Book excerpt: “Backstage Wall Street”, by Josh Brown | FT Alphaville

Book excerpt: “Backstage Wall Street”, by Josh Brown

FT Alphaville pal Josh Brown, who blogs as The Reformed Broker, just released his first book, Backstage Wall Street. Here we present a two-part excerpt from Chapter 16, “Tales from the Sell-Side”. The first part describes the moment Josh realised that brokerage analyst research was “a giant joke”, and the second part offers his analysis of why.


Part 1

It is the morning of June 12, 2007. My business partner Paul and I are at the NASDAQ MarketSite in New York City’s Times Square sipping Jamba Juice smoothies and waiting for the festivities to begin.

The event we’re there for is the first annual Jamba Juice Analyst and Investor Day presentation. The newly public Jamba (JMBA) is going to trot out its slate of executives who will outline the strategic goals of the company for the first time since its backdoor public offering as a special-purpose acquisition company.

Between Paul and me and a handful of other brokers at my firm, we are long $5 million worth of the stock for both our clients and ourselves. My personal account and my IRA are drowning in Jamba Juice stock; you could suck my portfolio up with a straw.

It was an exciting retail concept with mega-expansion potential and a product that I truly loved; I was buying the stock with three hands and visiting the city’s 19 Jamba locations every chance that I got.

The lines were out the door that summer from Union Square to the Upper East Side, and things were looking good. The stock was selling at an all-time high that morning; it was trading around 11 bucks a share, and we had been buying it from as low as 7.

There were a handful of midtier investment banks and brokerages covering the stock, most of them with price targets in the high teens. We were going to be rich.

The presentation room at NASDAQ is filled with hedge funders, shareholders, journalists, restaurant industry people, and, of course, brokerage firm analysts. The presentation began with some opening remarks from the newly appointed CEO, an ex-Burger King executive named Paul Clayton.

And he is just terrible. Clayton has the personality of a bag of sand, and he kind of looks like one too. The problem is that he is supposed to be the face of a company that wants to be seen as a “healthy lifestyle brand that transcends the smoothie business.” He is bald and paunchy and speaks so haltingly that I want to finish his sentences for him.

My friend Paul looks at me with one of those “what the f ∗ck?” expressions, but I smile. “Don’t worry. The vice president of product development is up next, he’s going to be killer!” Paul and I walked in hoping that this presentation would result in bullish coverage from the big firms like Citi and Merrill. Clayton’s so boring we’re now worried that some of the existing coverage might be dropped!

Somewhere between the CFO’s presentation and some remarks from Jamba’s chairman, Steve Berrard (of Blockbuster Video fame), we pause for an intermission. Paul and I rush over to a window overlooking that giant five-story electronic wall display of stock quotes at the heart of the NASDAQ’s headquarters.

We see shares of JMBA changing hands at around $10, down 8 percent or so from the open. Paul wants to go smoke 11 cigarettes and then walk in front of a crosstown bus. I convince him to stick around for the Q&A portion of the event.

We take our seats, and the girl with the microphone tells us to raise our hands if we want to ask a question. And that’s exactly the moment that I figured it all out. That’s the moment I had finally gotten it through my thick head that believing Wall Street research would never, ever work for my career or my clients.

I realized that it was all a giant joke and that guys like me were unknowingly delivering the punch line with every pitch.

The first question is asked by the guy from Rochdale Securities with the highest price target on The Street, 18 bucks a share. I forget the exact wording of the question, but it was something along the lines of “Why is Jamba so awesome?” If I’m not mistaken, there may have even been some light applause as he asked it among the bullish faithful in attendance.

The next few questions were about the potential rollouts of new smoothie flavors or muffins or some sh*t. This nonsense goes on for an hour while the stock continues to drop; it is now under 10 according to a stolen glance at someone else’s BlackBerry. Paul’s face is turning pink, and I feel like a total jerk.

And then something truly bizarre happens. One of the hottest girls I’ve ever seen in my life stands up and introduces herself to the room before asking her question. She is an eruption of blonde hair and self-confidence and Louis Vuitton in a room full of middle-aged, faceless male banking drones.

Her name is Nicole Miller Regan, an analyst from the firm Piper Jaffray. When she begins to speak, the entire room is paying rapt attention to her every word.

The only thing cuter than her face is her voice; it is at once girlish and authori- tatively serious; we are in a trance, and some of us are in love. Nicole’s “question” for management turns out to be more like a statement of support; she also mentions that she is “very excited” to be covering the company.

Ms. Regan had just come off a year in which she was ranked “No. 1 Stock Picker” by StarMine, related to her restaurant-sector coverage in 2005. Her buy recommendation carries weight given her track record along with the fact that Piper is the biggest firm covering the stock so far. We go back to the office willing to over- look the lackluster showing by Jamba’s executives along with the weakness in the stock that day. After all, if Nicole loves it, how could anyone disagree?

Jamba will spend the next three years-and-counting breaking every investor’s heart within reach. There will be a crop freeze in which the company cannot secure enough oranges later that year. Then there’s a national bee shortage (I kid you not) that threatens the rest of the fruit supply chain. Next there is a hepatitis C outbreak at one of the company’s storage facilities, which results in a massive recall and several customers in California being infected and hospitalized.

Clayton will resign, as will almost every other executive who “presented” to us at the NASDAQ that day.

Virtually all the company’s hedge fund shareholders, including Paul Tudor Jones, will liquidate their holdings, crushing the stock as millions of shares are dumped relentlessly and regardless of price.

