Really Bad Financial Advice?
These days, Richard Kelertas, a financial analyst at Dundee Securities, isn't saying much about Sino-Forest, the beleaguered Chinese forestry company at the centre of a FRAUD investigation by regulators. "I'm not speaking with the press or anyone, unfortunately," he says. That is unfortunate, because a lot of investors who followed Kelertas's advice to buy Sino-Forest's shares--either before the company got into trouble, when he insisted Sino-Forest was a "class act in timberland management in China," or after, when he called the fraud allegations a "pile of crap"--no doubt have a few choice words for him.
The Sino-Forest debacle has the potential to be the biggest STOCK MARKET scandal to hit Canada since the Bre-X gold-mining fraud in the mid-1990s. Until June, Sino-Forest was the most valuable forestry company on the TORONTO STOCK EXCHANGE, with a market capitalization of $6 billion. Then Muddy Waters Research, a U.S. investment firm, issued a damning report that claimed Sino-Forest "massively exaggerated its assets" and is nothing more than a Ponzi scheme. Muddy Waters said it was short selling Sino-Forest, or betting that the company's share price would plunge. It did. By the time the Ontario Securities Commission suspended trading in the stock on Aug. 26 and raised its own concerns about fraud, Sino-Forest had shed three-quarters of its value.
At this point none of the allegations have been proven. The OSC's accusations of fraud at the company could ultimately prove unfounded. This still may turn out not to be "Tree-X." Even so, investors would be right to wonder why a company with the potential to completely collapse on the basis of a single critical report was regarded so highly by analysts in the first place. Kelertas wasn't alone in his effusive praise of the company in recent years. Of the 10 analysts covering Sino-Forest before the Muddy Waters report hit the street, nine rated the stock a "buy" or "outperform," while just one considered it a "hold," according to Reuters.
No one should be surprised that the financial experts seem to have blown it. Again. Wall Street analysts completely missed the frauds at WorldCom and Enron, while closer to home, Nortel's accounting shenanigans went undetected. In the case of Bre-X, several analysts embarrassingly insisted right up to the bitter end that the company's Busang claim in Indonesia really was the world's biggest gold deposit, even in the face of evidence it was a sham.
Bungled analysis isn't unique to equity analysts, of course. The credit rating agencies, such as Standard & Poor's and Moody's, infamously gave their most-coveted blessing to worthless debt securities during the U.S. housing bubble and played a leading role in deep-sixing the global economy. (The rating agencies also missed potential problems at Sino-Forest, slashing their ratings and eventually ending coverage of the company's debt only after Muddy Waters made its fraud allegations public.) As for the economists who accurately foresaw the recent financial crisis, they're as rare as the northern hairy-nosed wombat.
Whether watching the stock market or the economy, those who are paid to figure out what will happen in the future and inform investors have repeatedly shown they're unable to get it right. It's not just that it's impossible to consistently and accurately predict the future. Financial experts are saddled with conflicts of interest and psychological baggage that can warp their research. The sooner investors realize this, the better off they'll be.
Frauds and financial meltdowns are, thankfully, quite rare. On a day-to-day basis, though, analysts are still often way off the mark with their research. Last year, the consulting firm McKinsey looked at a quarter-century of analysts' earnings forecasts and compared them to the actual earnings companies eventually reported. The focus of the study was on sell-side analysts, meaning those employed by brokerage firms that help bring new companies to the stock market. McKinsey found that, year in, year out, sell-side analysts were "typically over-optimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined."
The tendency for analysts to be cheerleaders for stocks rather than skeptics is reflected in the overwhelming number of buy recommendations on stocks, which consistently outnumber sell recommendations by a ratio of nine to one. Last month, after the headphone maker SkullCandy debuted in a US$190-million IPO, six analysts from the firms that underwrote the offering all labelled it a screaming "buy."
It's too bad that analysts don't issue more sell recommendations, because those are actually the stocks investors might do best to consider. Earlier this year, Bloomberg analyzed the performance of S&P 500 stocks since the market bottomed out in March 2009. It turns out those stocks with the most buy recommendations dramatically underperformed stocks that analysts disliked the most. In other words, it can pay to do the opposite of what analysts say.
