Securities rules have side-effects

Posted: Jun 19, 2001 12:00 AM
It's not much fun being a financial analyst anymore. For years, it was a good way to make a living. You studied corporate financial statements, talked to industry insiders and then made recommendations based on which companies were likely to see higher profits or lower earnings in the future. In theory, this told investors which stocks would rise and which ones would fall. But the last few years have been rough on analysts. First, most of them missed the Internet boom, because the vast majority were busy studying "Old Economy" companies like autos and steel. Then, when they applied traditional valuation methods, such as price/earnings ratios, to "New Economy" companies, they did not work for a long time. Companies with literally no earnings and no prospect of ever making any went up and up in price, making instant millionaires out of those lucky enough to get on board early. Of course, it is easy to see with the benefit of hindsight, that the tech-heavy NASDAQ market was in the midst of a classic bubble that could not last. But while it was rising, those who warned that it could not last lost favor with their clients. The fact that they ultimately turned out to be right did not redeem them. Many investors continue to delude themselves into thinking that they could have gotten into the tech boom, made a lot of money and still gotten out in time, if only they had better advice from analysts. Then, just as many financial analysts were already in the doghouse, the Securities and Exchange Commission issued a regulation limiting their ability to get "inside" information from corporate executives. Henceforth, all important financial information had to be released to everyone, including the general public, simultaneously. This meant that the information financial analysts had was little better than anyone else's, thus diminishing their value. There was an unfortunate side effect, as well, to the SEC's Fair Disclosure rule. Corporate financial information now tends to come out in large globs, rather than being dribbled out a little at a time. So instead of being able to gradually absorb bad earnings news, of which there has been plenty in recent months, markets now get it all at once. This has tended to exaggerate the impact of negative earnings announcements, increasing volatility and driving stock prices lower than if the same news had been released in the traditional way, through analysts who could interpret the figures before they became public. Now, in the midst of this already depressing situation, financial analysts are being hit by a new attack. They are being accused of fudging their analyses to benefit the investment banks that most of them work for. Although there is supposedly a "Chinese wall" separating analysts from bankers, many people believe that this wall is more transparent than real. They suspect that analysts inflate the ratings of companies doing business with their employers. Congress is now looking into it. No doubt, there are some analysts who have felt pressure to boost their ratings to help banks get or avoid losing business. There certainly are well-documented cases where companies have in fact pulled business from them when they were upset with an analysts' report. But even without direct pressure, some analysts probably have pulled their punches in hopes of currying favor with those who sign their bonus checks. This is obviously a serious problem. Even if the incidence of actual biased research is small, the perception is deadly. The Securities Industry Association is working to strengthen the wall between analysis and investment banking. But it may be that only a full-blown separation will restore the analysts' reputation. Instead of paying for analysis indirectly through commissions, investors ultimately may be forced to buy it directly. Only that way can they be sure they are getting an analysts' true opinion. In the end, however, even the most honest and unbiased research is going to fail investors from time to time. There is no crystal ball, no formula, no computer model that is going to provide a straight path to making money in the stock market. Ups and downs are inevitable, if only because unforeseeable events will intervene to upset the apple cart. That is why every competent investment adviser repeatedly emphasizes investing for the long-term. Still, there will always be those who think they can outguess the market and consistently do better than the Standard and Poor's 500 index. They will continue to employ financial analysts, in hopes of getting an edge. But there is no question that being an analyst is going to continue to get tougher.