Bull!

by Maggie Mahar

  Meanwhile, analysts began upping their estimates: “Goldman analyst Elizabeth Fontenelli raised her 1997 earnings estimate on Sunbeam to $1.45 a share from 90 cents,” Dow Jones News Service reported in November of 1996. “Fontenelli said she’s a ‘true believer’ in Albert J. Dunlap.”11

  Fontenelli was only one of many analysts who upgraded the stock.

  Not everyone swallowed Dunlap’s story whole. In April of 1997, four months after Tice’s second Sunbeam report, Fortune columnist Herb Greenberg quoted Tice’s charges that “the stock is being driven by ‘misunderstood hype’ and by analysts living under the ‘Dunlap spell.’” The headline on his column: “Sunbeam Is Toast.”12

  Two months later, Barron’s published a story that questioned Dunlap’s restructuring and the quality of Sunbeam’s earnings in greater detail.13 Trading at $39, Sunbeam-Oster now fetched more than triple the price it drew a year earlier when Dunlap took the helm. Readers who took either Greenberg’s or Barron’s warning to heart still had time to get out. But buy-and-hold investors—not to mention momentum investors who continued to buy on the way up—would be Osterized.14

  Sunbeam offered a clear case of how too many estimates and too many projections could obscure the few facts that were important. Dunlap’s larger-than-life personality also helped overshadow the company’s story. A West Point–trained former paratrooper begged to be profiled. Not everyone admired Dunlap; his ruthless job-cutting drew fire from many reporters. But there was no question that he was a personality, and “in order to engage people in business, you need personalities,” CNBC’s president Bill Bolster explained. “It’s no longer Sunbeam; it’s Al Dunlap. It’s no longer IBM; it’s Lou Gerstner.”15

  In October of ’97, CNBC would provide a showcase for the Dunlap personality, giving the CEO an opportunity to announce that Sunbeam had hired Morgan Stanley to explore the possibility of a merger, an acquisition, or a sale. Sunbeam’s shares bounced on the news.

  At the end of the interview, Squawk Box host Mark Haines did raise a prickly question: “According to Standard & Poor’s research, cautious investors should steer clear of Sunbeam shares, given the risk inherent in failing to meet rather lofty expectations.” Then he handed Dunlap an easy exit: “I take it that would not be the advice you would give investors.”

  Dunlap’s answer: “It’s total bullshit.” Apparently Haines deemed it a sufficient response. He did not ask a follow-up question.16

  A few months later, charges of accounting gimmickry finally caught up with the stock. In the spring of ’98, Sunbeam was still trading well over $50; by June, the shares had plunged to less than $9 on reports of an SEC investigation. That year, Dunlap was fired. Three years later, Sunbeam declared bankruptcy. A year after that, Dunlap agreed to pay $500,000 to settle SEC allegations that he used improper accounting to produce “materially false and misleading” results while at Sunbeam Corp. Dunlap did not admit to wrongdoing, but as part of the settlement, he agreed to a permanent ban on serving as an officer or director of a publicly traded company.

  Tice pointed out the hole in Dunlap’s story in December of 1996, more than a year before the stock tanked. The irony was that in an Age of Information, Tice’s reports rarely trickled out into the mainstream media. This was not because he was unwilling to share his ideas. Tice was quoted, from time to time, in publications such as Barron’s, The Wall Street Journal, The New York Times, and Bloomberg Personal Finance.