The thing is, when frauds do happen and analysts completely miss them, it's not clear they share in the pain with investors. In the days before Bre-X was exposed as an utter lie, analysts remained bullish on the company despite widespread rumours its gold ?nd was a hoax. Egizio Bianchini, a mining analyst at Nesbitt Burns, told investors he'd been to the exploration site and testing labs and could vouch for their work. The rumours, he said, were "so preposterous, I am not even going to address the possibility." He added, "The gold is there." While Bianchini was eviscerated by investors and their lawyers when the fraud was exposed, he retained his job. Just this past April, Bianchini was promoted to vice-chair at BMO Capital Markets (the renamed Nesbitt Burns division). Meanwhile, other analysts who also defended Bre-X continue to be mining analysts or are directors of mining companies.
None of this explains why analysts can't seem to get it right. Many argue it's because of conflicts of interest. Sell-side analysts typically get paid based on the trading commissions generated by their research, so it's in their interest to encourage people to buy a stock. In the case of the credit raters, S&P and Moody's were paid to rate worthless mortgage-backed securities by the very investment banks selling the ticking time bombs to investors. "It's in the interest of the financial industry to sell certain products and it's not in their financial interest to see problems with those products," says Ermanno Pascutto, executive director of FAIR Canada, an investor rights organization.
Having said that, Pascutto admits it is the nature of the markets that analysts will sometimes get it wrong, even when they act in good faith. The potential for errors is just that much greater for analysts covering companies in emerging markets, such as Sino-Forest. "The Canadian financial industry doesn't have much expertise in these markets," says Pascutto, who in the 1990s helped set up the Hong Kong Securities and Futures Commission. For all the visits analysts made to Sino-Forest's operations, language and cultural barriers make it impossible to do the same level of due diligence as in Canada. "You can't just apply the knowledge you have about a business in a developed economy and assume the same rules apply in an emerging market," says Pascutto.
Aside from all that is the simple fact that analysts and economists are human beings, plagued by the same psychological biases as everyone else. For instance, the herd mentality is a powerful force. When economists' models all point to another year of GDP growth, or all the other analysts covering a stock are bullish, taking a contrarian view will invariably draw attention, particularly if that contrarian argument proves wrong. Even those who do stick out their necks are prone to self-defeating mistakes. For a recent paper published in the Journal of Economic Behavior and Organization, John Beshears, an assistant professor of finance at Stanford University, sifted through thousands of earnings forecasts for examples of analysts who broke from the pack. In cases where their divergent forecasts were proving to be wrong, the analysts were reluctant to adjust their estimates to reflect new data. The more their forecast differed from consensus, the more stubborn they became and the more they escalated their commitment to their erroneous forecast.
"People are reluctant to admit their mistakes and move on," he says. "An analyst is likely to try to justify their past actions by upping the ante in the hopes of being vindicated in the long run, even if the chances are they won't." Which could explain why analysts are often reluctant to admit they missed a fraud. After researching a stock faithfully for years, admitting there are problems means acknowledging not only that you missed them, and unwittingly mislead investors, but that all that time and effort was wasted.
This all presents a dilemma for investors. For all their faults, analysts can tap information regular investors could never get, such as access to management at companies. So there is value in the recommendations of analysts, but it needs to be viewed with an understanding of their weaknesses.
There's another thing to consider when weighing the quality of the financial experts. If they truly believed they knew what the future held, they'd most likely have launched their own fund to act on it. Similar to the idiom, "Those who can't, teach," on Bay Street and Wall Street it's: "Those who don't completely trust their own advice, sell it to others." Having skin in the game is no guarantee for success--the fact that several prominent billionaire investors lost hundreds of millions of dollars on Sino-Forest proves that--but it's much easier to dispense advice when it's other people's money at risk.
Ultimately, analysts are the storytellers of the financial world, and for years Sino-Forest was a terrific and exotic story. Until it wasn't. Investors just shouldn't have relied entirely on analysts to tell them that.
Maclean's September 19, 2011