Maybe stock analysts should be held liable for bad recommendations

By DAVID MOON, Moon Capital Management
January 13, 2002

Thanks to detailed planning and excellent information, Knoxville managed to survive the Blizzard of 2002. Although schools were dismissed for only a day, some businesses struggled through an entire weekend of ice and snow-bound terror. The local TV stations dispatched top journalists, meteorologists and satellite trucks to provide up-to-the-minute reports on local driving conditions. I saw one daring newsperson, braving 25 degree temperatures and two mile per hour winds, standing next to a dry roadway that was free of ice and snow. He was quick to point out, however, that just a few feet from the road was a completely snow packed and dangerous sidewalk. Fortunately, with his warning, motorists avoided driving on the sidewalk.

Am I being tough to critical? Imagine being a meteorologist in Brazil. On Wednesday, Rio de Janeiro mayor, Cesar Maya, asked the city's chief prosecutor to file charges against meteorologist Luiz Carlos Austin for an incorrect New Years Eve weather forecast. Maya's offense was to predict continued rain, following a weeklong torrential (and deadly) downpour. After 71 people died in the previous week's flood, local officials feared another forecast for continued rain would create panic in the city. When it didn't rain, the mayor jumped to action. The meteorologist, a 35-year weather forecasting veteran, could spend up to six months in prison.

Imagine if we moved Wall Street from New York to Rio. Might the quality of some analyst reports improve with the threat of a stick and not just the promise of a carrot? Consider the Enron debacle. On November 2, Standard and Poor's described Enron's investment grade bond rating as "solid." They recommended investors "hold" the stock. On November 15, UBS Warburg rated Enron a "Strong Buy." Bank of America Securities called Enron a "Market Performer." On November 21, Goldman Sachs rated Enron "Market Perform." As late as November 23, CS First Boston described Enron shares as undervalued, rating the shares a "Strong Buy" and setting a 12-month price target of $25.

A week later, Enron filed for bankruptcy.

Of course, there are plenty of profitable analyst recommendations. The challenge is that there is little way to tell the difference until after the fact. The problems with the entire industry, however, are several:

1) Most Wall Street firms have lucrative business arrangements (or seek them) with the companies about which they purport to write unbiased research reports. How can an analyst write an honest commentary about a company to which she would like to sell her companies other services? It is very difficult to criticize your customer or prospective customer.

2) Wall Street lingo is confusing, at best. At worst, it is intentionally misleading. In a world where 'buy' means 'hold,' and 'hold' means 'sell,' who knows what 'aggressive hold' means?

3) Analysts are encouraged, either implicitly or explicitly, to make recommendations similar to other analysts. How can you be punished for being wrong if everyone was wrong? ('So? All the other weather men said it was going to rain, too.')

4) The system of making recommendations without investing real money encourages analysts to swing for the fences. There is an old joke about the difference between being interested in something and really invested in it. A chicken is interested in breakfast. A pig is invested in it. Analysts ought to be invested in the stocks they recommend.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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