  But at many publications, journalists were warned to steer clear of the shorts. Columnists like Greenberg were the exceptions. “I think it’s easier to use shorts as sources if you’re a columnist than if you’re a beat reporter covering a particular industry,” said Greenberg. “When you’re a beat reporter specializing in an industry, you know management, or you need to talk to the PR people—and you’re afraid of getting frozen out. If you talk to the shorts, and write negative stuff, the company won’t talk to you. In my old days as a beat reporter, in the early to mid-eighties, I was looking for scoops, I was looking to beat the competition, and often you got the scoops from the PR people. So, back then, I needed them.”17

  Even as a columnist, Greenberg took heat for listening to the contrarians. Critics insinuated that he was acting as a “foil” for the shorts. “You’re always going to be accused of being a tool of the shorts,” said Greenberg, “because that’s what people want to think.” He addressed the issue directly in his column:

  “Regarding whether my pans come from professional shorts or my own research: Honestly—usually professional shorts. No secret in that. I talk to loads of short sellers. Their research is usually far superior to longs in the same stock, and they can point me or any other reporter in the direction of the facts the longs have overlooked, usually hidden in public documents. I then take it from there—usually adding my research to theirs. Often, I dig up info even they don’t know. I take tips whenever and wherever I can get them—and then I check them out myself.”18

  “YOU GET WHAT YOU PAY FOR”—WALL STREET RESEARCH

  David Tice’s Behind the Numbers was not the only place where investors could find cutting-edge independent research. Steve Leuthold, the Minneapolis money manager who honed his analytic skills while charting stocks for his army captain in the early sixties, and Peter Bernstein, an author and economic consultant based in New York, each produced in-depth analysis for institutional investors. Other research boutiques flourished around the country, selling their work to a mostly small, elite audience. Sophisticated investors subscribed to newsletters such as Fred Hickey’s Hi-Tech Strategy letter, Richard Russell’s Dow Theory Letter, Grant’s Interest Rate Observer, Marc Faber’s Gloom, Boom and Doom Report, or welling@weeden, a newsletter that began circulating in 1999, featuring interviews with some of the best minds in the financial community.19

  On Wall Street, a small cadre of analysts and market strategists continued to offer insightful commentary. But independent analysts were much freer to throw a spotlight on corporate America’s inflated earnings. By 1996, Fred Hickey, for example, was warning investors about the outlook for companies like Micron Technology, AOL, IBM, and Compaq. Both the consumer and the business market for PCs were approaching saturation, he cautioned, and analysts were lowballing earnings estimates in order to make sure that companies would be able to “beat” the numbers. Later in the decade, Jim Grant would call attention to Cisco’s “imaginative” accounting.20

  Few on Wall Street offered the same combination of critical thinking and forensic accounting. The reason: no one was paying for it. In 1975, deregulation turned the economics of Wall Street research upside down. That year, brokerage commissions were thrown open to competition. For the small investor, this was seen as a boon: discount brokers and low-cost online trading followed.

  But in the past, brokers’ commissions underwrote Wall Street’s research. Mutual fund companies and other institutional investors rewarded brokerage houses that produced the best research by directing their business to those houses—buying the stocks that the firms’ analysts recommended and paying steep commissions on huge orders. With deregulation, commissions fell precipitously. In 1976, brokers had to move an average of $77 worth of stock to earn $1 of commissions; 10 years later, they needed to peddle $216 worth of stock to make the same dollar.21 The firms had to find another profit center.

  In the eighties, investment banking fees from leveraged buyouts, mergers, and acquisitions helped pay the bills; during that span Wall Street firms also began to focus on trading for their own accounts. In the nineties, IPOs propelled profits at many houses. Wall Street’s top firms were no longer in the brokerage business; they were in the “deal” business. And without cushy commissions to line their coffers, they desperately needed that business.

  Small wonder, the analyst’s function changed. Brokerage fees no longer supported the research effort. Inevitably, analysts realigned their priorities: those who helped bring in the business—and place the IPOs with large institutional investors
—drew the top salaries.

  For the individual investor, this change carried enormous implications. On the one hand, he no longer had to fork over steep commissions each time he traded. (This, of course, encouraged more trading, making low commissions a double-edged sword for all but the most nimble short-term traders.) At the same time, he could no longer expect objective Wall Street research designed to help him make the best possible trading decisions. He wasn’t paying for in-depth, labor-intensive stock analysis—and neither was anyone else.

