why Wall Street analysts are almost always bullish

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.

 

the last bull standing

Being the last bull standing isn’t necessarily a good thing.  The Wall Street cliche is that the bear market doesn’t end until the last bull capitulates.  The complementary, equally hoary, standby is that the bull market isn’t over until the last bear capitulates.

To my mind, both are useful guidelines but not infallible ones.  On the one hand, markets are inherently cyclical.  So if an equity investor has a close to infinite capacity to endure pain–and if his clients don’t fire him in the meantime–persevering with a bad-performing portfolio can eventually pay dividends.

More qualifiers:

–that’s assuming the companies whose stocks the suffering-oriented manager holds are inherently sound, and not barreling down the road to bankruptcy.  They’re just poorly positioned for the current economic environment, which will sooner or later change for the better.

–a surprisingly large number of pension clients love to hire managers who have a recent hot hand and to jettison ones who are cold as ice, no matter what the long-term record.  So my “if his clients don’t fire him” qualification is a much greater risk than one might think.

On the other, there is something to the idea that until the most vociferous and publicity seeking defenders of a given position that’s going wrong give up, the situation rarely changes.  This may be as simple as that when, and only when, the buyers of what short-sellers want to offload disappear, so too does the short-selling–and hence the downward pressure on the stock in question.

…which brings me to Valeant Pharmaceuticals (VRX).

It has caught my eye that William Ackman, a long-time booster (and holder) of VRX, has joined the board of the beleaguered drug firm.  He’s also raised something like $800 million by selling shares of Mondelez, which was reportedly the largest position in his hedge fund.

To the extent that one believes in the last bull theory, and if Mr. Ackman is in fact the last bull, he’s in a no-win situation.

what I find strangest about Valeant Pharmaceuticals(VRX)

Pharma company VRX went from about $20 a share in 2010 to a peak of $263+ last year.  It’s now trading at around $30.

To be clear, I don’t own the stock and never have.  My only acquaintance with the company comes through the financial media and the occasional analyst report–plus a fast look at the stock price history before writing this.

On the surface, the stock screens well.  Its ascent was mainly fueled by rapid earnings growth rather than by price-earnings multiple expansion.  The company seems to have served up continuing positive earnings surprises in a highly visible industry, where such operating performance for large companies is rare.  The only potential red flag I saw from historical data was the rapid build up of long-term debt resulting from VRX’s many acquisitions.

Among other places, I looked at an October 2015 report in Value Line.  I was mostly interested in the past financial reporting data the service provides, but I also happened to glance down at the accompanying commentary, which urges investors to buy.  The fall from $263 to $158 (the price on the date of the report) provided “a prime buying opportunity,”according to VL, with selling related to worries about drug price increases possibly “over done.”  The stock also received VL’s highest rank for Timeliness back then, a rating derived from a statistical analysis of prior financial and trading data.  My point is not to single out VL’s bad call,  but rather to illustrate that there was no obvious sign in historical data of the trouble the stock price was signalling.

What I find worthy of note:

  1.  The main drivers of the stock price seem to have been I’m-the-smartest-one-in-the-room-about-everything hedge fund managers, not traditional portfolio investors.
  2. Holders didn’t seem troubled by the fact that earnings growth was produced in considerable part by large price increases for mature drugs.  That’s OK for things like art works or prime real estate. But history shows Americans have a visceral dislike for companies that make large profits from human misfortune, especially form health problems.  Regulatory changes eliminating the profit “gouging” soon follow.  In my view, then, the whole VRX concept was trouble waiting to happen.  What veteran healthcare analyst wouldn’t know that?
  3. According to a number of media reports the chairman of VRX called select sell-side analysts after returning to the company after an illness last month, apparently to assure them that both he and the company were in robust health.  What’s wrong with that?  The purpose of Regulation FD, published by the SEC in 200, was to outlaw the selective dissemination of important company information (usually to favored brokerage house analysts) that most often occurred in phone calls like this.  Even if no sensitive information was disclosed in the VRX calls, they give the appearance of impropriety.  Why would any intelligent CEO do this?  Especially since…
  4. Last Tuesday, the company had a public conference call in which it sharply revised down its earnings guidance for 2016.  It also said it won’t be able to file its 2015 financials with the SEC on time, which will violate covenants on some of its debt.  That breach will allow the affected lenders to begin a process that could lead to default on those obligations–possibly meaning a demand for immediate repayment of principal.
  5. If media reports are correct, the predominant hedge fund reaction to the rollover in VRX stock has been to buy more rather than reduce their exposure (see point 1 for the reason why).

There may be a time for deep value investors to come in and try to pick up the pieces.  I don’t think we’re anywhere near that point, in time if nothing else, yet.

 

 

currency effects on US companies’ 1Q16 earnings

Over the past year or more, the international portion of the earnings results of US publicly traded companies has suffered from the strength of the US dollar.

Data dump:

-By and large, US products sold in foreign countries are priced in local currency.  When the dollar rises, the dollar value of foreign sales falls.  Speaking in the most general terms, firms can raise prices without damaging sales volumes only at the rate of local inflation, meaning that it can take quite a while for a US company to recoup a currency-driven loss through price increases.

-The rise in the dollar has come from two sources:

–the collapse of the currencies of emerging countries with unsound government finances and radically dependent on exports of natural resources like oil and base metals, and

–the greater strength of the US economy vs. trading partners like the EU and Japan.

