]$100 billion of stocks and bonds. In the 1990s, the brokerage industry
underwrote $700 billion to $2.23 trillion annually, according to [SIA director
of research Jeffrey] Schaefer's record-keeping. In the boom year of 1999,
brokerages underwrote $2,238 billion ($2.23 trillion) worth of corporate bonds
and stocks - more than 22 times the dollar volume of underwriting that occurred
in the whole of 1960s combined.
Another comparison: In 1974, the year before May Day, Wall Street raised only
$42 billion for American businesses. That's less than 2% of the 1999 level. In
other words, for big brokerages, revenues from investment banking have grown
roughly 50-fold since 1974, while retail commissions have drooped to the
ankles.
The underwriting boom translates into industry profit, as brokerages collect
underwriting fees of between 7% and 9% of the underwriting dollar volume.
Moreover, brokerages obtain an allotment of stock and warrants in the
underwritten company and can "make a market" in the stock, earning trading
commissions or even capital gains if they can sell their inventory at a profit
[more easily done when the resident analyst keeps a "buy" signal on]. [8]
Brokerages also made a great deal of money in mergers and acquisitions. As
such, this area of Wall Street has also seen stellar growth.
There were
2,297 reported corporate-merger deals nationwide, worth a cumulative $11.8
billion, in 1975, the year of deregulation [of commissions] May Day, according
to Mergerstat. By 1985, 3,001 domestic merger deals took place, worth $179.8
billions. By 1995, there were 3,510 deals, worth $356 billion. In 1999, there
were 9,278 deals, worth $1,428.1 billion (or nearly $1.4 trillion). [9]
Total mergers and acquisition activity hit $3.3 trillion in 2000. While there
was s slowdown over the 2000-02 decline, 2005, the best year since 2000, came
in at $2.3 trillion. In the first six months of 2006, M&A (mergers and
acquisitions) activity has hit $1,930 trillion. If this rate continues, 2006
will exceed 2000 and produce the highest level of M&A activity in history.
[10]
So what happened to the few analysts who dared defy the institutional banking
interests by issuing negative reports? I could list dozens of examples from any
number of books, but for the sake of time, we'll just look at one.
Howard Schilit of the Center for Financial Research and Analysis is an
independent analyst who is retained by about 250 institutional clients who pay
well for his research. In 1997, he issued a report on HBO & Co, a designer
of software for the health-care industry. The industry was doing poorly, but
HBO & Co was "growing", largely as a result of its acquisitions as a way to
boost their performance numbers.
Schilit's report noted that HBO's receivables were continuing to get older,
meaning customers were taking longer to pay. Even though older receivables are
less likely to be paid in full or paid at all, HBO was reducing its reserves
set aside for bad debts, and was counting "unbilled receivables" (money HBO had
yet to bill customers for, but which it believed it was owed) as income, and
was experiencing declining cash flow.
Word of Schilit's report leaked
out on April 15, and HBO stock took a 25% haircut. The mainstream Wall Street
analysts who followed HBO didn't just ignore what Schilit had to say. To the
contrary, they attacked him - viciously. No fewer than six analysts lambasted
his report publicly, three of them actually issuing written rebuttals that
impugned Schilit and his ethics. HBO officials derided him as a short. In fact,
Schilit and troops abstain from speculating in stocks they cover.
In fact, Schilit's report was not erroneous, nor did it contain any factual
errors. It was only a careful review of financial numbers that HBO filed with
the SEC [Securities and Exchange Commission]. [11]
In January
1999, HBO was bought by McKesson, becoming McKesson-HBO.
In April of
1999, McKesson was forced to report that more than $44 million in previously
recorded revenues didn't exist. The problem was - you guessed it - bogus
revenues reported by HBO.
But after that, a lot of people started to look ill at McKesson-HBO. With more
and more revenues of the former HBO beginning to look suspect, heads rolled,
and four major accounting firms were brought in to try to clean up the mess.
Talk was of restating profits going back two years, and earnings forecasts
going forward were reduced.
McKesson-HBO stock, which had peaked at $90 a share in 1998, then traded around
$65 before irregularities were publicly announced, fell to $33. McKesson- HBO
never really recovered from the financial accounting fiasco, and into the fall
of 2000 the company's stock traded in the $25-a-share range. [12]
I can think of no better way to close this than with Cole's own words.
A
question about the McKesson-HBO situation begs to be asked: How come only
Schilit called it? Schilit may be a smart forensic accountant, but he is only
human. There are plenty of brokerage analysts loaded with business and
accounting degrees just as impressive as his, plenty of other analysts with
brains to burn. So why does it so often seem as if Schilit's firm is the only
one that can ferret out financial shenanigans? What about all those highly paid
analysts at the major Wall Street brokerage houses? [13]
While
I'd like to believe that the industry and the regulators could do something to
change this situation to benefit the investors, market history tells me it's
far more likely that the pain brought about by a bear market will produce the
needed effect.
I'd like to thank Stan Brillo, mentioned in the chapter on short selling, for
suggesting that I read this insightful and entertaining book.
Notes
[1] The Pied Pipers of Wall Street: How Analysts Sell You Down the River
(2001), Benjamin Mark Cole, p 97.
[2] The Journal of Psychology and Financial Markets (2002, Vol 3, No 4), pp
198-201.
[2] Samex Capital's Stock Market Crosscurrents (September 26, 2005) Alan M
Newman, pp 1 and 2.
[4] The Pied Pipers of Wall Street (2001), Cole, p 61.
[5] Ibid, p 50.
[6] Ibid, p 57.
[7] Ibid, p 55.
[8] Ibid, pp 57 and 58.
[9] Ibid, pp 59 and 60.
[10]
Mergers and acquisitions.
[11] The Pied Pipers of Wall Street (2001), Cole, p 183.
[12] Ibid, p 185.
[13] Ibid.
Doug Wakefield is the president of Best Minds Inc, a registered
investment adviser. He can be reached at doug@bestmindsinc.com.
analysts' sell recommendations came in at only
4%. [3]
own companies' stocks?
Two words ...
