December 15, 1997

Why do investment banks and brokerage houses put out broker and analyst recommendations? Why do they put out earnings estimates? Is it mainly because they want to help investors make better decisions regarding stock selection, or is it mainly because they want to make sure that stocks are going to be continuously bought and sold to generate commissions? Even if the answer is to help investors make better decisions regarding stock selections, are the recommendations and estimates meaningful?

Last December 9, Oracle which had a market capitalization of over $30 billion, lost over 30% of its value in one day because it didn't meet analyst estimates for earnings. On December 8, the broker recommendations for Oracle were: 12 strong buys, 8 moderate buys, and 6 holds. There were no recommendations for moderate sell or strong sell. Out of 26 recommendations, 12 of them were saying Oracle was a great company and they strongly recommended it (these numbers were found by me on Yahoo Finance December 9, 1997). The brokers recommendations for Oracle were useless to me as an investor. I could have done just as well by flipping a coin.

Of course, after Oracle reported the lower than expected earnings, numerous brokers downgraded the company. However, if you were an investor this information was basically a day late and a dollar short because the stock had already fallen by 30%.

3Com Corporation is a large, established company, but the stock is very volatile. Why has its stock been so volatile this year (3Com was around $80 at the beginning of the year, fell to the $20s in the Spring, then went back up to the $50s in the Summer and now it is back to the $30s in the Fall). Has the company's fundamentals and outlook been that crazy this year, or is it the simple fact, that's what Wall Street wants (stocks to be volatile)? Look at all the revenues that have been generated by the heavy trading in 3Com in the form of commissions for the market makers and brokers.

Let's look at some of the broker recommendations for 3Com for just the past month. Under recent news for 3Com you will see that it was downgraded by Robertson, Stephens on November 7, but low and behold they turned right around and upgraded it on December 3 and on that same day, Gerard Klauer downgraded 3Com. And on December 3, Robertson, Stephens and Gerard Klauer weren't the only brokerage houses talking about 3Com. On that same day, downgrades were put out by BT Alex Brown, Lehman, and DLJ, but CIBC Opco rates strong buy and First Albany maintains buy. Obviously, people's opinions vary and that's my point, which one are you going to listen to today? If you do get lucky and listen to the one who is right they will most likely be wrong tomorrow. (I'm not saying that the activity in 3Com regarding recommendations and the buying and selling of the stock are not "normal," what I am saying is that I think 3Com is a blue-chip technology stock and the company's fundamentals and outlook for the past year have not been that erratic to justify losing 68% of its value at the beginning of the year, then doubling in a couple of months, only to lose 50% of its value again in just a couple of months. I believe a lot of the activity in 3Com is due to the constant upgrading and downgrading by the brokers and analysts.)

One sector that I keep close watch on is the semiconductor capital equipment makers. This sector was flying high in August, but since then most of these companies have lost 60% of their values. Would it have helped you to pay attention to the broker recommendations? To put it simply, no. Most of the companies had already lost 50% of their values before many brokers started to revise their earning estimates and recommendations. If at that point you had listened, you may have save 15-20% because like always, once everyone gets on the bandwagon, that fuels the movement (up or down) even more.

The industrial leader in semiconductor capital equipment makers is Applied Materials. I watch several companies in this sector and I noticed that as the stocks were losing their values, the earnings estimates on Yahoo Finance were staying about the same. I thought it was amazing that these stocks were not getting their 1998 earnings estimates lowered in a timely manner. Finally, on December 12, Lehman Brothers lowered its fiscal 1998 earnings for Applied to $2 per share from $2.15 per share. Applied Materials' stock fell from $54 a share to the $20s before I finally saw an earnings estimate lowered and the earnings estimate was only lowered by 7%. Now with the stock in the $20s you could say that Applied Materials is a strong buy, based on the average estimate of over $2 a share for earnings in 1998, Applied Materials has a forward PE of only 13, the S&P's is over 19. However, since it takes the brokers, analysts, Zacks, and First Call a long time to make revisions you never know. In a volatile and fast moving market, recommendations and earnings estimates must be revised and updated constantly to be useful to investors. A major stock like Oracle losing 30% of its value in one day is evidence of that.

