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CHAPTER FOUR
FAITH IN PROFESSIONAL ADVICE CONFLICTS OF INTEREST

EVALUATING THE CORPORATION

IT’S A DIFFICULT JOB, at best, to evaluate the merits of a corporation as a potential investment. Interpreting the accounting, understanding how the business operates, and factoring in a host of other issues, including current investor psychology, can make the task pretty intimidating for even the most seasoned professional. But the decision as to whether a stock should be bought, held, or sold is made easier for most employees of the brokerage and investment banking industry because as a group they think it’s always a great time to jump in and buy.

Investment Analysts

Investment analysts are researchers whose responsibilities include reporting on a particular company, following that company, and making recommendations on whether to buy, hold, or sell stock. With the emergence of CNBC and other investment-related media, analysts are continually in demand for interviews and their “educated” comments and recommendations. Their comments and stock ratings have become like gospel for certain investors. A new report on a company by these media analysts can have a dramatic effect on the stock price. In other words, they are influential figures in the investment world.

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The investment industry hires analysts to do research on specific industry sectors, such as automobiles, oil, and technology, along with specific companies that make up a particular sector. Analysts who years ago worked almost unnoticeably from public view are now often the firm’s public face. Two such analysts, Mary Meeker, of Morgan Stanley Dean Witter, and Henry Blodget, her peer at Merrill Lynch, both became media stars in the late 1990s and achieved powerful, almost godlike, status with individual investors.

Conflicts of Interest

A huge problem has developed over the years with analysts. In the old days analysts put out what was perceived to be unbiased research to grateful individual investors. Investment firms generated most of their revenues from stock trading by these individual investors. The modern analyst helps the investment banking team with identifying potential business from sources such as initial public offerings, bond underwritings, merger and acquisition activity, and so forth, and promises—implicitly at least—to “support” a company once it has gone public by giving favorable research. Honest, independent stock research is difficult if not impossible to come by.¹

Investment firms and their analysts all speak a different language when giving advice on a stock. Not surprisingly the bias is always on the buy side—so much so that research departments of Wall Street firms have been widely criticized for not giving correct or clear ratings for the stocks they cover. The ambiguity is intentional to avoid upsetting the firm’s investment banking clients. So researchers might give a rating of hold or accumulate when it should really be sell. The bottom line is that the conflict of interest between the analyst and the final reader of the report (the retail/individual investor) is so great that ratings don’t really mean anything anymore.

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When the markets test the extremes of reality, as was the case during the dot-com craze, some of the inherent problems in the industry become painfully obvious. Lawyers have to pass the bar, doctors have to go to medical school, and stockbrokers have to pass an exam and have a license before practicing. But stock analysts, who can make or break a company’s stock with their research, don’t need any credentials to practice their craft. Some stock analysts have achieved the Chartered Financial Analyst (CFA) designation, the fruit of a grueling program that tests topics from portfolio analysis and accounting to ethical standards. The two prominent Internet analysts mentioned earlier, Meeker and Blodget, are not CFAs.

Mary Meeker was important in popularizing the notion that the Internet industry was a giant “land grab” in which companies had to sacrifice profits for rapid growth. She was a leader in using new metrics to assess Internet companies. As the Internet exploded, she and other analysts became more aggressive about using nonfinancial statistics, such as page views and “eyeballs” to value companies. At the same time, she became more flippant about valuation. In 1997 Meeker wrote, “We have one general response to the word ‘valuation’ these days: ‘Bull Market’… we believe we have entered a new valuation zone.”

For a while, clients of Morgan Stanley Dean Witter (Meeker’s employer) who bought Internet stocks were making tons of money, even with the wild valuations. It seemed like all the Internet stocks she was covering were doubling or tripling. And whenever one of them hit a bump in the road, she was quick to reassure one and all that everything would turn out all right in the end.²

. . . AND THEN IT ALL FELL APART

NASDAQ collapsed, dot-coms imploded, and the valuation bubble burst. Throughout the carnage Meeker refused to70 downgrade the stocks she followed, even as they dropped 70 percent, 80 percent, and in some cases over 90 percent. Her critics complained that the nonstop optimism was due to the fact that most of the companies she followed used Morgan Stanley Dean Witter as their investment banking firm.

