Experts Are Pressured to Conform to Prevailing Ideology
“Asell signal from an analyst is as common as a Barbra Streisand concert.” Arthur Levitt, Chairman of the Securities & Exchange Commission It is not just the company, clients, and brokers who exert psychological pressure on analysts to maintain a positive attitude on the popular stocks they follow, although that would be more than enough. There is also pressure from other analysts to conform to the bullish point of view. If you are a mainstream Wall Street analyst and you have decided to turn bearish on a stock or an industry that is being recommended by virtually all of your analytical colleagues, you had better have your facts straight and be prepared for some criticism, veiled and otherwise. Curiously, the inverse is not true: It is perfectly acceptable for an analyst to turn bullish on an industry when everyone else is bearish; trying to be the first to catch the bottom, apparently, is within the rules of the analytical game.
But if an analyst tries to catch the top by turning negative on an industry or an individual stock everyone else loves, watch out! On November 22, 1999, The Wall Street Journalran a story entitled “Bearish Call on Banks Lands Analyst in Doghouse.” The story described the travails of Michael Mayo of Credit Suisse First Boston, and the doghouse to which Mr. Mayo was exiled was owned and operated by other Wall Street banking analysts who saw only blue skies ahead for the bank stocks. When Mr. Mayo peered into the distance and announced that he saw some storm clouds brewing for the banking industry he was treated like the Wall Street equivalent of a stinky wet dog trying to shake itself dry.
The head trader at Sun Trust Funds, said The Wall Street Journal, “angrily grabbed a picture of Mr. Mayo, blew up the photo on the copier, scribbled ‘Wanted’ over his face, and pinned it to her bulletin board.” When questioned about this response by The Wall Street Journal, the trader replied that “my impression [of Mr. Mayo] as a human being is that he’s somewhat self-promotional,” as though this were a rare trait among analysts on Wall Street.
Another bank analyst, angered by the sell signal, referred to Mayo derisively as “Mayo-naise” in a conference call with clients, according to The Wall Street Journal. Other analysts also questioned Mayo’s motives, both publicly and in private. Some of them whispered that Mayo was in cahoots with short sellers who were in a position to profit if bank stocks declined in price. Others said that he was gunning for publicity in an attempt to earn a high ranking in an upcoming analyst survey by Institutional Investor Magazine.
Even after Michael Mayo’s negative call on bank stocks turned out to be accurate, the critics refused to let up on him. Afew months after his cautionary report on the group, Bank One, a Wall Street darling, collapsed in price following the surprising news that problems at its credit card unit, First USA, would lead to lower than expected earnings. Mayo had put a “sell” on Bank One (ONE) at $59.81 a share; the stock ultimately fell as low as $23.19 following the disappointing earnings, a 61 percent decline.
But even that did not keep the critics quiet. Instead of giving Mayo his due for his gutsy and accurate call, the bank bulls decided that nitpicking was now called for.
Mayo’s general negative attitude toward the bank stocks stemmed from his belief that the earnings growth being reported by many banks was of “low quality”; in other words, the accountants were becoming increasingly creative in their ongoing effort to give Wall Street the earnings momentum it craved and expected. Anyone who understands financial accounting knows there are about 50 different and perfectly acceptable ways to look at almost everything and that your earnings may be up 5 percent, up 10 percent, or even down 10 percent, depending on which way the accountants decide they are going to paint the picture this particular quarter.
Eventually, though, the accountants’ bag of tricks gets depleted, and if a company is not growing all that rapidly—or worse, if creative accounting has directed analytical attention away from a festering problem—the piper must be paid.
This is not an uncommon occurrence with popular stocks that are under tremendous pressure to meet Wall Street expectations, and the general observation that a particular company or an industry, in general, has begun to resort to accounting gimmicks to meet Wall Street expectations—i.e., that reported earnings are of “low quality,” as Mayo stated—is a valid and sufficient reason to turn negative. If you smell something rotten, you don’t have to rummage through the garbage to figure out what it is—you can just walk away from it. When Bank One revealed that problems had been brewing in its credit card operations and that its earnings would be way below expectations, that should have been enough to shut Mayo’s critics up. But it wasn’t.
“Critics say,” The Wall Street Journal reported with a straight face, “that Mr. Mayo had not pinpointed the credit card problem.” When another bank stock cited by Mayo as having “poor earnings quality”—National City Corp.—warned that earnings would be lower than expected, that stock took a nosedive as well. But, The Wall Street Journalpointed out, “Mr. Mayo didn’t specifically have a ‘sell’ recommendation on that stock.”
The overall tone of The Wall Street Journalstory on Michael Mayo was that he was sort of a self-promotional kind of guy who sort of lucked out by issuing a generally negative call on the bank stocks and turned out to be right for the wrong reasons, and that he was not all that popular among colleagues and clients.