Another example of how earnings estimates are adjusted in slow motion is Veeco Instruments (NASDAQ symbol VECO). After the stock fell from the $70s to the $20s, Veeco finally decided on December 12 to adjust their forth quarter earnings outlook. They said they expected 40-45 cents per share, below the analysts' 49 cents per share estimate. Today, if you look at the analysts consensus estimate you will still see 49 cents a share estimate and who knows how long it will take them to update the number.

Another thing that happened today with the semiconductor capital equipment makers was a downgrade of ten stocks in this sector by an analyst with BT Alex Brown. All ten stocks were downgraded from buy to market perform. It amazes me how they downgraded all ten stocks from buy to the same category market perform. I have read nothing that states how these companies are going to deal with the so-called crisis in Asia (Without knowing how the companies are going to deal with the crisis how do the brokers and analysts know how to make recommendations?). Are all ten companies going to deal with the problem in the same manner? I'm sure some of the companies are going to deal with the problem in a prudent manner, but I am just as sure some of them won't, meaning you will still see some of these companies giving large bonuses and raises to high ranking officials during this "crisis" which will hurt earnings even more. Then again, maybe the companies are telling certain brokers and analysts information that they are not telling all the shareholders, that is, information on how they are going to deal with the crisis in Asia? (I discuss this later, that is, companies giving share-sensitive information to certain brokers and analysts that have been "nice" to the company before they give it to the small shareholders.)

The fact is at any given time there are as many upgrades as there are downgrades in any given stock. And most changes in recommendations are made after material information is given which is usually after the stock has already fallen or went up. Earnings estimates, like recommendations, are usually revised to late to help investors.

One thing I am not saying is that no one ever downgrades to sell and lowers earnings estimates before the stock falls (or vice versa, upgrades to buy and raises earnings estimates before the stock goes up). That does occasionally happen, but it is the exception and not the rule. And like I said before, if you do get lucky and listen to the broker who made the call in time for you to place a trade that saved or made you money, you can bet next time when you listen to that same broker they will be wrong.

More evidence to support that broker recommendations and earnings estimates are meaningless can be found in two articles in Business Week magazine. In the November 11, 1996 issue on page 119 there is an article "If You Can't Say Something Nice About a Company...Analysts are under growing pressure to stifle negative reports." The article states, "Analysts who issue critical reports may have difficulty getting access to the companies they cover. If you go out of the way to say negative things, whether you have an investment banking relationship or not, companies do move to cut you off, says Bruce Lupatkin, director of research at Hambrecht & Quist. Sell signals have become rare. [I noticed this with the semiconductor capital equipment makers before their fall, there were no moderate or strong sells to be found, even as the stocks in this sector fell, some up to 60%, I still saw no moderate or strong sells, I'm not saying I didn't finally start seeing downgrades such as strong buy to moderate buy or moderate buy to hold.] H. Bradlee Perry, chairman of money-management firm David L. Babson & Co., surveyed an investment bank's research opinions for the week of Oct. 21 and found 50 strong buys, 98 outperforms, and 7 neutral ratings." The article ends by saying "The retail investor may be the one most affected by conflicts. As John Keefe of consultant Keefe Worldwide Information Services puts it, the little guy is watching the game and betting the game, but isn't really in the game."

The second article is from the July 29, 1996 issue of Business Week, page 32. The article stated, "Making matters worse, some companies selectively disclose market-moving information to big institutional investors, giving them an even greater edge. Take Bank of New York Co. It created a big problem on June 19, when it told 92 analysts and institutional investors in a 2 P.M. conference call that it would set aside $350 million to cover expected losses from delinquent credit-card accounts. The bank didn't publicly announce the charge until 4:09 P.M., after the market closed...There was never an intent to advantage or disadvantage any shareholder [the bank said]." Can you believe this? They told privileged people market-moving information before the market closed, and then told everyone else after the market closed, but they did not intend to advantage or disadvantage any shareholder?

