Category Archives: Investment firms

where is the stock market headed?: Wall Street strategists vs. analysts

May 13, 2013 By in Industry Analysis, Investment firms, securities markets, sell-side analysts vs. strategists, stock market, using research Tags: , , , , , , , , , , Leave a comment

 Factset:  what Wall Street thinks

Last week I got a press release from Factset, a financial data collection and analysis service, on the topic of where the S&P 500 is headed over the coming twelve months.  The short answer from Factset:  brokerage house analysts think the market is going up a little bit, strategists think the market is going down–again by just a touch.

I’m going to write about this over the next few days.  My short answer:  if history is any guide, neither outcome is likely.  The market seldom drifts along.  It either goes up a lot, or down a lot.

strategists vs. analysts

Who are these people?

First of all, they’re both sets of “researchers” who work for brokerage houses.  Now, they don’t call brokers the “sell-side” for nothing.  The number-one job of any sell-side researcher–analyst or strategist–is to persuade customers to do their trading business with their firm.  In other words, they’re primarily salespeople.  That’s important because it means that at least to some degree they both tailor what they say to fit what their buy-side audience wants to hear.

strategists

Strategists are typically economists or statisticians by training, although they are also sometimes former portfolio managers (snide pms would probably say failed portfolio managers).

Strategists normally work “top down.”  That is, they use data about the macroeconomy to make forecasts about GDP growth and  the course of interest rates.  They then derive expected future earnings growth for the overall stock market and the price earnings multiple at which they think the market will trade.  That gives them a forecast of the future stock market price.  For the S&P over the next year, Factset says the strategists’ consensus is down, but my less than 10%.

Based on their analysis, strategists also recommend sector- and industry-based portfolio structure.  In conjunction with analysts, the may also suggecst individual stock holdings.  They may also help set policy–like the official forecast of the oil price–that analysts more or less adhere to in making their company earnings forecasts.

Strategists are normally much more conservative than sell-side analysts.  Their earnings growth projections are almost always lower than analysts’.  Clients occasionally permit strategists to be bearish, and–as is the case now–to say the market is headed south.  But a prolonged bearish tilt is almost like buying a ticket for the unemployment line.

analysts

Analysts are specialists in specific industries or economic sectors.  They may have academic training in engineering or other subjects pertinent to the industry they cover.  They may have worked in the industry, often in strategic planning or M&A.  They’re invariably deeply knowledgeable about company financials and about the competitive dynamics of their coverage. They often also have privileged access to the top management of the firms they analyze.

That access usually comes at a price.  Analysts can come under considerable pressure not to deviate–either up or down–from the official earnings guidance announced by these firms.  A “sell” recommendation can sometimes trigger a violent reaction from the company in question.

Many investors–childishly–don’t like to hear bad news about the companies they own.  At the same time, the analyst won’t earn much if he doesn’t have good things to say about at lease some firms in his industry.  As a result, analysts tend to err very substantially on the side of optimism.  They turn bearish, even for a short time, at their peril.

year-ago predictions

Industry analysts make projections of earnings growth and set stock price targets for the companies they cover.  They don’t make projections for the S&P.  Factset gets an implicit analyst forecast for the market by aggregating the analyst projections for each company in the S&P 500.

Getting a strategist forecast is much more straightforward.  Factset just takes a median.

Anyway, in April 2012 the implied analysts’ forecast for the S&P was much more bullish than the strategists–at +11.9% vs. +2.6%.

No surprise there.

What is a surprise (“shock” may be a better word), however, is that the analysts were a lot closer to the actual S&P 500 results of +13.8% (capital changes only).

year-ahead projections for the S&P

That’s tomorrow’s topic.

current equity market money flows

April 2, 2013 By in Current Market Thoughts, ETFs Vs. Mutual Funds, index funds, Industry Analysis, Investment firms, securities markets, stock market Tags: , , , , , , , , 1 Comment

There’s been a lot of press recently about investors suddenly waking up after four years of strong market gains and deciding to take their money out of “safe” fixed income investments and put it into stocks.

What’s implied in many of these articles is that this flow is what’s putting the recent zip into the S&P 500.  What’s also implied, and sometimes stated, is that this is the “dumb money” whose arrival on stage is a signal that we’re entering the closing act of the current bull market.