  So analysts like Salomon Brothers’ Jack Grubman focused on becoming experts in an industry: “No one knew as much about telecommunications as Jack,” said one of his colleagues. Even his critics agreed. Grubman knew the business inside out and used his expertise to advise investment banking clients such as WorldCom. His first allegiance was to the companies he covered, and to the mutual fund companies and other large institutional investors who owned large blocks of WorldCom’s shares. As the late-night caller had warned Henry Blodget, these investors did not want an analyst to question the earnings of a company they owned.22 Mutual fund managers had followed WorldCom to the top of the cliff. Once there, they had taken large positions: if Grubman downgraded the stock, they would have no way to rappel safely to the ground without being crushed in an avalanche of selling.

  Looking back on the bull market in 2001, The New York Times’ chief financial correspondent Floyd Norris summed up the shortcomings of Wall Street research: “You Get What You Pay For.” Despite all of the talk about reforming Wall Street’s research departments, “the real problem,” Norris observed, “is money. With commissions on share trading continually falling the money comes from investment banking fees, and the companies that direct those fees want praise, not criticism. Investors who want good research will have to pay for it,” Norris warned. “Until a mechanism is devised to pay Wall Street for quality advice, no new rule is likely to produce it.”23

  Still, the question remains: How much should that research cost, and who should pay for it? Research on many subjects is supported by universities, the government, or private foundations and is disseminated, freely, among interested parties. On Wall Street everything is for sale, including ideas. Yet the notion that the knowledge needed to trade successfully is available only to those who can afford it undermines the notion of a transparent—not to mention a democratic—market.

  INFORMATION AND THE 401(K) INVESTOR

  The sophisticated investors who went off Wall Street to buy the crème de la crème of independent financial research realized that they needed unbiased analysis. “But the average investor didn’t,” acknowledged columnist Herb Greenberg. “Our original goal at TheStreet.com was to level the playing field, but ultimately I think we realized, you can’t give it away. Our company wanted to stay in business.” In 2003, for example, TheStreet.com moved Greenberg’s column from its “RealMoney” website—a site that charged subscribers $225—to “Street Insight,” a site aimed at professionals that charged $2,200. “I said, ‘Why are you moving me?’ I had a larger audience on RealMoney,” Greenberg recalled. “But management had decided that the information I reported was worth more than $225.”24

  This is not to say that there is not some excellent information available, at no cost, on the Net. But because there is so much information online—some of it inaccurate, much of it irrelevant—it is difficult for any but the most astute investor to sort out the gold from the dross. “People will pay for the stuff that’s good,” added Greenberg, “but unfortunately, only the people who know why they’re paying buy it. The average guy doesn’t. He doesn’t understand that it’s a part of the cost of doing business.”

  The average 401(k) investor does not think of himself as being in business, even though in fact he is running a very small mutual fund—his own nest egg. Yet in 1996, the average 401(k) account balance totaled just $30,270.25 The typical individual investor could not afford the cost of buying expensive research, even if the best of it was well worth the price. Nevertheless, “to get really skilled analysis, you have to pay,” insisted Peter Bernstein. “There is no free lunch. A small investor can get access to the Value Line Investment Survey at a reasonable price,” he added, “and it has a very good track record.”26

  Bernstein had a point. While an annual subscription to Value Line cost $598 in 2003—a large sum for an investor trying to decide how to allocate, say, $5,000, to a 401(k)—many public libraries carry Value Line. Still, the question remained: How many investors would make the trip to the library to study Value Line’s recommendations?

  The dilemma underlines the problem inherent in the 401(k)’s basic mandate: do-it-yourself investing. Many investors have neither the time, nor the money, nor the training needed to take advantage of the best research. Of course the 401(k) investor has the option of entrusting his money to a mutual fund, with the expectation that the fund manager will do the research for him. Certainly a mutual fund company running billions in assets can afford whatever research it needs. But this is not to say that the average fund manager is likely to step out of the box to read the challenging, in-depth analysis that someone like Hickey, Grant, or Bernstein offered. Or that he would feel free to follow that advice.