In the same article, Business Week states, "The timing of big earnings announcements and other news is critical to whether everyone has an equal chance to trade on it. Motorola Inc. announced its disappointing earnings at 5:30 P.M. on July 9. In robust after-hours trading by institutions, Motorola's stock dropped nearly nine points, to 57 5/8, by the time the stock opened after a brief delay the next day. We report our earnings at the end of the day to give our analysts time to study and absorb the information overnight, says a Motorola spokesman." The same article also states, "About one-third of public companies disclose share-sensitive information in ways that may shortchange individual investors, says a survey by the National Investor Relations Institute, an association for investor-relations professionals. Small investors deserve the same information at the same time as institutional investors, says Gerri Detweiler, policy director for the National Council of Individual Investors. But neither the Securities & Exchange Commission nor the stock exchanges have clear rules on how companies must share sensitive information."

What these two articles from Business Week are saying is that if the brokers and analysts were to give honest opinions on certain stocks and those opinions happened to be negative, the companies may not give them special consideration when issuing share-sensitive information. By getting special consideration the brokers and analysts have an advantage that they can use to help their favorite customers by trading for them on the information. Unlike the rest of us that have to wait until the company decides to release the information to everyone else which may be after the market is closed which means we have to wait until the next morning to trade, most likely after the stock in question has already moved significantly.

My conclusion to all this is that I believe that the main reason for brokers and analysts recommendations (including forecasting earnings estimates) are to keep the stocks trading, buying and selling. 3Com Corp. is a prime example, a blue-chip technology stock that fluctuates hundreds of percent in just one year with the help of the brokers, analysts, market makers, institutional investors and the financial news media, all of which have a vested interest in 3Com's volatility (This volatility that is now becoming the norm for the stock market is the main reason for the success of the brokerage business in the last 12 months, in Business Week magazine's Investment Figures of the Week, December 15, 1997 the best performing equity mutual fund for the past 52 weeks is Fidelity Select Brokerage and the second best performing group for the past 52 weeks is Invest.Banking/Brkrge).

The second reason which again is motivated by the broker's and analyst's own self- interest, is to keep the companies happy by promoting their stocks. If the brokers and analysts put out good reports on companies, the companies are more likely to include those brokers and analysts when giving out early, share-sensitive information. The brokers and analysts also reap other rewards by promoting stocks such as unloading unwanted stock inventory their companies have, and by generating profits from secondary offerings and IPOs through their company's investment banking branches.

The last reason for brokers and analysts recommendations are to give you, the small investors, sound investment suggestions. The NASD and SEC could care less what the track record (as far as total return of their portfolio goes) of any investment bank, brokerage house, broker or analyst. There are no standards for performance that any of these institutions or individuals have to live up to. They can all have piss poor returns when compared to the S&P and turn right around and do the same thing next year. I can remember when, every now and then, I would see the performance results of brokerage houses, brokers, and analysts published in newspapers and magazines. It never failed that the "dartboard" would come in third or forth place out of twenty or so entries. The dartboard was a fictitious portfolio assumed to be one that was developed by simply throwing darts at a newspaper's stock listings. It seems that the financial news media has done away with the dartboard because I don't see it listed any more. I guess the brokerage houses and analysts didn't want to let investors know that the investors could do better, in most cases, by throwing darts vice taking their recommendations.

I'm going to end with the headline of this week's Business Week magazine (12/15/97): "Ripoff! The secret world of chop stocks-and how small investors are getting fleeced." The article claims that chop stocks are a $10 billion-a-year business and that most of the money "fleeced" is from broker cold calls. As a reasonably intelligent investor I know the risks of cold calls and I simply give those brokers a cold hang up. However, I am much more concerned about the brokers, analysts, market makers, institutional investors and the financial news media's obvious runup of Oracle stock and inevitable fall (even now after a 30% drop, the stock still has a PE of over 45). In one day Oracle investors lost $9 billion. Even if you exclude the $2 billion lost by Oracle's CEO, the loss is still $7 billion which is over half of what is "ripped off" in all chop stocks in one year. Like I said I can hang up on the brokers cold calls, but I have no choice in the matter when it comes to the market manipulation of some of the best so-call stocks in the world. The financial news media, NASD and SEC love to talk about how they are "cleaning up" all the scrupulous brokers dealing with penny stocks and chop stocks. Too bad they can't deal with the real and most costly problem with is with those so-called "upstanding" companies and individuals on Wall Street.