Both implications might have some truth to them.  But neither is anything like the full story.   Most people are a lot smarter than that.  Money flows are a lot more complex.

This is what I see:

1. Any money going into stock market mutual funds or ETFs is not coming out of bonds.  Bond funds have had large inflows every month since January 2009, except for tiny outflows in December 2010 and August 2011.

Money coming into bond mutual funds accelerated in 2012, to around $25 billion a month, according to the Investment Company Institute, the mutual fund trade organization.

2.  Bond inflows have been matched by steady though smaller, outflows from stock mutual funds.  The lost stock mutual fund money may be feeding part of the bond buying binge.  But there are also two important trends within the equity world.

–There’s a big multi-year shift away from actively managed equity mutual funds toward index ETFs.  Two reasons:  better performance, and lower costs.  ETF flows are clearly much healthier than equity mutual funds’.

–Virtually all the net equity mutual fund outflows have been coming from US-only funds.  Global, international and emerging market mutual funds have been at least treading water.  Similar ETFs are seeing large inflows.  Again, this has been happening for years.

3.  So far in 2013 over $60 billion in net new money has come into equity mutual funds, breaking an almost two-year stretch of outflows.  Two-thirds of that has gone, as usual, into global etc. funds.

Much more interesting, to my mind, but almost completely unnoticed, is the HUGE outflow of over $112 billion from equity funds that occurred last year, from August through December.

Why this rush to the door?  My guess is that this is the final shoe dropping from the stock market collapse of the Great Recession. In my experience, some investors will panic and sell at the bottom.  Others will nurse their wounds and refuse to sell until they get back to breakeven.  Then nothing on heaven or earth can persuade them not to take their money and run.  I’ve turned around two woefully underperforming global funds for two different organizations.  In both cases, this sort of almost inexplicable outflow was the last step in the healing process.

If that’s what happened during the second half of 2012, it’s a significant bullish sign for stocks.

a great academic paper: “Playing Favorites: How Firms Prevent the Revelation of Bad News”

March 28, 2013 By in earnings conference calls, good academic articles, Industry Analysis, Investment firms, Portfolio management, Stock ideas Tags: , , , , , Leave a comment

A sidebar next to the “Heard on the Street” column of yesterday’s Wall Street Journal highlighted a research study by Profs. Lauren Cohen and Christopher Malloy of Harvard and Prof. Dong Lou of the London School of Economics titled “Playing Favorites…”.  I found the study itself on Prof. Cohen’s web page (along with a lot of other neat stuff that I’ll be writing about soon).  It’s well worth reading at least the summary at the beginning.

information manipulation

Mssrs. Cohen, Lou and Malloy studied the way in which companies choreograph conference calls by selecting the analysts who are allowed to ask questions.  Their finding:  companies that routinely call only on the analysts who are the most favorably disposed toward them–as measured by how bullish their official buy/sell recommendations are–may have a temporary positive bounce right after the call.  But they end up being significant subsequent stock market underperformers.

how so?

The authors suggest three motivations for companies to engage in this type of information manipulation.  It may want only softball questions because (in my words, not necessarily theirs):

–a company may be trying to “smooth” earnings by making more or less arbitrary changes in its accruals for, say, inventories or tax rates, and doesen’t want these devices subjected to scrutiny, or

–a company may have made its earnings guidance only by the skin of its teeth–and maybe even then only by making dubious accounting choices, which they may not want exposed to the light of day, or

–a company may want to present a glowing, somewhat bookkeeping PED-assisted, quarter because it’s going to soon sell new equity and wants the most favorable price.

why do analysts play ball?

After all, it’s embarrassing to be seen as a sycophant.

CL&M point out that the analysts called on may get to fill the holes in their earnings forecast spreadsheets, and therefore improve their future profit forecasts.  Colleagues who can only listen to the call may have different holes but can’t get them filled, so their forecasts may gain nothing.  In any event, CL&M demonstrate the favored analysts do indeed have better numbers.

As far as “why,” my experience is that the brokers the favored analysts work for garner more investment banking business from the firm in question.  Management returns the follow-up calls of the favored analysts faster, so they have better answers for their money management clients.  And when the CEO or CFO visits institutional holders of the stock, the softball-tossing analysts most often get to arrange the itinerary.   All this means more money for the brokerage houses they work for–and because of this for the analysts themselves.

the best earnings estimates?