Hear No Risk, See No Risk, Speak No Risk

On May 14, 2001, Fortune magazine published an article entitled “Hear No Risk, See No Risk, Speak No Risk (How a Bunch of Wall Street Analysts Hyped a Company Called Winstar to Death).”³ Winstar, a former ski apparel shop turned broadband network and service provider, convinced the world that it was a legitimate high-tech up-and-comer and was an exceedingly eager participant in a system that rewarded companies for keeping up appearances at any cost. And analysts and investors were too blinded by greed, too captivated by an alternate financial reality known as EBITDA, and too tangled up in conflicted interests to raise questions—much less look at the company’s balance sheet.

The sheer size and head-snapping speed of its decline made this company stand apart from the hundreds of other hightech misadventures. In March 2000 its common stock hit a high of $65, giving the company a market value of about $10 billion. A little more than a year later, on April 18, 2001, Winstar filed for bankruptcy.

An analyst for Credit Suisse First Boston (CSFB), Mark Kastan, maintained his target price of $79 and continued to hype the stock, even as it dropped below $1 per share, until twelve days before the bankruptcy filing. In March 2000 CSFB and Salomon Smith Barney underwrote a $1.6 billion bond offering for Winstar and earned what one observer calls “really exorbitant” fees—more than $50 million.

In June 2000, Winstar management announced that they were “fully funded” through 2001. This assertion was repeated by analysts like Credit Lyonnais’ Rick Grubbs, who initiated 71coverage on the stock on June 23, 2000, when the stock was at $40 with an $86 price target. All the while Winstar was employing all kinds of accounting tricks that should have been caught by at least one analyst.

On December 15, 2000, the company announced that it was fully funded through 2002, aided by a private placement of preferred stock to companies such as Microsoft and Compaq. In addition, Cisco and Compaq agreed to lend Winstar money to buy equipment from them. The sordid details of these kinds of wheelings and dealings (vendor financing) between companies are nauseating.

In February 2001 the company announced earnings for the year 2000. They were absolutely dismal, with bottom-line losses of over $1 billion for the year. Analysts were able to find a positive in the report since EBITDA losses had fallen to $153.4 million from $297.3 million the year before. “Better than expectations,” raved Salomon Smith Barney’s Jack Grubman, who called the stock “severely undervalued” and reiterated his $50 price target. Around this time the stock was selling for $11 per share.

In early March 2001 the outspoken short-seller Manuel Asensio released a series of devastating reports indicating that Winstar common stockholders had a high probability of losing their entire investment in a short period of time. He dismissed analysts as “idiots.”

Salomon’s Grubman characterized Asensio’s report as “incomplete, inaccurate and inconsistent with our analysis.” On March 13, CSFB’s Kastan emerged from a meeting with Winstar’s management and said that concerns about the company were overdone. He reiterated his buy rating and $79 target price on the $7 stock.

On Monday, April 2, Winstar announced that its required filing of financials with the SEC would be delayed. The next day, with Winstar now trading below $1, Glenn Waldorf, a new analyst at UBS Warburg, changed the rating to hold. Late 72on April 17 Winstar announced that it couldn’t make its $75 million interest payment. With the stock at 14 cents, Grubman finally downgraded the stock to underperform on the day before the bankruptcy filing. Kastan simply dropped coverage of the stock.

Top Internet analysts like Mary Meeker and Henry Blodget made $15 million to $25 million per year (with bonuses) while exhibiting blatant disregard for the welfare of the firm’s investing clients.⁴ But the cash for those Wall Street bonuses came from investment banking fees, and the companies that generated those fees wanted praise, not criticism.⁵

Many a scorned investor pursued legal action against the brokerage firms. Of course, winning a lawsuit doesn’t necessarily mean winning the fight. Attorneys are eager to take on such cases because of the huge potential settlement and contingency fees that range between 30 percent and 50 percent. As with most class action settlements, individual investors would see very little recovery of their losses, but the attorneys have the potential to reap huge windfalls.

In one of the biggest class action lawsuits of its kind so far, plaintiffs alleged that six major brokerages required their analysts to issue positive recommendations on certain Internet stocks in order to get investment banking business for the firms, and never disclosed that fact to the public. Those recommendations, the suit charges, led to investors’ losses on overhyped securities.⁶

When the state of New York fined Merrill Lynch, Wall Street’s largest broker, $100 million in May 2002 for pushing stocks to the public that it was privately bashing, none of the money went to the investing public. Out of the $100 million settlement, $48 million went to New York State, and $50 million went to other states, while $2 million went to the North American Securities Administrators Association.⁷

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Given that all this advice from the brokerage firms was “free,” investors certainly got what they paid for.

