One of the few consistent themes of this blog is that bad things, including client-screwing ethical lapses, happen not because of the rise of individual evil people but as the end result of a steady erosion of principles caused by the temptation of huge pig troughs of potential compensation. In rebutting Josh’s reinforcement of the useless, self-aggrandizing analyst stereotype printed by the FT yesterday we’ll go through how this process works for the typical equity analyst.
First, picture a Laffer curve with some measure of ethical behavior on the Y-Axis, “number of retail clients protected from being fleeced” for instance, and potential commission along the x-axis. To simplify things somewhat, we’ll assume that the moving out on the x-axis to higher cake is primarily a function of payments made to an analyst as a result of commission on investment banking transactions in their sector. The peak of the curve, which will be a different for every analyst is the “too much money to ignore” level, where visions of a decent-sized ranch in the Hamptons replace early-career notions of “helping people with their finances” and general adherence to the extensive but flushable CFA ethics guidelines.
It is important to note here that the vast majority of equity analysts toil away in obscurity, even within their own firms. They cover their companies in sectors where investors currently don’t care or where they are overshadowed by a CNBC-friendly, dominant counterpart at another firm. The 5% of analysts you have heard of cover hot stocks like LULU that are “in play”, attracting oceans of daily market liquidity or in sectors where significant M&A activity is apparent.
Interloper’s General Rule of Understanding Finance applies directly here: Whenever something looks fishy, look to how the situation benefits Investment Banking revenue. That’s where the big checks are – new offerrings and M&A consulting. An analyst covering a stock where this activity occurs goes “behind the wall”, generating a fat personal check in the 100s of thousands when a deal is completed.
Now we’re ready to discuss Josh’s Jamba Juice example where the analyst kept hyping the stock as it collapsed into nothingness. For our purposes, the important part of the story is that the analyst in question was the biggest name covering the stock. Why is this important? Because it implies (almost assures actually) that this analysts’ company would be the primary banker on any capital raising, hopefully a number of them over a decade, that Jamba Juice would do to fund its expected growth. Lots of big checks for I-Banking, and enough potential personal revenue for the analyst that they, at some point, reached the “too much money to ignore” peak of our bastardized Laffer Curve after which the permanent pom poms came out.
This happens all the time and Josh is right to call them out. On the other hand, I find the stereotype unfair, not least because it does not reflect the day-to-day efforts of 95% of analysts who diligently follow their companies and answer client questions to the best of their abilities. More importantly, the analyst is not the driving force in these instances – they are just the visible vanguard for Banking. The I-Bankers just quietly move on to shoo-fly another potential big pile of money when things don’t work out and the analyst is publicly hung out to dry. And no, I am not excusing analyst behavior when this happens, just suggesting that blame be apportioned more generally.
As a group, equity analysts in my opinion are the most ethical of all capital markets staff. They are the ones forced to live with their public declarations. Furthermore, whereas the finance industry inexplicably sidestepped regulatory punishment after the GFC, analysts suffered a disproportionate beating and increased legal liability after the tech bubble imploded. The driving force behind Blodgettgate remember, was banking revenue and yet notably few restrictions were put on Banking as a result. The TMT analysts were a much smaller percentage of the problem than most believe, The Mouth of Sauron rather than the dark lord him-or herself.
Again, I am not defending the crappy, client-unfriendly things analysts do all the time. But in my experience, which features hundreds of research meetings, analysts are not routinely dishonest. Bankers, particularly when retail investors are involved, kinda are – they are looking for the highest fees they can possibly get and they could care less what happens after a deal is done. I don’t have space really to get in to Structured Products, but I will note that the term “cesspool” is unfair to outhouses in this regard.
It is really convenient for an investment bank to have public and regulatory focus on the analysts, as if changing or adding disclaimers will do anything to affect research content. They are an effective screen obscuring where the sausage and all the money really gets made. Analysts are just the rock that must be lifted so that sunlight can reach the Investment Banking department.