One of what I call my industry’s “dirty little secrets” is how analysts are paid. They are not fiduciaries and therefore do not have to make recommendations in the best interests of clients. When I worked for the regional and big brokerage houses, analysts got their income from their salary and their bonus. The bonus was based on three sources:
- Performance of their recommendations
- Trading commissions in the stocks they covered
- New business from IPOs, mergers, and acquisitions
During the late 1990s, as two or three IPO dotcoms seemed to come public every day, the bonuses paid for lead generation were a big part of most analysts’ incomes. Charles Schwab ran that famous commercial showing a manager motivating his brokers by saying,
We’ve got a lot of stock to move today, people. Tell your customers this one’s hot… Just don’t mention the fundamentals, they stink. Now let’s put some lipstick on this pig.
That commercial ran just weeks after regulators disclosed unethical emails from Merrill Lynch’s top internet analyst, Henry Blodget. Blodget had been privately telling certain clients and Merrill Lynch associates not to buy the stocks his Merrill Lynch group was publicly touting to retail clients. But analyst bonuses were, what I consider, huge during those days, and much of it came from bringing all those pigs out as IPOs.
The New York Attorney General sued Wall Street firms for such abuses. They were forced to put internal policies into place in the early 2000s with the stated goal to stop analysts from inaccurately characterizing stocks to their clients. While the purpose of the new rules was to stop compensating analysts with investment banking revenues, in order to implement that, compensation goes through a committee that cannot include anyone from investment banking. To me, this does not guarantee that there will be no compensation for investment banking referrals from analysts. It only ensures that the committee will not include investment bankers. This rule was instated two decades ago, and in theory it should have stopped analysts from “[putting] lipstick on [a] pig”.
But have these rules been successful? I am not sure.
Analysts are rated by different agencies based on their stocks’ performance, which is itself a dirty little secret. Performance, in my opinion, is very often presented with a bias toward increasing the analyst’s bonus, even when, in reality, client returns suffer. Here is an example of misstated performance from my personal experience.
In the early 1990s, there was a biotech company called Procyte, which had developed a topical gel intended to reduce or eliminate plantar ulcers. The gel, Iamin-2 hydrating gel, was copper-based and had passed both its Phase I and Phase II clinical trials. Coming out of Phase II, the gel showed a 67% success rate at closing the plantar ulcers it treated while the placebo closed only 13%. Mysteriously, the treated group also had only 6% of infections, compared to 32% for the placebo group. The gel should have had no impact on infections.
Procyte presented their results at a biotech conference which happened to be attended by my daughter (who works in the field of biotechnology). She attended the session where Procyte presented their results. Management claimed that they had performed a double-blind study, meaning neither the doctors nor the patients knew who was receiving the gel and who was receiving a placebo. My daughtered asked, “Since copper gives the gel a bluish color, how did Procyte mimic the color in the placebo?”
The answer was the placebo gel did not have a bluish tint – it was clear. What that meant was that both the doctor and the patient knew whether they were getting the Iamin Gel or the placebo. The trial was anything but blind.
At that time, I was a financial advisor with Dain Bosworth (now RBC). Since 1986, I had spent considerable time educating myself about biotechnology, and I had attended several conferences where the biotech companies presented their findings. I had gotten to know some of the analysts.
Dain had an in-house analyst who covered Procyte, and she was recommending “BUY” on the stock. Based on her recommendation, several hundred brokers at Dain purchased the stock for their clients. With my daughter’s insights from the biotech conference, I shorted the stock for a number of my clients.
Some weeks later, as Procyte was getting ready to present their Phase III clinical trial results, five analysts dedicated to following the company hopped on a conference call to review the data from the first two trials, and I was invited to listen. There were multiple brokerage companies represented among them. They reached a consensus that Procyte was a “table-pounding buy” and was headed much higher. After all, Procyte had issued $55 million of new stock based on these analysts’ previous buy recommendations. Many of my peers at Dain and those firms the other analysts represented had loaded up their clients with the stock.
I did not share my information, just listened to each of them validate one another. In fact, I had begun to question my own thought processes. I had shorted the stock around $10 per share, and that day the stock was trading at $12. If the results were in line with the analysts’ predictions, the stock would probably zoom upward to the mid-twenties or even higher. That was a big risk. The call took place on a Friday afternoon, and I spent six hours on Saturday going through all the data I had.
Prior to the market open on Monday, Procyte announced Iamin Gel failed the Phase III trial. The stock opened at $2.75, down almost 80%.
The analysts had been wrong. I expected that those analysts who had touted the stock as a “table-pounding buy” should have seen their bonuses reduced and a negative mark for their performance. It was not to be.
The Dain analyst (and I would guess all the others) saw the report of failure prior to the open of the market. The Dain analyst issued a “SELL” recommendation just before the market opened. Since the last close was the $12 price on Friday, the analyst was credited with that as the price at the time of her recommendation. That meant an 80% performance gain. In addition, the analyst also received credit for the commissions generated from all the stock that was sold at the low price.
Not one financial advisor or institution benefitted from that sell recommendation. Every single holder of the shares lost about 80% of their investment. My guess is the Dain analyst got a nice bonus based on the commissions for the initial buy orders, the sell orders, and for the performance of her recommendations. She moved onto another firm. After all, she could show how well she had done with the sell recommendation of the stock and the commissions she had generated for Dain. I would guess she also got a signing bonus and a bigger salary.
These buy and sell recommendations were not made in the best interest of the client. The analyst got a big bonus and a new job. Some of the financial advisors probably lost a few clients. The clients lost a lot of money.
Analysts serve a useful purpose, and most of their research is good. At AFC we do our own research on the stocks in our portfolios. Yes, we make mistakes, but we believe in the importance of admitting to and learning from our mistakes. Unlike analysts we do not benefit unless our clients also benefit. We do not want to participate in Wall Street’s dirty little secrets. We have seen our client portfolios drop significantly in value, but we are guardedly optimistic not only for a recovery, but solid portfolio performance as we conclude the second half of the year and move into 2023 and 2024.