Alan Abelson, an editor at Barron’s, has brought humor and a razor wit to his columns for over forty years. He had this to say about the qualifications for being a Wall Street analyst: “You should be equipped with the kind of face that doesn’t scare small children when you make your obligatory appearances on Tout TV.… Knowing the difference between a bond and stock is helpful but not essential. The only true requisite is that, in good times and bad, come rain or shine, whether the market’s woefully depressed or really flying, you must be bullish. And that means all day, every day, including weekends, lest you lose the habit.”⁸

The Perpetual Optimists—the JDS Uniphase Example

In early 1999 JDS FITEL, Inc., based in Ontario, Canada, and Uniphase Corp., in San Jose, California, merged to create a new company called JDS Uniphase. The company manufactures lasers, amplifiers, and filters that are accessories to fiberoptic networks.

I had never heard of this company until late 1999 when several people asked me if this was a good investment. The company reported that profits and sales were increasing, but the stock seemed overpriced to me, even taking into consideration that the analysts asserted the company was well positioned in a “hot” industry.

JDS Uniphase decided to report its financial results in U.S. dollars and initially was led by Kevin Kalkhoven from Uniphase, who was cochairman and chief executive officer, along with Jozef Straus from JDS FITEL, who was cochairman, president, and chief operating officer.

For the twelve months ended June 30, 2000, the company had sales of $1.43 billion. That’s a big number! It’s hard for most people to relate to it. In the following analysis I have brought the numbers down to a level that is easy to comprehend74 by knocking off four of the zeros. Here is how the company would shape up if it were a small business for the twelve months ended June 30, 2000:

See Table

Note: JDS Uniphase actually showed a loss because of the amortization of goodwill and other items such as acquired R&D. I chose to ignore these items to attempt to show the company in the best light possible.

The balance sheet has some huge numbers on it, but a good portion is goodwill, which isn’t worth anything. Goodwill is just a “plug” figure that is needed when one company acquires another company and pays more than the net worth of the purchased company. The adjusted balance sheet numbers would look like this:

See Table

Now just imagine that this is a small business with tangible assets that exceed liabilities by $244,000, and that it currently has the potential to make a profit of around $40,000. However, this business has a chance to grow quite nicely. Sales have the potential to double or even triple over the next 75few years. That means profits could get up over the $100,000 level if everything goes exactly right. How much would you be willing to pay for this company? Remember there are no guarantees.

On July 26, 2000, there were 845 million common shares of JDS Uniphase outstanding, and they were trading at $135.83 per share. This is equivalent to saying that the company was worth $114 billion!

Bringing these numbers down to earth and relating them to my example, the market value of the company would be $11.4 million. If you took a company with $143,000 in sales and $244,000 in net assets to a small business broker and told him that you wanted $11.4 million for it, you would probably generate a hearty laugh and be quickly shown the exit for wasting his time. “But wait,” you would say, “it has such great potential.” The business broker would say, “You have a lot to learn about business.”

I wouldn’t have put a (adjusted) value of more than $500,000 on this company. Based on my quick look, the company was trading for more than twenty times what I thought was reasonable.

Here is a quick rundown on the stock price history of JDS Uniphase from July 26, 2000, to August 1, 2002 (adjusted for stock splits):

See Table

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At $2.29 the company had a market capitalization of approximately $3.6 billion, or about $360,000 if you lop off the four zeros. Hey, the price had finally reached the sanity range.

In 1999 JDS Uniphase’s common stock was on fire. It began the year at a split-adjusted $17.25 per share and closed the year at $161.31. Now that’s some serious price appreciation! The increase made no sense to me, but my early background was as a cautious accountant, not a stock speculator.

In the beginning of 2000 the price of the stock kept going up until it reached an all-time high of $293.06 on March 6, 2000—an increase of 82 percent in just a little over two months since the end of 1999. The people who asked for my opinion about this company in the middle of 1999 weren’t very happy with me. I was told many times that I was too conservative. Investors in JDS Uniphase experienced a gargantuan increase in value during this period up to March 6, 2000.

In January 2001 Kiplinger’s Personal Finance published an article with the title “Earnings Are so Passé.” The article says to “look at sales growth to predict which stocks will make money. Indeed, examining sales numbers might make you a better investor. Two recent surveys confirm that growing or accelerating sales may be better indicators of which stocks will go up than the old standby, earnings growth.”

