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Runaway Research

Column
Column
Column
9/14/2000
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The Internet has provided a lot of great content and tools for the technology investor: lower commissions; wider availability of company information, including conference-call Webcasts; research tools, such as Edgar-Online; and a plethora of investment content, including news and discussions.

So, what hasn't been so good? The growing influence of sell-side research. It's not that sell-side research is inherently bad -- it's the context in which it's presented and the amount of disclosure provided to the investor that determines its worth. And at times, Yahoo, CNBC, the investment banks, and the regular news outlets appear to present sell-side research as the Gospel Truth. Upgrade! Strong Buy! Double upgrades! You've hit the jackpot!

There's a reason sell-side analysts are on the sell side. Their main purpose, in the grand investment banking food chain, is to help brokerages sell stock. And even if an analyst of the utmost integrity and knowledge is doing his or her best to provide the investor with objective information, the analyst inevitably falls under pressure from the investment banking parents. Investment banks exist to take companies public and sell stock, which makes it virtually impossible for any sell-side analyst to say anything truly bad about companies being underwritten by the bank.

This has become especially dangerous in cases in which an analyst -- or a reader of sell-side research -- assumes objectivity on a matter on which the research is undoubtably biased. Money corrupts, absolutely. And unless you are Gandhi, there is no way that you can detach yourself from the influence of large sums of money flowing through the banking system.

Let's take, for example, the matter of Paul Johnson, the well-respected managing director of research at Robertson Stephens who has followed the networking industry for years. He owns $9 million worth of ONI Systems stock, which derives from a personal investment he made in the company before it went public. Now he covers the stock as a sell-side research analyst, and he believes that he can continue to cover the company in an objective manner. This notion is, quite simply, absurd. Light Reading senior editor Marguerite Reardon interviewed Mr. Johnson on the matter, asking if he thought he could continue to cover the company in an objective manner (see Analyst Owns $9M in ONI Systems Stock ).

Johnson asked, "What can I do?"

Well, first of all, you could assign another analyst to the ONI Systems research.

Let's say we granted analysts the leeway to make large pre-IPO investments in companies they later cover as a research analyst in the public markets (and apparently the SEC does grant them such leeway). It seems to me that a lot of VCs are missing a grand opportunity: They should all moonlight as sell-side research analysts. That way, they could advise their banks to take all of their portfolio companies public, seamlessly yielding successful IPOs for their companies at the investment banks. Then they could write glowing research reports on the companies once they have gone public. What's wrong with this picture? Johnson said the investment was secondary to building his reputation, which is "how he puts food on the table." The first question is, what exactly does Mr. Johnson eat? After that, the investor should ask Paul what his career path is -- is he a VC or a sell-side analyst? And isn't there an inherent conflict in trying to take both roles in the same company when you work at an investment bank? My first reaction to hearing the story was: If Johnson's making great money as a pre-IPO investor, what's he doing staying in the sell-side research business? Why not just become a private investor and leave it at that?

I've spoken to many analysts about such scenarios and their answers are always the same: "There's disclosure" or "It's legal".

Such responses fall short. What on earth does legality have to do with it? Have we so many lawyers in the world that we've forgotten about common sense?

In many cases, of course, the analysts are doing their jobs -- and good jobs at that. But in cases in which their equity positions have grown unduly large, disclosure has been limited to fine-print legalese at the bottom of reports, and it is the responsibility of news organizations and individual investors to put sell-side research in its proper context.

-- R. Scott Raynovich, Light Reading http://www.lightreading.com

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