(August 26, 2002 there's a story titled, "Analysts on list of top scammers State regulators say conflicts of interest by stock analysts join this year's list of top 10 scams." Here's more from the story:

"NEW YORK (CNN/Money) - Stock analysts and unscrupulous brokers have joined the list of those engaged in top investor scams, according to an organization of state regulators released Monday.

'"Record-low interest rates and a bear market on Wall Street have created a bull market in fraud on Main Street,"' said Joseph Borg, president of the North American Securities Administrators Association, which includes the securities regulators from the 66 states, provinces and territories in the United States, Canada and Mexico.

New to the list this year is conflicts of interest by stock analysts in making recommendations to investors. The organization points out that it was a state official, New York Attorney General Eliot Spitzer, who led the way on this problem, winning a $100 million settlement from leading brokerage house Merrill Lynch & Co., along with promises to reform research practices. It said other state investigators are reviewing materials provided by a dozen firms for possible securities law violations..."

I wrote my story December of 1997, five years ago. Read about it today at Inside the Stock Market or read about it tomorrow in the Times, and Journal, or hear about it from CNBC later...much later.)

ADDENDUM (April 14, 1998)

At the end of last February, Intel warned about lower than expected earnings in the first quarter. Before the warning, analysts were expecting Intel to beat their previous years first quarter results of $1.10 a share, but of course, after Intel warned, analysts revised their estimates to $0.72 a share. Fair enough. You would expect when Intel actually reported earnings (today) that no one would even suggest, in their wildest dreams, that Intel beat consensus, unless Intel posted earnings of more than $1.10 a share. Wrong, today several analysts talked about how Intel beat consensus earnings estimates with $0.81 a share first quarter profits (excluding a one time charge).

Another way of looking at this is to say that your boss told you that you were going to get a $10,000 bonus in the first quarter, but a month before the quarter is over, your boss tells you that they bought another corporate jet and they are only going to give you a $5,000 bonus. Then a few weeks after the first quarter is over, they give you a bonus check for $6,000. Granted, some employees will look at it as getting $1,000 more than they thought they would, however, some employees will look at it as getting $4,000 less than they thought they would.

My point is not about if Intel did or didn't beat expectations, but about the fact that there are many ways of looking at the same data and brokers and analysts may have a vested interest in looking at it one way or another. The way they choose to look at it, may not be in your best interest as a shareholder of common stock.

ADDENDUM (May 1, 1998)

Today on CNBC I heard that earnings are expected to be flat in the second quarter. The fact that earnings are expected to be flat suggests that the stock market should do anything, but go up. CNBC went on to say that Wall Street is expected to start revising earnings estimates lower. This is exactly what happened with Intel above, but this time (the second quarter) it looks like it will affect a lot more stocks. Make sure you don't just look at rather the company met or beat earnings estimates, but look at how the company improved earnings over last year's second quarter earnings.

You would think that Wall Street wouldn't be able to get away with this, that is, when there is an expected flat quarter, Wall Street just revises earnings estimates down, and then when the quarter's earnings come out, Wall Street makes everything look better than what it actually is by stating that companies are meeting or exceeding earnings estimates (estimates that were revised down, just a few weeks earlier). The fact is Wall Street does get away with it and I think they already did get away with it in the first quarter.

I have heard the financial news say that this is what fools the small, inexperienced investors, but the professionals are not fooled by tatics like this. If this was true, that is, that the professionals couldn't be fooled, there wouldn't be a problem because the professionals through institutions are the ones that decides where the markets are going or where a stock is going because they are the only ones that have the power (money) to do it. If every small investor in XYZ thought that the stock was overvalued and sold, the stock might fall a few points and it would only take a couple of institutional players to buy and bring the stock right back up. However, if all the institutional players thought that XYZ was overvalued and all of a sudden decided to sell, XYZ would fall like a rock.

