FSO editorials

Sell-Side Research

by Richard A. Eckert, CFA| July 31, 2009

In response to the rally in the equity markets over the last three weeks—the DJIA and S&P 500 are both up 12% in that span—apparently the result of an enthusiastic reaction to corporate earnings, which were not quite as bad as expected, I thought a look at how those expectations are developed would be timely. Granted, I haven’t made a comprehensive survey of institutional and individual investors—impractical, if not impossible—but, after 9 years of sell-side research, I get the impression that the foundation of those expectations are company guidance and sell-side estimates. Even if many investors view the latter with a jaundiced eye, they know that sell-side analysts are talking to managements—and, other than access to deal flow, access to management is the only reason the buy-side pays the sell-side—and confidently assume, for some reason that eludes me, that their estimates reflect management’s most current outlook.

I have never understood this confidence. Even before Reg FD, when company executives regularly made selective disclosures to analysts, I always operated on the premise that management lies or doesn’t know. Or both. They were lying about what they couldn’t have known. And nowhere was this truer than in the small- and microcap universe. Unless it was right on the eve of an earnings report, when such disclosures could help the analyst either turbocharge the market’s excitement in the event of an upside “surprise” or temper its disappointment in the event of a miss, I viewed anything company managers shared with me with a healthy dose of skepticism. Hey, speaking of selective disclosures, which are now unlawful, on the eve of an earnings report, has any one looked into Meredith Whitney’s upgrade of Goldman Sachs the day before that company released second quarter results? How timely! Especially since she had been so negative on the big banks and broker/dealers prior to the upgrade.

I believe the 2nd quarter’s earnings reports validate my skepticism. Corporate executives guided to numbers they knew they could handily surpass. And my understanding is that companies were unusually militant about enforcing compliance with their guidance. If an analyst published estimates that differed materially from that guidance, they would find their phone calls and e-mails unanswered. They would lose their access to management. Or they would find themselves second-guessed or belittled by other analysts, presumably with the encouragement of management. There was no independent thought, research or rigor applied to the development of earnings estimates upon which market expectations are formed. So much for rational expectations.

The only thing more irrational that the market’s expectations—based solely as they were on corporate spin—was its reaction to the news that operating results at many companies exceeded those expectations when the bar was deliberately set so low. Operating results may have exceeded expectations, but they weren’t necessarily good. Year-over-year comparisons were still negative, particularly on the top line. A former colleague sent me this representative sample of sales declines at major corporations:

GE – down 17%
CAT – down 41%
DuPont – down 22%
Coca Cola – down 9%
ADM – down 13%
Yahoo – down 13%
Apple – up 12%
Boeing – up 1%
Pfizer – down 9%
Ford – down 40%
McDonald – down 7%
UPS – down 16%
ATT – down 1%
MSFT – down 17%
Amex – down 18%

Furthermore, those companies that did report positive year-over-year earnings did so on the basis of cost cuts. Revenues were still off, sometimes well off, from the same period last year. Obviously, I haven’t looked at every single earnings report, but the only stock that seems to have been punished for reporting positive y-o-y results on declining revenue was Colgate-Palmolive (NYSE:CL-$71.83). Not only did sales decline 1.5%, but they did so even after the company raised prices 7.5% across the board. This is not an indicator of a healthy franchise. Not only does the decline in revenue suggest that price increases actually drove down unit volume, but there is a limit to which a company can cut costs.

I’m anxiously awaiting third quarter operating results and the market’s response to them. What do publicly traded companies do for an encore? If revenues are still falling and they have cut costs as far as they can without shrinking their franchises, how will corporations report positive comparisons with 2008’s third quarter—or even the one that just ended? What will make it all the more interesting is that expectations are considerably higher than they were going into 2nd quarter reporting season. I guess we’ll know for certain we’re in for disappointment if Meredith Whitney publishes a report lowering her estimates and ratings of the big banks and broker/dealers the day before the first of them reports.

Another former colleague asked “If all that sell-side analysts do is relay company sentiments and corporate propaganda, why does anybody still rely on them?” My reply was “They don’t”. There may be a misguided faith in analysts’ estimates, which is really a misguided faith in company guidance, because that is widely believed to be the source of analyst estimates. But no one relies on their analyses and investment opinion. Once more, the only reason most institutional investors still patronize the sell-side is for access to company management and deal flow.
Sell-side research has entered a negative feedback loop and the trends have become self-reinforcing. The whole sell-side sales/trading/research model was breaking down. Each year more and more of the institutional brokerage business gravitated (cascaded?) toward the electronic venues. Both the volume of transactions and the commission per trade continued their inexorable march south. Analysts and salesmen were working harder for less money.

