Does "Close" Count?
"Only in horse shoes and government work", might come the answer. But what about analysts? Do they ever hit their mark?
Fundamentals Guy was pouring over some trade publications still received from his past life in the commercial real estate business - shopping center sales and leasing, to be exact. What struck me was the similar number of downgrades made to various retail chains compared to the number of upgrades. In the heyday of the equities bubble, we had to search high and low, then in a haystack for the proverbial needle of Downgrade in which to pop the bubble. In other words, analysts NEVER downgraded stocks back then and the field was heavily loaded with Upgrades.
But now, at least by the ratings I read for the month of January, Upgrade quantities roughly equaled Downgrade quantities, at least amongst the retailers whom I used to follow closely. I wondered why since I figured Downgrades were a taboo among the analysts at large.
First, a couple of details to give us all a flavor of what we're talking about. During the month of January, there were 54 rating changes - either Upgrade or Downgrade - in the retail sector, 24 of which were Downgrades. Doing the math, 30 were upgrades. Yes, the figures are still skewed toward Upgrades, but no longer the lop-sided field it use to be.
Companies getting an upgrade during January included 99 Cents Stores, Abercrombie and Fitch (2 upgrades), Amazon.com (yes, the shopping center business now considers Amazon a retailer), American Eagle Outfitters, Bebe Stores (4 upgrades), Best Buy (Warrant Buffet's Berkshire Hathaway disclosed heavy buying in October through December, 2002), BJ's Wholesale, Chico's (3 upgrades), Costco, Dillard's, Dollar Tree, Duane Reade, Friedman's, Gymboree, Michael's (2 upgrades), Movie Gallery, Radioshack (2 upgrades), Talbot's, Target, The Gap, Wet Seal, and Wild Oates
Downgraded companies included Bed Bath & Beyond, Border's, Duane Reade, Federated Department Stores (2 downgrades), Gart Sports, Great Atlantic & Pacific Tea Company (A&P Markets), Gymboree, Haverty Furniture, Hibbett Sporting Goods, Home Depot (2 downgrades), Lowe's, Pacific Sunwear, Restoration Hardware, Ross Stores, Saks (2 downgrades), Too Inc., Urban Outfitters, Wet Seal (2 downgrades), Whole Foods, and Williams-Sonoma.
It's interesting to note that Duane Reade, Gymboree, and Wet Seal were all upgraded or downgraded, both, by different firms during the same period, and sometimes on the exact same day. Some days, you feel like a nut; sometimes you don't! Anyway, I guess that's why there are chocolate and vanilla - we get to choose our favorite - upgrades from some; downgrades from others.
Forget the specifics though of which companies received what rating change. That really doesn't matter. The big picture is that analysts were not afraid to hand out downgrades any longer. There seems to be no fear or trepidation about doing so. That seemed odd to me.
Then I stopped to think a bit about what might cause such a seeming anomaly.
DUH! In the old days, Upgrades meant job promotions, fat bonuses, and your children being accepted to exclusive schools. Just ask defrocked telecom analyst, Jack Grubman! All those benefits inured to Jack and others because their well-timed upgrade, which was placed to goose the price of the stock, meant juicy underwriting fees to the firm - fees said analyst got a piece of - for a supposedly unbiased (hack, sputter) analysis of the stock in question. The logical conclusion was that analysts NEVER issue a downgrade (or do so very quietly where and when the fewest will notice) when they are trying to woo business. It looks bad for the firm and they'll go hungry because they will be out of a jobs. Just common sense, really
In a nutshell, and just like any other sales endeavor in life, the higher the gross proceeds of the underwriting, the more money the seller (aka underwriter/broker) gets to keep. As an analyst of said underwriting firm, a favorable rating was a part of the sales pitch to get the underwriting business, a part of which would go back in your pocket if they, in fact, successfully got the business.
Frankly, with a lack of a "Chinese Wall" at many brokerage firms separating analysts from underwriting divisions, it paid to be unscrupulous. To put it bluntly, nobody buys stock on a downgrade and thus brokerage commissions to the firm diminish. Downgrade a stock? Decrease the firm's income. Lose your job.
Perhaps that is no longer as much the case as it use to be. I can't think of the last time a new company went public, let alone went public with a lot of hype and astro-projection behind it. It appears that the underwriting business has all but dried up. I don't suppose that comes as a surprise to anyone, given the decline in overall equity values over the past three years. If the public is in a mood to sell equities, there sure isn't anybody lining up to buy the new or secondary issues, hence dried up underwriting market.
The fact is, the market has changed dramatically. Nowadays, for any analyst on Wall Street, there is no bonus. . .that is unless keeping your job is actually the bonus, which to some, it might be. I imagine that if I were an analyst and my underwriting overrides had gone away, I'd be looking for another way to make money in a different facet of the same business, instead of issuing fraudulent upgrades in hopes of winning business that no longer exists. To that end, I'd be faced with the reality that I better start doing some real analysis, issue some real ratings, and hope I'm right. In other words, I'd seek to sell some honest analysis work instead of trading favors with the underwriting department. They are out of work. I can still have work if I choose to straighten up and fly right.
Personally, I think that's exactly what's happened. I'm not saying every analyst has all of a sudden sprouted a new golden halo, but the fact that Upgrades have been reduced and Downgrades have grown more commonplace tells me that there is no longer the negative stigma attached to issuing downgrades.
Sure, it's not a desirable thing to do. But there is no longer punishment for analysts or their firms in the form of cancelled underwriting contracts. Very few of those seeking to be underwritten are actually "underwrite-able". About the only punishment they can offer in response to an analyst downgrade is the childhood equivalent of someone telling your mom that you are being mean to them. Sooner or later, everyone is mean to someone, especially on Wall Street. And on Wall Street, mean comes with the territory.
Still, commissions drive the business and the objective is to get people to buy stocks. That will never go away. But it is heartening to see that analysts are slightly more compelled now to issue more honest ratings (in the form of an unashamed Downgrade) than to continue foisting total books of fiction about how the Next Big Thing (Cabbage Patch Doll Adoption Agency?) is going to make us all billionaires.
The system isn't perfect. It never has been and never will be. But it's far better now than the depths three years ago from which it has crawled. I'm not suggesting that from here on out we take every analyst's rating change as the gospel, but both upgrades and downgrades are probably much more unbiased in their arrival than they use to be.
Until next time, make a great week for yourselves!