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Investors beware

Mar 30, 2001

There was a recent news item from Bloomberg and carried in the International Herald Tribune (Thursday, March 22, 2001) that has received no attention in the Indian press and, yet, suggests that there is a decisive shift in the way investors interests are looked after. The headline of this article is “Let Companies Approve Changes in Ratings, Morgan Tells Analysts”. The article goes on to state that the Head of European equity research for JP Morgan Chase (they recently acquired Fleming and Jardine Fleming) “has told his analysts that they must seek approval from companies and investment bankers before changing their recommendations on stocks”. The article also stated that “the standard policy of providing independent advice from analysts is under pressure at securities firms as investment bankers produce a growing share of profits. At many firms, (investment) bankers typically use analysts as salespeople to help win underwriting and mergers business. As a result, investors are calling into question the objectivity of their research.”.

Our Indian press, of course, is silent on this issue. In fact many of the reporters and investors (and even the government officials and regulators) still get confused about what all these terms mean. So here is a primer.

Investment banker: companies need to raise money either by issuing shares or by issuing bonds (we call them debentures in India). These deals can be very lucrative and the companies pay about 6% as fees to investment banks to raise money in USA and about 3% in Asia. So, if an Indian company wishes to do a US$ 100 m IPO on the NASDAQ, the potential fees are about US$ 6 million (approx Rs 28 crores). Typically, companies hire many investment bankers (a “syndicate”) to manage their issue. Now, when investment bankers compete for these profitable deals, they need to show that they have sales people and equity analysts. Keep in mind that it is the intention of the investment banker to promise the highest price that they can get for their share and this is often the criterion used by companies to determine who to award the IPO contract to. And, needless to say, a high price for an IPO is good for the company but it comes out of the pocket of the investors.

Sales: The “sales people” are the folks who sit on the phone and keep on dialing and chatting up with fund managers who manage money. Their objective is to get the fund manager to do a trade (if the fund manager is a foreign fund, then we call him a FII – Foreign Institutional Investor). When the fund manager does a trade of a share that is already listed on a stock exchange, the sales person gets a broking commission for the company he works for. These days the broking commission is about 0.3% to 0.5% for the FIIs. If the fund manager buys a share of an IPO, then the sales person gets a sales or placement fee from that transaction which is typically 3% in USA or nearly 6 to 10 times the commission he would earn from a normal trade of a share that is already listed on a stock exchange.

Before we move ahead, a quick quiz:

Question: If you were the owner or CEO of a financial securities powerhouse which had an investment banking arm, which revenue stream would you like to maximize, the investment banking business that brings IPOs to market for a 6% fee or the broking side with the sales people that earns a 0.3% fee?

Answer: The investment banking business. If you got this wrong, please start reading from the top or you will not qualify to be the CEO of a global financial powerhouse – look for another career.

Fund manager: Manages money. Could be someone who manages money for a wealthy individual, a company that has excess cash, or runs a pool of money for an open-ended or closed-ended mutual fund in India or for a foreign company (in which case, we may call him an FII). Typically, a fund manager manages “other people’s money” and those “other people” is what all government and regulators of stock markets around the world try so hard to protect. These “other people” are folks like you and me called “the small investors” who have placed their money into the mutual funds. A fund manager receives phone calls from sales people who try to excite him into buying or selling shares of listed, existing companies or new issues and IPOs. A fund manager may visit and meet with companies on his own to decide whether to invest in them or not or may use the help of “research reports” written by equity analysts. But don’t forget, the money is ours.

Equity analysts: The folks with the knowledge. They meet the companies, they analyse the industries, and they make guesses or estimates about what the company is likely to do in the future. They give judgements and views and write “research reports” to suggest that investors should “Buy, Sell, or Hold” a specific stock. They make mistakes because they are examining variables and trying to estimate the future. Consider them as a weatherman or an astrologer, not as gods.

Research Report: A document written by an equity analyst giving his views on a stock. Could be wrong, could be correct but is assumed to be fair and a product of independent thinking.

Bonuses and salaries: Money is what everyone needs to earn to live and, in some cases, to live very well. These bonuses and salaries come out of profits from the commissions generated by fund managers who buy and sell shares based on research reports written by equity analysts whose views are communicated to fund managers via the sales people.

Before we move ahead, another quick quiz:

Question: If you were an equity analyst working for a financial powerhouse and the CEO was trying to maximize the revenue and profits of his company (a very fair and honourable capitalist objective) and you were asked to meet the investment banker who is about to pitch for a mandate that will earn your employer a 6% fee and if the potential client doing the IPO happened to be a company you did not particularly like, what would you do? And if you are now told that a copy of your report has to be sent to the investment banker and to the company to give them a chance to react to it and to say that they have seen a copy of a downgraded report and they have no problem with that, what would you do? And if this is happening in the United States and in UK, countries with supposedly strong investor protection philosophies what should an analyst in India do?

Answers (select one):

  • Become a Mahatama Gandhi and do a “dandi march” (also be prepared to lose your job and teach your kids to spin the wheel and make khadi), or
  • Follow obediently and say that this is what the USA and UK allows so why should India be different and why should the lone equity analyst start a revolution?

Hopefully you got this one correct. If not, read the article again.

We don’t know what answer the equity analysts at other houses choose and don’t wish to hazard a guess. But you, the investor, do have a choice. You can stop reading what these financial powerhouses have to say and listen to equity analysts who do not work for companies that have an investment banking division and whose sole revenue model is to earn a broking commission from giving views. The equity analysts of a equity research led broking firm may not be better than the analysts with the financial powerhouses, but the analysts in a pure broking firm have to be honest only to themselves and to no one else. There is no investment banker to approve the equity research report.

In the United States and UK there is the concept of a “Chinese Wall” which separates the equity analyst from the investment banking departments. This has been widely touted as a way to ensure a fair separation of interests and job function between the investment banker (who wishes to please his potential client, the company) and the equity analyst (who is supposed to look after the interests of the investors). However, recent events in the Internet and NASDAQ stocks have shown that equity analysts got huge bonuses from their employers because their research reports allowed companies to raise a lot of money at crazy prices. For the record, that was also one of the worst years in the history of the NASDAQ index with the index plunging by 60% from its peak and 30% for the year. Those in the know of things in this business are not surprised. There is a saying I heard many years ago (and not widely advertised) that the Chinese wall is high for sure, but it has been crossed many times. And with electronic communications these days, what use does a wall have?

If you think I am paranoid or making this up, here’s the ending quote from the same article. “Nigel Lanning, who helps manage US$ 38.6 billion (2 times the amount of money UTI manages) at Dresdner RCM Global Investors in London, said, ‘From our perspective, it appears there is a growing trend for analysts’ recommendations to be driven by corporate objectives, rather than it being a matter of first giving best advice to institutions.’”

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