Paradoxically, despite the drop in overall analyst compensation, many sell-side firms—especially the smaller shops—feel that they are spending too much on research. The only reason a sell-side shop hires an analyst is to support the investment banking effort, but, after NASD’s 2711 and the NYSE equivalent (I wonder whether they’ve changed the nomenclature now that the two have merged into FINRA), that shop can’t pay the analyst from investment banking. So the analyst becomes a fixed cost, an overhead item, with the only means of defraying that cost being the decaying business of institutional brokerage (see paragraph above). The dwindling stream of commission dollars available to subsidize company-wide overhead in general only ratifies the belief among sell-side firm managers that they are investing way too much in research.

As a result, many have cut back sharply on their investment in research. And it shows. I don’t think it is unfair to conclude the quality of sell-side research deteriorated visibly. Which, in turn, has created a self-feeding cycle of decline? It only reinforced the trend toward greater usage of the ECNs. Why pay a sell side firm 4 – 5 cents a share to cover both execution and research you can no longer use when you can execute on Instinet or POSIT for 1 - 2 cents a share and do your own research? The resulting decline in institutional brokerage commissions meant that there was even less money with which to subsidize the cost of research, promoting sell-side executives to further trim their investment. Which, in turn, resulted a lower caliber of analyst and further declines in research quality? Which caused institutional investors to send more and more of their trades to the electronic platforms and negotiate ever lower commissions on the transactions they did complete with a live broker. And so on and so on.

The eroding viability of the sales/trading/research model has created another conundrum. Well, not so much a conundrum, but a total misalignment of interests. From the perspective of the firm, the apparent demise of sales/trading research means that it is even more important than ever that the analyst identify, court, land, and sponsor investment banking clients. However, the firm can’t pay the analyst for these efforts. So, from the perspective of the analyst, the only upside to his/her base pay (which has come to reflect the reality that research is just a cost center) is a slice of the declining institutional trading commissions. But the only way to realize that upside potential is to make trading calls—which is eventually going to piss someone off. The bankers, the covered companies, institutional clients on the other side of the trade.

And do you think the firm is going to support the analyst for doing what is right, making the right call? Are you kidding? In the firm’s eyes, the analyst is jeopardizing a lucrative investment banking relationship for a small cut of a 3.5 cent-a-share trade. Recall that the only reason most sell-side shops hire an analyst is to provide sponsorship to their investment banking clients. So sell-side shops, especially the regional shops and the boutiques, can neither afford to pay their analysts nor allow them to demonstrate any integrity. It’s a lose-lose proposition for the analyst. Is it any wonder all the real talent on the sell-side has migrated to the buy-side or more entrepreneurial pursuits? The sell-side has become the definition of “adverse selection”. Anyone who is capable of upward mobility, of improving their standard of living and, at the same time, maintaining their integrity moves on. Those that remain are content to work harder for less pay and able to live with being intellectually dishonest. Or else they’re just plain dumb.

The Cost of Fear

This next theme—are we paying too much to insure against our worst fears—was developed after talking to a former client about the stock of a student lender he owned. This client wondered aloud whether the very availability of credit to finance higher education was one of the major factors in driving college tuitions and fees through the stratosphere. There seems to be this vast tacit conspiracy among government officials, lenders, institutions of higher learning and those who work at such institutions to drive up the costs of a college education to the student and the taxpayer. The conspirators benefit from additional political capital, larger profits (higher coupons on private student loans on higher loan balances when the costs of an education, particularly at private colleges and universities, quickly exhaust the government-subsidized loans an individual or his/her family is eligible for) and simply obscene salaries for college administrators and educators. Furthermore, I am beginning to question the value of a college education. I think it has simply been oversold. And it is oversold with fear: “you can’t ever aspire to a middle class standard of living if you don’t have a college degree”. I am extremely skeptical of all the statistics used to instill this fear—even if I did use them myself when covering a student lender on the sell-side. Hey, maybe I should enthis section “Confessions of a Reformed Sell-side Analyst.”

So, yes, we did conclude the availability of all this loan money—just like in every other category of consumer spending, certainly homes in the first half of this decade—has vastly inflated the cost of a college education. Gary Schilling, ex-chief economist at Merrill Lynch, observed in one of his monthly newsletters that borrowing—buy now, pay later—seems to de-sensitizes us to the true cost of things. This observation is supported by the report that the average ticket rose 20-25% (something like that) at fast food chains when they started accepting credit cards. As well as my own personal observations. When occasionally eating out or visiting the local purveyors of cold, refreshing adult beverages, I see all these young adults spend all kinds of money because they could put it on a card—in fact, just about everybody pays with a card. I can’t help but think of how much less they would spend if they had to pay with their hard-earned cash. And, if they did pay in cash, how much more often they would question the cost of what they were buying or, at least, try to negotiate a lower price. God, think of how much money people might save if they might become consumers again, instead of borrowers.