-What appears on the income statement as a currency gain or loss is the result of a complex process with two components:  cash flows; and an adjustment of balance sheet asset values. There’s no easy way to figure out what the exact number will be.

-We do know, however, the very important fact that the dollar has been weakening against the euro and the yen for the past several months.  If the quarter were to end today, the euro would be 3.2% stronger vs. the dollar than at the end of 1Q15.  The yen is now 5% stronger than it was at the end of last March.  The Chinese renminbi is 5% weaker against the dollar than this time a year ago, but there’s much greater scope to raise prices in China.

My conclusion:  US companies with mainly and EU or Japanese assets/earnings will likely post modest foreign exchange gains during 1Q16 vs. large losses in 1Q15.

Hedging?  Many international  firms try, more or less successfully, to smooth their foreign earnings by hedging.  This activity is crucial for an exporter with long lead times, cosmetic for everyone else.  The key point, however, is that in my experience when hedging results in a gain, this is recognized in operating profit and companies say nothing.  When the hedging makes a loss, companies disclose the figure and argue that this is a non-recurring item.  For whatever reason, Wall Street usually ignores a loss of this type.

So, ex emerging markets, currency can be a significant positive surprise for internationally-oriented firms this quarter, instead of the earnings drag it has been in recent quarters.  My guess is that Wall Street hasn’t factored this likelihood into prices yet.

 

 

 

 

is “tenure voting” the answer?

tenure voting

The weapon institutions are currently discussing to combat the potentially negative influence of activists on company management plans is called “tenure voting.

Under a tenure voting scheme, a shareholder accrues more voting power the longer he holds a given stock.  On day one, for example, the shareholder might have one vote to cast on proposals at a shareholder meeting.  This might rise to three votes after three years of continuous ownership and peak, say, at five after five years.

This heavier voting power given to long-term shareholders would, in theory at least, make it much more difficult for an activist investor with a hit-and-run strategy to coerce favorable action from a timid CEO.

the arithmetic of influence

An activist can have leverage over company management at present by buying, say, 3% of the outstanding shares to obtain 3% voting power.  If the typical institutional holder bought his core position five years ago and if institutions overall hold 60% of the outstanding stock, then with tenure voting in place the activist wouldn’t achieve the same amount of clout until he had accumulated at least 10% of the target firm’s stock.  Of course, the activist could also wait for a half-decade for his stake to achieve maximum voting power, but none strike me as having that much patience.

an effective deterrent

So tenure voting would likely insulate many of the large firms potentially under activist attack from such predation.

But…

–there’s a practical issue of implementation.  Instituting tenure voting at a firm would presumably require rewriting corporate bylaws.

–it doesn’t stop activist action.  It just changes the game.  Activists would have to adopt a two-step strategy, the first of which would be to court one or more big long-term institutional holders of a target firm’s stock.  Of course, this is arguably the intent of proponents of tenure voting–the presumption being that professional portfolio investors would rebuff the activists.  Maybe so.  But maybe not.  However, the obvious place to start would be index funds.  It’s not really clear what unintended consequences this might produce.

–tenure voting has been a traditional practice in places in Continental Europe like France.  In my view, it has been a disaster there, cementing in place an elitist old boy network of corporate managements that have had little regard for ordinary shareholders.  More than that, the French government’s move last year to make tenure voting mandatory for all publicly traded firms met with violent opposition from investors who know this system the best.

All in all, although I’m not necessarily a fan of activists, I think in this case the cure is worse than the disease.

institutional investors vs. “activists”

As I see it, today’s activist investors are the successors to the corporate raiders/ “greenmailers” of the 1980s.  In some cases–Carl Icahn is an example–they’re the same person.

Greenmailers (a takeoff on blackmailers) would typically attack small cash-rich companies by buying a 5% – 10% equity position and threatening to launch a hostile bid to take over the firm unless they were bought out at a high price.  That price would typically be all the cash in the corporate treasury.

The tactic often worked.  A CEO who had spent thirty years clawing to the top of the heap  so that he could exercise power and reap large cash/stock rewards during a five-year tenure as chief executive, knew he would be out the door if a change of control took place.  So he might be all for acquiescing to the greenmailer.  Sometimes, too, a company might have questionable accounting or other dirty secrets that could scarcely stand to see the light of day.

The issue for other shareholders:  while the greenmailer would make a financial killing, he would leave behind a firm drained of cash and typically worth considerably less than before the greenmailer showed up at the door.

Activists play a slightly different game.  They attack large companies (perhaps because smaller prey has long since been devoured).  They typically invest millions of dollars in buying a company’s shares, but because of the size of the target, may only hold 1% – 3% of the outstanding equity.  Activists typically demand seats on the board of directors and offer “advice,” which may be sound (or may not), and which usually consists in actions like dividend increases, stock buybacks and/or spinoffs of business lines.  These are all levers designed to get the stock price up quickly–so the activist can sell and be on his way.

The threat is the same:  the sitting CEO has run a grueling thirty-year corporate marathon only to see the prize snatched away as he’s crossing the finish line if the activist decides that he’s part of the problem.

The issue for other shareholders:  none of the actions activists recommend may be good for the long-term health of the company (look at what happened to J C Penney).  And unlike the greenmail case, where the attacker’s threat is to take over the firm–meaning a profit for other holders and resolution to the issue–the activist may well tie up management time and energy with proxy fights or other distractions that go on for years.

Tomorrow:  what to do.