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Leithner Letter No. 14
26 February 2001

Analysts, Cheerleaders or Used Car Salesmen?

According to Glen Stevens, Assistant Governor of the Reserve Bank of Australia, many market professionals make forecasts “with a view to selling a product, or a piece of advice. Many forecasts made in the private sector are essentially of this variety. The forecaster has a story to tell in order to provide credibility to their employer’s efforts to win business” (quoted in September 1999 by Australian Financial Review correspondent Stephen Koukoulas). Do brokers, analysts and the like have similar incentives? On 11 February the Nine Network’s Business Sunday program broadcast a report, produced by CBS News of the U.S., which comes to the unpalatable conclusion that they often do. A full transcript of this excellent report is available on ninemsn.com’s website. Several other recent articles draw attention to this festering issue. Bethany McLean (Does Wall Street Need a Reality Check? Fortune 5 February 2001), for example, notes that “some investing pros are declaring that the worst is over. Sounds great, but remember-they were positive last spring too. [and there] are strong reasons to be cautious right now. Wall Street firms make money by selling stocks, and it’s probably naive to expect them to say that stocks are a bad business. Analysts’ ‘buys’ are notoriously untrustworthy. And as for the strategists, these are the same people who have been saying ‘buy’ since the Nasdaq crossed 5,000. This is also the same crowd who argued that tech stocks were growing so quickly and had so little debt that they would be immune to rising interest rates. A highly paid Wall Street professional isn’t going to say, ‘I’m sorry, I missed it, I cost you millions, and now I don’t know what’s going to happen.’ But the truth is, no one does know. And some market observers are concerned-in part precisely because the Street seems a little blithe about the current downturn.”

A second article, The Price of Being Right by David Rynecki, also appeared in Fortune on 5 February 2001. It tells the story of Mike Mayo, an analyst who “thought he could change the ratings game on Wall Street. He thought he could be honest-and tell people to sell stocks that were headed for a meltdown. It cost him his job.” Part three of the article states that “it is hardly a deep, dark secret that the ratings game on Wall Street is beset with serious conflicts. Once kept separate, by long-held convention, from the investment banking side of the business, brokerage house analysts now find themselves in the supporting role of assistant dealmakers. Researchers pull double duty as stock boosters, often serving as liaisons between the companies they cover and the investing public. It is, after all, a game about money. Piles of it.”

Rynecki also notes that “even during the uncertain, recession-fearing, shoulder-twitching present, more than 70% of the 27,000 analyst recommendations tracked by First Call/Thomson Financial are buys or strong buys. That compares with a minuscule 1% for sell ratings of any kind. Among the ten largest investment banks (which do the vast majority of underwriting), the pattern is more pronounced. First Call identifies a total of 57 sells vs. 7,033 buys.” In Australia, a recent study cited by Business Sunday stated that, of the 415 analysts’ reports sampled, 18 (4.3%) were ‘sells.’ 

Rynecki concludes that whilst “the rewards for positive coverage are well known--and remain an issue of continuing concern for the Securities and Exchange Commission – it has never been obvious (beyond the top-floor corridors of Wall Street) just how stark the penalties could be for being overtly negative. The Mike Mayo case is instructive for just that reason. If a top-rated, thoroughly respected analyst earning a seven-figure salary with a name-brand firm can take this kind of career hit, Wall Street’s legions of lower-profile analysts have little hope of summoning the courage to shout ‘Sell!’ on a given stock or sector. The message to retail investors is sobering: If, in fact, stocks are headed for a disastrous slide, you won’t hear it from the researchers paid to predict it.”

Bulls’ and Bears’ Etymology

“How did the word ‘bear’ come to apply to stocks? The most common answer is that, in 18th-century England, and perhaps earlier, stock traders who sold shares ‘short’ (betting against the market by selling shares they didn’t yet own) were dubbed ‘bearskin jobbers’ after dealers known for selling bearskins they hadn’t yet acquired. They became known simply as bears, and eventually the phrase applied in general to naysayers on the market, not just short-sellers. The origin on ‘bull’ is much less clear; some historians say it’s because bull-and-bear baiting once was a popular sport, or because a bear tends to paw at, and pull down, its prey, while a bull charges forward and sends its prey flying upward.” (E.S. Browning, The Wall Street Journal, 16 January 2001). 