But, back to the “cost of fear”. Think of what it costs us as taxpayers and consumers and homeowners and patients when we succumb to fear. In the context of a college education, what would happen if more and more kids stopped buying fear and learned a trade? According to one of my former accounts in Seattle who manages money for the trades council there, generously paid apprenticeships go begging—even now. Shipbuilders and other defense contractors can’t find nearly enough skilled machinists, despite the offer of extensive training (with good pay) and relocation assistance, defined benefit retirement plans and indemnity health care. These jobs enable middle class standards of living and the skills learned last one a lifetime. What if more people discovered once they left an apprenticeship program for which they were paid—instead of paying for—with a starting salary in the high double digits and a host of traditional benefits. Contrast their standard of living with a college grad saddled with $10s, if not $100s, of thousands of debt who can only find a job peddling insurance or as an accounting clerk for a small manufacturer. Then, as college enrollments declined and institutions of higher learning had to compete with the trades councils for high school grads, you can bet tuitions would fall—as would the compensation of those working at these institutions.

This is also a good example of where the free market breaks down. I, too, am a free market guy, but the free markets only work when there is a level playing field and every participant in any given market is fully informed. In the case of a college education, how many students and their families are fully informed when making decisions that may influence a lifetime of earnings and future standards of living. How many guidance counselors provide information about the trades? Careers in the military? Jobs for which high school grads may qualify right after they graduate? What about going into business for oneself? Do college-bound high school grads know all of their options?

I can extend these examples to health care (“you need this procedure or drug or you may become seriously ill or die”) and dentistry (“you need this expensive crown or implant or all your teeth will fall out”). I remember watching an expose on the latter on the evening news in L.A. several years ago. An official at the UCLA School of Dentistry did an informal study by traveling around the country with a small cavity and visiting two or three dentists at every stop. The recommendations varied from “take aspirin if it bothers you and see your own dentist when you get home” to “root canal surgeries”.

Dental insurance is a rip-off. The only thing it fully covers is regular examinations and cleanings. It seem like just about every other procedure has a huge co-pay or is not covered. Most people—or their employers are paying about $500-$600 a year in premiums to cover the two cleanings most dentists recommend every twelve months. If they just paid for those cleaning themselves and saved the rest of the money they now spend in premiums every year, then, over time, they could easily cover the cost of an occasional filling or crown—and still come out ahead. If more people started dropping coverage—and stopped subscribing to the fear peddled by the insurers—they will have to lower their rates or increase their coverage.

Same thing with medical insurance. Once more, people have to look at what they’re paying and what they’re getting. Many of us—and our employers—are paying $1,000s a year in health insurance premiums to cover a few $100s in office visits. Insurance companies peddle fear—“What happens if you get really sick?” The answer should be get a high-deductible or
catastrophic illness policy (many property and casualty as well as life insurers sell these), which cover everything after the deductible is met and just pay for the routine expenses out-of-pocket. And the out-of-pocket expenses can be funded by pre-tax contributions to eligible health savings accounts (HSAs). Once more, if enough people did that, health insurers would have to lower rates or increase coverage to remain competitive with the alternatives. As a side benefit, if one is paying for office visits and simple procedures him-/herself, one is going to shop around for doctors in an effort to find those that provide the highest level of care at the most reasonable cost and they will question recommendations more often, asking about lower-cost alternatives—or even those that may not necessarily cost less, but provide a better outcome. Again, we have to turn patients into consumers.

The list goes on and on. Auto mechanics. Public employee unions, especially public safety employees, and teachers. Treasury secretaries and Federal Reserve Bank chairmen. Presidents and federal lawmakers. The military. We are paying more and more for their increasingly expensive services, yet the outcomes yielded by the additional expenditures are marginally better, if at all, than the alternative of doing nothing. $700 billion and eight months later, banks are making fewer loans than they did in October 2008. “Three strikes and you’re out” (sponsored by the CCOA, the California Correctional Officers Association, the largest contributor to CA statewide elections) has not made our streets safer. It has only boosted the costs of our correctional system exponentially and turned petty thieves and drug addicts into professional criminals by locking them up with hardened gang members. And, as a last example, $900 billion and 6 years later, the incursions into Iraq and Afghanistan have not made the U.S. any more secure. I would argue it has made us less secure as it has pissed off many people around the world, making it easier for Al Quaeda and the Taliban to recruit and it has distracted us from even greater threats that lie within our borders. Or just outside them. The intelligence community now ranks the disintegration of order in Mexico and the growing power of the drug cartels there as a more serious risk to American security than any that may reside in Iraq, Iran, or Afghanistan?

All of these programs and expeditions were sold to the American taxpayer and citizen with fear. Yet they have cost us more than estimated and only heightened the risks they were supposed to mitigate or neutralize. Whenever somebody tries to peddle you something using fear, run, don’t walk to the nearest exit. Or “just say no”. The bottom line once again—and I hate sounding like a theme drunk—is that we all must become active consumers (or is that “activist” consumers?), not just passive price-takers, in almost every facet of our lives. We must carefully weigh what we are paying with what we are getting and, even if it is subjective and personal, come to some kind of determination of whether the former is commensurate with the latter.

Contact Information

Richard A. Eckert, CFA (415) 674-4996 | San Francisco, CA | Email