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Garbage In, Garbage Out

Thanks to Eliot Spitzer, we now understand that the bad boys of Wall Street -- research analysts -- fabricated buy recommendations to line their pockets. Encouraged by investment bankers who controlled their paychecks, these Pinocchios often times recommended a stock only to be quoted -- via email no less -- as saying these same stocks were laughable "dogs" unfit for investment consumption.

No question that telling lies and sucking-in trusting investors is not a good thing. But would it have made a difference if research analysts never bent their opinions at the behest of their employers? What is the alchemy of producing these millions of pages of company reports with the accompanying billions of pieces of fundamental data generated? Is it worth the sacrifice of all those trees chopped down to produce the paper it's printed on? In search of an answer, let's look at the process.

Analysts, with annual reports staring them in the face, typically find the easiest way to streamline the confusing process of building an earnings model is to phone corporate executives at the companies they follow. After all, who better to guide them through the land of market share, growth, margins, competitive analysis than the horse's mouth? These execs, eager to please and to PR their brilliance, are more than happy to provide the analysts "target earnings"-under the rubric of "guidance." The analysts take this input and then pretend to crunch numbers that invariably confirm these target earnings. With a straight face, researchers tell their bosses and the investing public that the confluence of management guidance and this number-crunched earnings model is coincidental.

For over a decade, nobody seemed to care that company management either manipulated or arrived at this number through the convention of "pro forma" earnings. And if the advertised number was in danger of being missed -- despite massaging (manipulating) the earnings numbers during the quarter -- the analysts were supplied "profit warnings" or "revised targets" from CEOs and CFOs. Ever mindful of their responsibility, Wall Street analysts dutifully passed on to their clients, as if it were something they discovered on their own, these revisions. In such instances, institutional clients might receive upwards of two dozen broker emails from competing investment banks, each passing along this hot news, each sounding as if it were an exclusive to their firm. If nothing else, it kept portfolio managers from having to tune in to CNBC where the information was also being announced as "breaking news."

That's not to say that research isn't a creative endeavor, however. It certainly is. How else could one understand the genius of pro forma earnings? In a nutshell, here's how pro forma works: company X has problems making anywhere near enough money to justify its stock price. No problem. Let's assume that certain costs weren't included (or revenues were unduly impacted by an exogenous event, so we'll add them back) and see what earnings would have been. Low and behold, if you back out certain costs, earnings go up-and for good form, claim these costs were non-recurring even if they seem to pop up each and every quarter. Yippy! Company X not only made their number, but, through the magic of pro forma, may have even exceeded that number by a penny. A penny a share! For years, that penny was reason enough for the stock price to gap up. And nearly everybody is happy: the analysts claim brilliance, executives get rewarded, and, for a time, investors feel rich.

Then one day, a group of spoiled sports comes along and says: "Hey, you research guys aren't adding any value. In fact, I bet you don't really believe any of that bull you're spouting."

As a result of a brewing scandal, stocks go down. Smiles turn to frowns and the eyes of ambitious regulators narrow. Emails are subpoenaed and-surprise, surprise--we find a conflict of interest (no matter that this conflict of interest has been ongoing for decades, there for everybody to see). We discover, unequivocally, that sometimes analysts did manufacture a happy face for stocks they really didn't like, calling them "dogs" and "pigs" in supposed secrecy. But is that the whole of it? What of all the stocks in which analysts simply bought into management's mantra? After all, that's all the research 90% of these millionaire analysts did. When they said, "Company X is a screaming buy!" more often than not they had convinced themselves it really was. "No earnings? No business plan? Pimple-faced management? No problem. The company has great expectations. How do I know? Management said so and here's the pro forma analysis to prove it."

And had the trend continued, who knows? We might have seen pro forma earnings eventually back out such items as cost of goods sold. Now that might have really justified some fancy share prices.

The point is: much of Wall Street research involved no nuts and bolts analysis to begin with and recommendations weren't worth the paper and ink it took to print them up. So what did it really matter if analysts believed that a given piece of research was bogus-and we have the smoking-gun email to prove that it was bogus--or that the research was simply lousy by the very nature of how Wall Street research (or lack-of-research) is conducted?

Let's face it, investors are going to get nailed in either event. No getting around the fact that when there's garbage in, there's bound to be garbage out. And separation of banking and research may end the obvious conflict of interest, but what will it do for the fact that even sincerely stated investment opinions, when worthless, are still worthless?

And all those poor, dead trees. It's a crying shame.