How do the CEO’s pets end up with the best earnings estimates?  It may be the way CL&M suggest.

I don’t believe it, though.  Personally, I think selective disclosure still happens, despite its prohibition by Regulation FD.  At the very least, more frequent contact with management gives the favored analyst a greater chance to understand and decipher body language, intonation and word choice–all of which can provide valuable hints about how business is going.

why do these firms subsequently crash and burn?

CL&M observe that the analyst selection behavior is designed to prevent bad news from reaching the market.  But there are limits to how long negative information can be suppressed.  Eventually the companies have to come clean–if for no other reason than the auditors have arrived.  This results in negative earnings revisions and stock underperformance.

Maybe so.  Personally, I have a simpler, though non-verifiable view.  I think the conference call manipulation stems from–and reveals–a character flaw in a firm’s CEO.  The boss doesn’t want to have his ideas questioned and never wants to hear bad news.  Because he always shoots the messenger, subordinates hide unpleasant realities until they’re so big they’ve done serious damage to the firm.

one complaint, sort of

The study has a lot of statistics but no names of offending companies.  They would be worth knowing.  A shrewd investor, however, would keep that information for himself.  He’d also thereby avoid a firestorm of protest from egomaniacal CEOs.

Morgan Keegan, fund directors and fair value pricing: and SEC action to keep tabs on

March 27, 2013 By in ETFs Vs. Mutual Funds, fair value pricing, Getting financial advice, index funds, Investment firms Tags: , , , , , Leave a comment

Morgan Keegan, now a part of Raymond James, was a regional brokerage firm with a strong fixed income emphasis.  It was severely wounded by large losses in fixed income mutual funds during the housing meltdown, and by subsequent SEC legal actions.  The regulator accused the firm of misrepresenting the risk character of some mutual fund offerings to potential clients and of systematically mispricing funds over extended periods of time.  As part of a settlement, the portfolio manager who ran a number of these funds agreed to a fine of $500,000 and a lifetime ban from the securities industry.

“So, what’s new?” you may ask.

What’s unusual about this case is that late last year the SEC sued the boards of directors of some of these funds for what it says was their failure to ensure that the funds were priced correctly.   Although directors are, legally speaking, the highest-ranking officials in any mutual fund and are therefore directly responsible for the conduct of the fund’s officers and staff, the SEC has until now only held the investment professionals and support staffs of wayward funds accountable for their actions–and left the directors alone.

my thoughts

1.  The returns cited by the Wall Street Journal  for one of these funds in reporting on this case are really ugly.  It lost 30% of its value in 2008 vs. a return of +6.8% by the fund’s performance benchmark.  In 2008, the fund was down by 73.2% vs. a benchmark return of +4.0%.

2.  Fair value pricing–meaning having third-party experts estimate a price for a security if there are no trades for it on a given day–is an important issue.  Typically a rogue manager or a rogue firm will want to assign securities a price that’s too high, to disguise a fund’s underperformance.

The problem:  shareholders who sense the problem early and cash in their shares get more than their share of the fund assets, leaving loyal/trusting shareholders with a large hole in their fund NAV once the fraud is uncovered.

3.  Fair value pricing isn’t a new issue.  It was a big problem during the collapse of the junk bond market in the late 1980s.  It was also the centerpiece of Eliot Spitzer’s expose of shady practices by international funds in the mid-1990s.  Apparently the SEC again called mutual fund boards’ attention to possible fair value pricing issues with funds holding mortgage-backed bonds in 2007.

4.  The SEC must think that its warnings were being ignored by mutual fund boards and that it had to make an example of someone.

5.  If so, the agency appears to have chosen its target well.  Morgan Keegan isn’t a large, deep-pocketed, politically powerful investment banker like Goldman Sachs or Morgan Stanley.  The Morgan Keegan name no longer exists.  The firm has recently been sold to Raymond James, whose executives presumably have no personal ties with the accused directors and no interest in prolonged or expensive litigation which would only keep any past Morgan Keegan misdeeds in the public eye.

Yes, the directors doubtless have liability insurance against possible lawsuit.  But my guess is that the insurer in question may assert that coverage doesn’t extend to instances like this.