ADDENDUM (July 3, 2000)

Three months ago there were 30 analysts following Amazon according to Yahoo Finance Research: 11 rated Amazon strong buy, 11 rated it moderate buy, and 8 rated it a hold, out of 30 Analysts, not one, rated Amazon a moderate sell or strong sell, today, Amazon has lost 40% of its value in the last three months, you have to admit to yourselves rather you like it or not, to not have one analyst out of 30 rate Amazon a moderate or strong sell and then have the stock fall by 40%, makes the analysts as a group, look pretty stupid.

ADDENDUM (July 2, 2001)

For the past 12 months the analysts have been as lost as a duck in the desert when it comes to their earnings estimates, and buy and sell recommendations. The analysts are useless. The supporters of the analysts would say, "What do you expect, it's been a rocky time for companies and the stock market for the past 12 months."

Since analysts are basically useless when the "markets" are rocky what should be done is to shit can them and replace them with hardware and software. Hardware and software could do a much better job overall of predicting and estimating a company's profit and therefore buy and sell recommendations. So why don't they do that? The answer is that the analysts main function is not to make educated decisions on buying and selling securites, but is actually to promote stocks even if the stocks are not worth what investors are paying for them.

Also, the analysts use CNBC, CNN, and FOX as one of their platforms to promote stocks. If the analysts were all thrown out, CNBC, CNN, and FOX would have half of those they interview gone which would mean less advertisement revenue for them. Remember, those financial news program you all watch are not about giving you just the facts, they are also about selling Wall Street and all their products to you rather those products are worth a shit or not.

ADDENDUM (February 27, 2002)

Read about it tomorrow in the papers and on CNBC or read about it today at Inside the Stock Market.

The following story is from CNN/Money, "Investing Analysts in the hot seat Enron analysts were grilled during a Senate hearing. But can Congress really change Wall Street?" (February 27, 2002: 6:37 p.m. ET By Staff Writer Paul R. La Monica)

"NEW YORK (CNN/Money) - Wall Street analysts seem to be almost as good at spin doctoring as politicians are.

During a Senate hearing on Wednesday, four analysts had to explain how they could remain bullish on Enron throughout its fall from grace -- even after all the allegations of accounting improprieties came to light.

And the analysts stuck to their guns, trying to push off the blame on Enron whenever possible. Antatol Feygin, the analyst who followed Enron for J.P. Morgan Chase, said the accuracy of public information is important for any analyst to do his job effectively. Ray Niles of Salomon Smith Barney said that a company's public financial information is the 'bedrock' of sound analysis. In other words, 'Don't blame us. We're not the ones cooking the books.'

But the senators weren't about to let it go at that (just consider the title of the hearing -- 'The Watchdogs Didn't Bark: Enron and the Wall Street Analysts'). And they were quick to point out a string of gaffes made by the analysts after it became painfully obvious that Enron was in a lot of trouble:

Feygin did downgrade Enron on Oct. 24, but it was simply from a 'buy' to a 'long-term buy.' And that was eight days after the company announced that it would write down more than $1 billion in investments and two days after Enron disclosed that it was the subject of an SEC probe.

Niles actually reiterated a 'buy' rating the day the SEC probe was announced and finally downgraded Enron from buy to neutral on October 26, two days after then CFO Andrew Fastow was fired and a day after Standard & Poor's downgraded Enron's credit outlook to negative.

Following a conference call on Oct. 24, Richard Gross from Lehman Brothers wrote in a research report that Enron gave an 'inadequate defense of its balance sheet' during the call. Despite that indictment, he still maintained a "strong buy" rating on the stock.

To a man, the analysts (Credit Suisse First Boston's Curt Launer was the other one to appear before the panel) stressed that their integrity and independence was crucial and that they were never pressured by investment bankers to keep saying positive things.

The senators on the panel, which included the former CEO of Franklin Covey, Sen. Robert Bennett (R-Utah), and a former stockbroker, Sen. Jim Bunning (R-Ky.), weren't buying it. Sen. Bunning was particularly skeptical of some the analysts' claims about not knowing whether or not their employers owned stock in Enron or other companies they covered."