The article went on to state the following: “PaineWebber recommends fiber optics player JDS Uniphase, one of the S&P 500 stocks with the fastest growing revenues over the past 12 months. Edward Kerschner, chief global strategist for UBS Warburg & PaineWebber states that stocks are trading on revenue growth rather than earnings per share. One reason is a growing skepticism over the reliability of corporate earnings figures, which a savvy chief financial officer can sometimes manipulate. Beyond that, revenues are a good measure of a 77company’s ability to sustain earnings growth when profit margins fall.”¹⁰

One way JDS Uniphase increased sales was by an aggressive acquisition program. I think it would have been good to use the overvalued stock to buy undervalued or even fairly valued companies, even if they were in an unrelated industry. Instead, JDS Uniphase used its overvalued stock to buy other overvalued companies in the same industry.

Its largest acquisition was a $41.5 billion buyout of rival SDL, Inc., announced on July 10, 2000, that closed on February 13, 2001. SDL was an optical-parts maker with 1999 sales of $187 million and profits of $25 million. Assets were less than half a billion dollars on December 31, 1999. SDL had an eye-popping $23 billion market capitalization on July 7, 2000, just before the acquisition announcement. This means that JDS Uniphase paid $18.5 billion more than the already lofty market valuation for SDL.

An article in the July 24, 2000, issue of Business Week entitled “Is JDS Uniphase Bonkers?” questioned management’s sanity but found that some analysts thought it was a good deal. According to Conrad Leifur of US Bancorp Piper Jaffray: “If you factor in the synergies from the merger and the momentum of both companies, you can justify the price and show a path to higher earnings in 2001.”¹¹

JDS was still digesting seventeen acquisitions it made over the previous five years before the SDL announcement. Its latest acquisition, which closed on July 5, 2000, was the $18 billion buy of another rival, E-Tek Dynamics.

On March 31, 2001, JDS Uniphase had goodwill of $58.4 billion on its books. Goodwill, which has no value, accounted for approximately 90 percent of assets. Now the company was faced with amortizing the goodwill for the next five years, a charge of over $11 billion per year. That’s huge! The company was projected to have only $3.5 billion in revenue for all of 2001.

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A slowdown in the fiber-optic telecommunications market in 2001 made it painfully obvious that these acquisitions were not a good deal. On July 27, 2001, JDS Uniphase announced a loss of $50.6 billion. Of this amount, $50.2 billion was from amortization of goodwill and an acceleration of this amortization. They took the big bath. The press release mentioned a $270 million charge for the write-down of excess inventory and $500 million for a “global realignment” program. The program included a reduction of 16,000 employees.

Macleans quoted JDS Uniphase: “These are not real losses but paper losses.”

Much of the wealth creation was through undisclosed accounting fictions. Now that they got into the wealth destruction phase, the losses were dismissed as accounting fictions.¹²

In May 2000 Kalkhoven resigned. According to Business Week he had total compensation of $106.9 million in 2000.¹³ According to the publication Canadian Business, Jozef Straus, the remaining CEO and chairman, “treated JDS Uniphase shares like hot potatoes—the second he got them, usually through exercising options, he’s on the phone to his broker screaming sell, sell, sell.”¹⁴ Filings with the Securities and Exchange Commission indicate that Straus had unloaded 1.6 million shares, realizing a value of $150 million on the exercise of stock options during the fiscal year ended June 30, 2001.

JDS Uniphase was tracked by a bevy of analysts. Listed here are the analyst firms, dates, ratings, and prices of the stock on the day the recommendation was issued after JDS Uniphase hit its all-time high on March 6, 2000. Analyst recommendations were worthless, and the following provides ample evidence of that fact. 79

ANALYSTS’ INITIAL COVERAGE RECOMMENDATIONS ON JDS UNIPHASE

The referenced firms that changed their recommendations in the following thirteen months did so as follows:

Note: All data on prices as well as analyst recommendations from finance.yahoo.com.

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Here is what several analysts were saying about JDS Uniphase in late 1999:

Susan Streeter, an analyst with Sproutt Securities Ltd., rates the company a buy and expects shares to hit $330 in 2000. She credits management with grabbing hold of this burgeoning market in optical network infrastructure through a steady stream of acquisitions.

Doug MacKay, manager of Red Oak Tech Select Fund, rates the company a buy. He says, “It’s a market that’s just exploding now.”

