Several days ago, the Financial Times wrote an article about the troubled Canadian pharmaceutical company Valeant (VRX) in which it observed that 21 of 23 professional Wall Street securities analysts had rated VRX a buy just as it was about to lose 50% of its value in a day. The loss was understandable: VRX reported weaker than expected earnings figures and said it might soon be in default on some borrowings because of its inability to produce accurate and complete financial statements.
To my mind, that isn’t necessarily the worst part. VRX shares had fallen by 60% in a flat overall market during the prior year. Yet very few analysts picked up on the signal that price action was flashing that something might be wrong. Of course, the CEO of Valeant, no longer with the company, had also called his most favored analysts shortly before the announcement to say that everything was fine.
VRX isn’t a once-in-a-lifetime case. Comments from readers accompanying the FT article correctly cite Enron and the internet bubble as prior instances of the same phenomenon. The SEC complaint in the case of Henry Blodget, a former Merrill Lynch internet analyst who was barred from the securities business for publicly recommending stocks he privately believed had no investment merit, spells out the latter situation in detail. (By the way, Blodget now writes for Yahoo Finance. Go figure.)
So, why are Wall Street analysts so bullish?
–There’s a saying in commercial banking that no one ever gets promoted for not making a loan. Same thing for securities analysts. No one gets rich by warning what stocks not to buy. Fame and fortune come from introducing clients to stocks that will go up.
–Having a “sell” opinion isn’t a purely intellectual stand. It entails considerable professional risk. Institutional/hedge fund customers who own the stock in question may call up the analyst’s boss to complain. They may intimate, or flat out state, that they will withdraw/reduce the commission business they send the firm unless the analyst changes his opinion …or is fired.
Companies with poor ratings may complain, too, and threaten to take their investment banking business elsewhere. They can (and do) make the offending analyst’s life miserable. They can deny access to top management. They won’t return phone calls. They may not attend industry conferences the analyst arranges. They’ll ask the analyst’s rivals to set up meetings with important shareholders. Just ask Mike Mayo, the bank analyst who suffered greatly for years for his negative view of financials.
–Brokerage firms believe that their in-house research loses them money. They regard investment banking, trading for their own account and acting as a middleman for third-party trades as their major businesses. Because of this, they have a tendency to think that research should support at least one of these efforts. In my experience, they also think that the third-party trading business comes in on its own. So, while they may not say this in public, they view their institutional research as being either an adjunct to investment banking or proprietary trading.
–During the recent recession, very many experienced sell-side securities analysts were laid off. Their replacements have less experience, and they don’t have the same kind of personal followings with clients that can protect them from external pressure to be bullish.