You can see that the bar is raised considerably higher when you are bearish than when you are a conforming bull. The Wall Street Journalcould have run a story about the 99 percent of analysts who were incorrectly bullish on Bank One, for example, and interviewed theirclients, to see how they enjoyed riding that stock down by 61 percent. But it didn’t. Instead, The Wall Street Journaldissected Mayo’s bearish (and correct) call with a fine-tooth comb, and created the impression that while he turned out to be right, he wasn’t really all that right and that he was a publicity hound to boot.
Michael Mayo’s reward for being bearish on the regional banks was to be fired. On September 29, 2000, he announced that Credit Suisse First Boston had terminated his employment. “It’s hard to do investment banking for a client with an analyst who is negative on that client,” a source told Reuters.
It doesn’t work the other way around, by the way. If you’re a cheerleader for a stock and it goes up, nobody complains that it didn’t go up for the reasons you said it would. You’re just a brilliant analyst who made the right call. But if you’re a bear on the bank stocks because you think that earnings quality is deteriorating and that some banks have been stretching to make their earnings forecasts and that this cannot go on indefinitely—if you say all that and you turn out to be right—that is still not enough. You have to pinpoint exactly what the problem was or your correctly bearish call can be dissected, analyzed, and ultimately criticized anyway.
The whole thing would be funny if it were not so important to you, as an investor, and these cautionary tales involving Mr. Mayo and Sunbeam analyst Andrew Shore are meant to illustrate a truth: If you really want original, independent research and you think you are going to get it from Wall Street, you may be in for a big disappointment. Back in the 1980s a group of penny stock brokers had just completed a public offering for a company that was trying to develop a cure for cancer derived from shark fluids. I ran into the brokers at a restaurant one evening and they were so enthusiastic about this company’s prospects they could barely contain themselves. The stock had run up from $0.10 a share to $1.30, and there were plans for a secondary offering to finance further research into new drugs once the company had proven it could use shark fluids to cure cancer. Everything was going swimmingly until the scientist who ran the company called the president of the brokerage firm with the bad news that the process doesn’t work.
“What are you talking about?” the brokerage firm president said.
“We cannot cure cancer with shark fluids,” the scientist said.
“Yes, you can,” said the brokerage firm president.
“No, we can’t,” said the scientist. “The process doesn’t work.”
“Yes, it does,” said the brokerage firm president.
The scientist was taken aback at this response. “I wish it did work,” he said again. “But it doesn’t.”
“Hold on,” said the brokerage firm president.
When the brokerage firm president returned to the line, the scientist found himself in the midst of a conference call with every broker in the office. For the next half hour the brokers browbeat the scientist into submission, trying to convince him that he could, indeed, cure cancer through the use of shark fluids. The scientist tried his best to hold his ground. “It doesn’t work!” he said pleadingly.
“It has to work!” screamed one broker. “Your stock is at $1.30, all of my clients own it, and we’re almost ready to do your secondary offering!”
And so, at the urging of his “constituency,” the scientist agreed to go back to the drawing board to try to find a cure for cancer using shark fluids, trying to fulfill the fervent hope of a group of penny stock brokers that such a cure could be found so that these brokers could do a secondary stock offering. Yet, the scientist knew full well, as he continued his research, that the process didn’t work.
The scientist admitted, long after the fact, that listening to those guys nearly convinced him that he had missed something. I was reminded of this story on December 1, 2000, when The New York Timesreported that certain analysts were “skeptical” of computer maker Gateway’s shocking announcement that it was lowering its revenues and earnings forecasts for the quarter because its sales had unexpectedly plunged 30 percent over the weekend following Thanksgiving. Like the shark fluid brokers, these analysts just could not accept the bad news that Gateway delivered. Instead of accepting the news and revising their forecasts, some analysts tried to convince themselves (and Gateway) that the sales slump didn’t mean what Gateway said it meant, which was that business was turning rotten. Loaded with Gateway shares in client accounts and stuck like SuperGlue to their overly bullish forecasts, these analysts accused Gateway management of “overreacting,” which only goes to show you that whether we’re talking about shark fluids and penny stock brokers or computers and big-time Wall Street analysts, there are few things so constant as human nature. As songwriter Paul Simon reminded us in The Boxer, “a man sees what he wants to see and disregards the rest.” That is a fundamental truth of Wall Street that every investor should keep firmly in mind.
So, one thing to keep in mind when you’re listening to the opinion of an expert: Who is the expert’s constituency? Or, to put it more bluntly, who pays the expert’s salary? If it isn’t you—and it usually will not be you—consider the possible agenda of the expert and/or constituency and view the expert’s point of view in that light. Even experts who are honestly taking their best shot and are not influenced at all by an agenda or a constituency can get things all wrong.