Analyze This
Financial analysts have the same problem as Arthur Andersen.

Mr. Bartlett is senior fellow at the National Center for Policy Analysis
March 6, 2002, 8:00 a.m.

This is only the latest blow to the credibility of analysts. In recent years, there have been many complaints that they hyped dot-com stocks in order to win underwriting business for the investment banks that most of them work for. Theoretically, there is a "chinese wall" between them and bankers to prevent collusion. But there are documented cases where analysts have slanted their recommendations about stocks in order to win banking business or have been pressured to do so.

For example, in 1999 Business Week reported that an analyst named Ashok Kumar wrote glowing reports about a PC maker called eMachines. He later solicited underwriting business for his employer from eMachines. When eMachines went elsewhere with an initial public offering of stock, Mr. Kumar abruptly turned against it and issued scathing reports highly critical of its prospects.

This is an extreme case, but many analysts report that they have been lobbied within their firms to go easy on its clients, or to pump-up ratings on companies whose business was being solicited. Moreover, there are cases where companies have in fact withdrawn business from banks whose analysts issued unfavorable reports. And it is not at all uncommon for companies to demand that analysts be fired for issuing "sell" recommendations for their stock.

Although analysts are seldom actually fired for making politically incorrect recommendations, they have long known that they can pay a price. Companies that they follow may cut them off and make it as hard as possible for analysts to get information about them. Their employers may give larger bonuses to analysts whose recommendations bring in underwriting business and demote those who anger potential clients.

For these reasons, there has been a trend for some time to virtually eliminate "sell" recommendations. In effect, a kind of grade inflation has taken place where a recommendation to "hold" a stock is tantamount to saying sell. When an analyst actually wants to say "hold" he now says "buy." And when he really wants someone to buy the stock he now says it is a "strong buy."

This has created a bias within financial markets that helped hide Enron's problems from investors. It seems there is never a point at which an analyst can say, "Get rid of this stock. It's going to implode!" As a consequence, investors are often left thinking there is little difference between a stock that simply will trail the Standard & Poor's 500 index and one in danger of imminent collapse.

Related to this problem is the decline of "short" selling as an investment tool. Investors who sell short are betting that a stock's price will fall. They borrow stock from someone and sell it without actually owning it. Later, if the stock price falls, they then buy the stock and return it to the original owner,
thereby "covering" their short. Thus they buy-low and sell-high in reverse.

For many people, the idea of selling something you don't actually own is vaguely immoral. Also, there is the fact that profits are capped when selling short — prices can theoretically rise to infinity on the high side, but can only fall to zero on the down side. Moreover, for many relatively small companies, it is not easy to borrow stock in order to sell short. And, of course, no one earns dividends on a stock sold short; indeed, any dividends that accrue must be paid out of the short-seller's pocket.

The decline of short-selling plus the demise of "sell" recommendations means that bad news about companies like Enron tends to be absorbed by the market all at once, rather than being assimilated over time. The stock price ends up in the same place eventually — because it is ultimately a function of real values and profits — but instead of falling gradually, as short-sellers and analysts beat it down, it falls precipitously once the truth becomes widely known.

Arthur Andersen and other accounting companies have rightly been criticized for having conflicting interests when they both do a company's books and have large consulting contracts with it as well. They may be reluctant to criticize its accounting practices for fear of losing lucrative consulting business. Financial analysts have the same problem when their employers solicit underwriting business. The solution is the same in each case: total separation of functions.

In the future, companies should pay totally different entities for accounting and consultation, and investors should pay completely separate ones for analysis and financial services. There is no other option.