This case has the potential to change the way mutual fund directors are selected, what qualifications they should have, how they carry out their duties and how much they’re paid.  It’s worth keeping an eye on.

a blast from the past: eToys and the IPO market

March 11, 2013 By in internet, internet bubble, Investment firms Tags: , , , , , , , , Leave a comment

In yesterday’s New York Times, business reporter Joe Nocera wrote an opinion column about investment bankers’ behavior in bringing companies public.  It’s based on documents from an ongoing lawsuit between 1999 IPO star, eToys (which went into Chapter 11 in 2001), and its lead underwriter, Goldman Sachs.  Mr. Nocera got the data from the New York County Clerk’s office, where they were supposed to have been under court seal, but weren’t.

eToys

No, it’s not the one with the sock puppet.  That was Pets.com.  eToys was an online toy retailer.  Both made it into CNET’s Top Ten internet bubble flops, though.

The pricing range for eToys shares in the initial prospectus was $10-$12.  The final offering price was $20.  The stock closed on its opening day at $77.  It peaked a few months later at $84.  It was trading at $.09 when it went belly up.

The lawsuit:  eToys contends that Goldman failed in its fiduciary duty to get the best price for eToys shares.  Although it was losing money at the time of the IPO, eToys thinks that if it had raised, say, $400 million (an offering price just north of $50) instead of the $155 million it got, it would have been able to stay alive long enough to become profitable.  This was basically the AMZN strategy.  In eToys’ case, who knows what might have happened.

Goldman’s defense is apparently that it had no such duty.

the documents

Grammar and spelling errors aside, the Nocera documents shed some light on less well-known aspects of the IPO process.  No one comes out looking especially good.  For example:

–Goldman allocated 20% of the offering to “flippers,”  that is, to brokerage clients who had no interest in owning the IPO companies.  They just wanted to sell, or “flip,” the stock during first-day trading.

–one investment manager said he did large amounts of trades with Goldman simply to get IPO allocations.  He also appears to me to have paid commissions at almost twice the then going rate.  A cynic would say he got no services for this extra payout;  he just wanted to make the payments fatter–and thereby get a bigger IPO stock allocation.

–an internal presentation argues that Goldman should look at first-day trading gains in an IPO stock as being an asset of the firm, one that Goldman should seek to maximize the return on.

–Goldman regarded first-day gains as a quid pro quo for two things–the size of a client’s commission business and his willingness to participate in “cold” IPOs.  (“Cold” IPOs are ones with little or no upside; participation allows the underwriting syndicate to earn IPO fees at lower risk.)

–Goldman kept track of the first-day gains achieved by each client and informed at least some that it expected to receive 20%-30% of that figure back in increased trading commissions.

the underwriting fee/trading commission tradeoff

In the eToys IPO, the underwriters (I’m including the selling syndicate in here, too) received fees of $11.2 million, or 6.75% of the offering price of $20 a share.  If we assume they received from all brokerage clients what amounts to a kickback of 25% of the first-day gains of $53 on 8.2 million shares, that would have amounted to $108.7 million.

If, on the other hand, the IPO had been priced at $50, the underwriting fees would have been $28 million.  The commission “kickback” would be $47 million.

The total investment banking take at an IPO price of $20 a share would be $119.9 million; at $50 it would be $75 million.

This is Mr. Nocera’s point, and eToys lawsuit contention–that Goldman had every incentive to underprice the offering.

on the other hand…

…let’s suppose that the underwriters could only collect from flippers, who made up 20% of the eToys offering.  SEC-regulated money managers, after all, have a fiduciary obligation to get the lowest possible commissions.  If so, the “kickbacks” would have amounted to $21.7 million and $9.4 million.  The total investment banking take $20 a share would be $32.9 million; at $50 a share it would be $37.9 million.  Not a huge difference.

And I suspect this is closer to the true state of affairs.  Still, the tone of the documents Nocera unearthed suggests to me that Goldman felt it was missing a golden opportunity by not exploiting its underpricing better–not that there was something wrong with the underpricing strategy.  It may also be they knew that firms with more Internet cred, like Merrill (whose famous analyst, Henry Blodget was subsequently barred from the securities industry for fabricating his research reports) or Morgan Stanley (Mary Meeker apparently convinced the SEC she really believed the crazy stuff she wrote) were better able to cash in.

 

 

 

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