John Wilson, analyst with Dillon Read, rates it a buy. “We are on the front end of the curve in terms of the deployment of optical technology.”¹⁵

If you took any of these analysts and their firms at their word and purchased stock in JDS Uniphase as recommended, you would have lost as much as 98 percent of your investment principal. I admit it’s a difficult if not impossible job to predict whether a company should be bought or sold. But this was crazy! And JDS Uniphase was only one of hundreds of companies that suffered price collapses while analysts fiddled with their hopelessly sky-high price targets and recommendations. As the market crumbled and analysts stuck with the same old tune, investors learned another expensive lesson in who not to trust.

How “Independent” Is the Audit?

A company’s managers hire independent auditors to examine their books and records and issue an opinion as to the presentation of the financials to shareholders, creditors, and other interested parties. It’s very tedious work, and it’s cost prohibitive for the auditors to verify everything. So the auditors rely 81on management and their system of internal accounting controls as part of the auditing process. The auditors make a determination as to “fraud risk.” If it is overestimated, then unnecessarily high audit costs will be incurred. This could directly affect the bottom-line profits of the accounting firm.

If the auditors decide that the financial statements are not correct and corporate management refuses to change them, the auditors will issue a qualified opinion and risk losing their client to another accounting firm. Management can choose whatever accounting firm they want and can change at will. It’s a peculiar relationship. The corporation is the customer of the auditing firm, and it pays for the “stamp of approval” in the form of an unqualified opinion of its financials. A CPA is supposed to maintain independence and objectivity while performing duties as an auditor. But how can CPAs be independent from their client/customer when it’s the customer choosing the auditing firm and paying the fee?

Many CPA firms also provide services in addition to auditing, such as tax preparation and planning. So, when they lose a client, they may be losing more than just an auditing fee. And what about the effect on independence and objectivity of a long-term auditor-customer relationship?

These are serious issues. A few countries such as Israel, Italy, and Spain have adopted mandatory rotation policies as a solution to the independence concerns. Changing auditors every few years would ensure that different audit “experts” review a corporation’s representations. Auditors would have greater incentive to resist management pressures on ambiguous issues. Some suggest the auditors be appointed by a government agency to further distance the auditing firm from the corporation.

In any event, a structural problem exists with the system of auditing as it is practiced in the United States today. There is an inherent conflict of interest between the auditing firm and its client, the corporation, which makes it difficult for anyone to have confidence in the numbers.

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The Fallacy of Professional Management

Statistical evidence consistently shows that professional investment advisers can’t beat the market. As a matter of fact, every time you add a layer of complexity (as well as fees), total investment returns are diminished. Why is complexity synonymous with an investment professional? Well, if you are paying a fee for professional advice, you want to feel like the adviser is using his or her expert knowledge and experience, along with state-of-the-art investment software, to provide you with superior returns.

Investment professionals are taught the importance of diversification right from the beginning in Investments 101. However, there is a bias toward equities and equity mutual funds. Again, that unquestioned holy mantra in the investment field is In the long run the stock market will always go up. Mutual fund companies print and distribute a history of the stock market indexes going back seemingly to the beginning of time indicating that despite the bumps in the road the market just keeps increasing. Some advisers and brokers frame this chart and hang it in their office to give clients (and themselves) the reassurance that history is on their side. The country’s largest retail broker, Merrill Lynch, has even selected a bull as its corporate symbol that goes in tandem with the “We’re bullish on America” slogan. This is their permanent identity. I’m positive that I’ll never see Merrill change its symbol to a bear with a new catch phrase like “We think the market’s going down for a while.”

When the market dips, investment advisers are fond of stating to each other, “This is where we earn our fees.” The theory is that if the market always goes up in the long run, an investor shouldn’t panic and get out of the market when it dips and everything looks so bad. The adviser feels that by holding their clients’ hands through such periods and regurgitating the holy mantra (let’s adhere to the long-term plan, we’re long-term investors, etc.) that they are fulfilling their duties as the trusted adviser.

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Many investors rode the market up during the “roaring nineties” all the way to the top in early 2000 and rode it right back down. Lots of investors got in toward the tail end of what is now viewed as a speculative bubble and lost significant sums of real money, not just paper profits. Even though indexes such as the NASDAQ composite were down by 70 percent in just a year and a half, most advisers stuck to their guns throughout the drop, telling their clients to stay the course and not worry—in the long run, that is.

Investment advisers and money managers do not have a crystal ball to tell them what will happen in the future. They have no more indication than you or I. It’s the belief in the past that gives investment pros the confidence that the best advice to give an equity investor is to hang in there and keep the faith.