The perils of crack investment research

By DAVID MOON, Moon Capital Management
January 23, 2005

In 2003, 10 large Wall Street firms agreed to set aside $1.4 billion as a fine and compensatory damages for their misleading stock research. Unbeknownst to many individuals, many of these purported research reports were nothing more than sales pitches for the stocks the analysts were supposedly researching. Analysts were recommending stocks to their clients while describing the stocks as 'dogs' in internal emails. Part of the settlement was supposed to compensate investors who lost money following the recommendations of these firms. The Wall Street Journal reported this week, however, that few investors are actually receiving any money from the settlement fund.

One law firm interviewed in the article lost all 800 cases it has filed against Citigroup and Smith Barney. Another firm lost 275 cases against Merrill Lynch. According the Wall Street Journal, a Merrill Lynch spokesman says that the investors who have filed claims against Merrill 'did not lose money because of research but because the market sharply declined.'

That defense is appalling.

I wonder if the Merrill spokesman has given any thought about the reasons why the market sharply declined? The huge stock market price declines in 2000 and 2001 were precipitated and made possible by the irrational level of stock prices in late 1999 and early 2000. And why were those stock prices at stupidly high prices? Because those same Wall Street firms were touting the companies that drove the market indices to those grossly overvalued heights.

In early 2000, Wal-Mart was one of a handful of stocks that significantly influenced the daily price fluctuations in the S&P 500. As Wal-Mart went, so went the market. Even at $67 a share and a P/E of 50, analysts continued to tout the shares as undervalued. Almost any analyst would now tell you those prices were crazy. The stock was so overvalued in 2000, that five years later, Wal-Mart's earnings are 68 percent higher, yet its stock price is still almost 20 percent below its artificially supported price in 2000. The price was inflated because of faulty research that fed an emotional and greedy mania.

Many other companies were similarly overpriced, ultimately causing the losses experienced by many investors, including the people now losing cases against their brokerage firms. But the brokerage firms were complicit conspirators in creating the price bubble ' the condition necessary for the sharp price declines.

I'm not a professional fan of plaintiffs' lawyers or their clients. But in this case, the defendants are escaping responsibility because of conditions that existed as a result of their own actions. Imagine a 20-year-old crack dealer who gets doped up and robs a convenience store. In court, his attorney argues that he shouldn't be convicted of the robbery because while under the influence of the drugs his client wasn't capable of discerning right from wrong and can't be held responsible for his actions.

Now imagine the crack dealer is wearing a $2,000 suit and is carrying a briefcase full of stock research reports.

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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