Corporations and Their Debts

The monetary expansion of recent years has sown the seeds of economic difficulties in the future; and the gulf between psychological expectation and financial reality, fostered by easy access to credit and celebration of debt, is creating significant strains in many individual Australians’ finances. There are also signs (interest-cover ratios, gearing, comments by ratings agencies and other indicators of creditworthiness) that the quality of Australian corporate debt has deteriorated during recent boom conditions.” Signs of economic difficulties have been reported more prominently during the past 2-3 months. One of these signs is the growing quantity and deteriorating quality of debt. The Extraordinary Edginess of Crowds (The Economist 11 January 2000) described the risks which various forms of corporate debt may presently pose to investors. It noted that “the derivatives markets are certainly showing signs of stress; and the market for credit derivatives, which has grown rapidly in the past couple of years, is exhibiting stress to an extreme degree. Which institutions are bearing the bulk of the risk in these contracts is not clear to the public, and it may not be clear even to the Fed. It is possible that banks have used financial engineering to take on risks that do not show on their balance sheets, which mostly look healthy. Credit quality has deteriorated rapidly in recent months, both for marketable debt and for bank loans. And it is expected to get a lot worse. Many banks, including Bank of America, which bid aggressively for loans, have warned investors of big losses on bad loans. The market for high-yield (‘junk’) corporate debt ground to a halt in December. Several well-known investment-grade companies, notably Xerox, have since seen their debt sink swiftly into the junk category, scaring investors who thought that ‘investment grade’ meant ‘low risk.’ The risk of California’s electricity utilities going bankrupt has added to the market’s jitters. Seemingly the safest of all securitised corporate lending is the market for commercial paper. But even that market has suffered an attack of investor nerves.”

This debt-induced angst, according to The Economist, may explain why the U.S. Federal Reserve unexpectedly cut the funds and discount rates during the first week of January: It cited one analyst who reasoned that “nearly $600 billion of commercial paper would need to be refinanced during the first three weeks of January: a vast sum in such a short period. The rate cut may have been intended to help reduce the cost of this borrowing, and to ensure that less-healthy firms--already squeezed out of markets for longer-term corporate debt--were not shut out of short-term paper and, crucially, forced to turn to the banking sector.”

Corporate (Mis)finance

The 27 January 2000 edition of The Economist, which reviews the present state of corporate finance, expanded and elaborated these sombre themes. The Party’s Over notes that “a long corporate-borrowing binge” has occurred in the U.S., that risks to borrowers and lenders alike are growing apace and that lenders are getting wary of shouldering this risk. And Debt Trap! states that “the risk that everything on the economic front could go wrong this year remains real. It is most pronounced in America; and its most fearsome guise is as a debt trap. In simplified terms, the big worry is whether America might follow a similar road to that taken by Japan ten years ago: a burst bubble followed by a deep and prolonged recession, or even slump.”

The Economist concludes that “there are enough eerie similarities between America today and Japan in 1989-90 to be worrying. The biggest is excessive debt. Too much debt was always at the heart of Japan’s weakness. So it is alarming that America’s boom has also been fuelled by massive borrowing by companies and households. Our survey of corporate finance in this week’s issue explores how American firms’ borrowing binge has left lenders exposed to some nasty risks. And, as if corporate debt is not alarming enough, consumer borrowing has been even more rampant. By borrowing against paper gains in share values, households have been able to shop until they dropped, not bothering to save.” 

Three Possible Risks and One Possible Opportunity

I disclaim any ability to predict the future course of interest rates; nor do I know whether the business cycle will turn (or whether it has turned) downwards; and still less can I claim to know when, to what extent or by what process this reversal of fortune might occur. Yet I can and have structured Leithner & Co.’s portfolio in response to three possible risks and one possible opportunity.

The first risk is a misplaced obsession with rates of interest. The relevant question to ask about interest relates not to its level but to its integrity. Investors should ask whether time preferences – and changes therein – convey accurate information. Acting on them, would individuals make reasonable choices? Or would they undertake ‘malinvestments’? The second risk is that the confidence (and in some quarters unshakeable conviction) in the ability of central banks to ‘engineer soft landings’ may be misplaced. The third is that the consequences of recent decreases in interest rates in Australia, Britain and Canada (the Reserve Bank of New Zealand is smarter in this respect), if maintained and extended, may be harmful rather than beneficial. For today’s debt-burdened consumers and businesses, in other words, lower market rates of interest may do more harm than good – they merely delay the correction of the mistakes of recent years. 

The possible opportunity, in Mr Buffett‘s words, is that “the best time to buy assets may be when it is hardest to raise money” (Fortune 23 October 1989). A good time to invest, in other words, is when others are unable or unwilling to invest. Leithner & Co. therefore likes credit crunches, if one is in the offing, not for their own sake but because they help to make good businesses available at sensible prices.

All best wishes for the remainder of the summer.

Chris Leithner


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