  After all, portfolio managers also lived in a society where most people truly believed that stocks could only go up. Deviations from the conventional wisdom could kill a career.27

  Moreover, even if an individual investor could count on his mutual fund manager to take advantage of the very best research available, the small investor still needed help in picking funds. How much should he allocate to a bond fund? To foreign stocks? To technology? To health care? Within each sector, which funds should he choose?

  MUTUAL FUND REPORTS

  The financial press made every effort to provide the information mutual fund investors needed to make their choices. But despite the reams of paper devoted to mutual fund scorecards, the data did not lend itself to prophecy. No matter how carefully the numbers were sliced, diced, and sifted, it often was difficult, if not impossible, to know what they might mean for future performance.

  Most mutual fund reports focused primarily on the funds’ quarterly, one-year, and three-year returns. Sometimes the scorecard looked back five years, though as one magazine editor explained to a reporter in the mid-nineties, “No one really cares about what happened further back than three years.”

  Yet history suggests that a fund’s returns over three-and five-year periods offer little insight into how it is likely to perform going forward. In fact, a fund’s one-year performance might serve as a better short-term indicator, observed Mark Hulbert: “Funds that own a given year’s top performing stocks have a good chance of outperforming the next year too. It has nothing to do with the manager’s ability. It’s the momentum effect—the wind at your back,” Hulbert explained. “If you had a bunch of monkeys running the funds, the ones that did best for the previous 6 or 12 months would be likely to outperform the next year. But the effect is short-lived; in the third year they would do no better than the average fund. Investing based on a fund’s one-year performance works only if you’re a short-term player.”28

  And of course, when a bull market ends, momentum goes into reverse: the funds that owned the top technology stocks of 1999 were doomed to plunge in 2000.

  “At the other end of the performance spectrum, long-term performance can tell you something about a fund manager’s ability,” Hulbert explained. Just how long a track record is needed to predict future performance? “At 5 years, the predictive value is minuscule,” Hulbert acknowledged. “Based on my own research tracking roughly 160 newsletters, I’ve found that a newsletter’s 15-year record was four times better at predicting future rankings than a record based on just 3 years.”

  Mark Carhart, head of quantitative research at Goldman Sachs, has done extensive research on mutual fund performance, and his work shows that “for your average fund manager, in order to get results that are statistically signif
icant—results that allow you to say with some certainty that his active management has added value to the returns you would have gotten in an index fund—you might need 64 years of data. On the other hand, a 10-year record might be enough for you to say ‘I can’t project statistically that he’s a star, but I feel pretty confident that he’s a star. I think I’ll give him some of my money.’ The problem with past performance,” Carhart added, “is that there is always so much noise in it.”29

  What seems clear is that a three-year record, by itself, is virtually worthless: “It’s too long to capture the momentum effect, and too short to capture the manager’s ability,” said Hulbert. “I think this is one reason why rating services like Morningstar have been so disappointing despite their use of methods that otherwise seem eminently reasonable. Even though Morningstar looks at 3-, 5-, and 10-year returns, they heavily weight 3-year returns. Basically they’ve got the opposite of the sweet spot—they’ve got the sour spot. If they only looked at 10-year performance they would do better. But of course, most funds don’t have a 10-year record. If they limited themselves to that group, they would rate many fewer funds. By focusing on 3-year returns, it seems to me they’ve made a marketing decision [to cover more funds.]”

  Given the inadequacy of 3-year track records, it should not be surprising that Morningstar’s top-rated equity funds have lagged the market by a wide margin. According to Hulbert’s research, after deducting fees, Morningstar’s top-ranked equity funds underperformed the broadest market index, the Wilshire 5,000, by an annualized average of 5.5 percentage points from the beginning of 1991 through May 31, 2002.30