Then California’s entire economy falls off a cliff as every square inch of the state is foreclosed on and 12 out of 10 residents file for unemployment— kind of a bummer considering half of Jamba’s stores are located there. The strategy of building company-owned stores nearly bankrupts the company, and it begins refranchising these locations at a furious pace.

The one thing that never changes as the stock trades from $11 to $0.50 a share is Piper Jaffray’s buy recommendation. Piper Jaffray has a buy rating on the stock all the way down, even if Regan’s commentary does get less and less “constructive” on each successive iteration.

The brilliant and beautiful Nicole Miller Regan is now a managing director and senior research analyst at the firm (according to the company Web site). I have no idea how her other recommendations have done over the years, but I have her to thank for the fact that I’ve never listened to a brokerage firm analyst since then.

Nicole, if you’re out there and reading this, congratulations on the promotion and thanks again. You may have literally saved my career.


Part 2

There are many vestigial organs and appendages on Wall Street, but the most hilarious ones are the massive sell-side research departments of the brokerage firms.

While our appendixes and tonsils are a mere annoyance that must be removed when they act up, brokerage firm research is more like our coccyx, the remnant of a lost tail we haven’t had use for in quite some time.

Like these biological structures, which have lost all meaning and function through evolution, brokerage analysts are regarded with a near-universal disdain, both in the eyes of the public and within the firms themselves. They exist now primarily for the name recognition their research breeds; having analysts covering stocks has devolved into a form of brand-awareness advertising for the firms’ other operations.

After decades of disappointment, the buy-side has inexorably shifted toward a preference for boutique or in-house research as opposed to the same old ambiguous ramblings from bulge bracket brokers.

According to the Bureau of Labor Statistics (BLS), there were 250,600 financial analysts employed in 2008, many of whom worked at financial institutions in New York. I can vouch for this personally; you can’t swing a Yankee Stadium hot dog around without splattering mustard on one. The same BLS report found that “47% of financial analysts worked in the finance and insurance industries, including securities and commodity brokers, banks and credit institutions, and insurance carriers.”

The agency is forecasting 20 percent growth for the financial analyst profession over the 10 years ending 2018. This would mean the addition of 50,000 new analyst jobs for a total head count north of 300,000. I think the folks at the BLS are smoking opium with that estimate, but as we have learned, they are fortunate enough to be in a position where they can pretty much make up any stats they want. Perhaps they’ll be right after all.

The presence of so many professional stock market forecasters employed at Wall Street firms is a triumph of marketing over any kind of actual mastery. We are constantly assured that brokerage firms have done their “channel checks” and their “discounted cash flow analysis modeling” on the companies they follow, but it has consistently not mattered in the aggregate.

We are told that the analysts have their “boots on the ground” and their “ears to the street” in all the various metrics they watch; yet their upgrades and downgrades seem to come consistently after the fact. For these reasons, the brokerage firm analyst has steadily morphed from rock-star egghead to bought-and-paid-for grifter to oft-ignored object of ridicule in the esteem of the public.

Wall Street’s analysts have always been under the microscope to some extent, as mocking the accuracy of their countless calls makes for an easily written article that readers enjoy digesting. And for researchers, the premise that Wall Street predictions are worthless in the aggregate is almost too delicious to abandon for very long. If you run a Google Scholar search, you’ll find more than 500 papers on the efficacy of financial analyst research. It seems as though many academics delight in nothing more than repeatedly picking over the brokerage analyst corpse every chance they get.

There are other ingredients in the sell-side misery stew to be aware of.

Big pools of professionally run assets (like endowments, retire- ment funds, and money management firms) have learned the hard way that in a bear market the brokerage firm analysts won’t get them out and in a bull market their ratings are worthless as everything moves higher. After several embarrassing episodes, buy-side firms have spent more and more of their budget on internal research and analysis.

In addition, the hedge fund manager has become the dominant market participant of our era. Although hedge funds manage a relatively small amount of total investment dollars (somewhere above $1 trillion), their methods and tactics are the envy of the buy-side, and this includes the way they select stocks and other investments. The majority of hedge funds are paying a cut-rate 1 penny per share when they trade with the brokerage firms versus the 3 to 6 cents that most institutions used to pay.

Hedge funds tend to have very little use for the research reports that brokerage firms are trying to sell them, and so why would they pay a premium execution price on their trades? As industry-standard commission rates for institutional brokerage mimic the revolution we saw in retail brokerage, it becomes very hard for the wirehouses to support a cadre of analysts that no one is listening to.

The Internet certainly hasn’t helped matters either. It is upending the primacy of the Wall Street analyst just as it has with every corner of the economy it’s touched since the mid-1990s. With the rise of social media and the blogosphere, opinionated experts from fields as varied as finance, health care, technology, and energy can weigh in with estimates and hypotheses of their own with virtually zero barriers to entry.

With so much distrust surrounding the stock rating process, investors began adopting another type of research that completely ignored balance sheet metrics and earnings statements. As markets sped up, traders began looking for a way to cut out all the wasted time and get right to the analysis of the only thing that paid them at the end of the day: price. “Only price pays” became the mantra, as technical analysis became the new religion of the speculator and the hobby of the amateur.

This wave of acceptance for technical analysis, which began in the early 2000s, was in some way a rejection of the squishier art form of listening to conference calls and meeting with company executives. There was a time when this kind of access and familiarity gave the analysts at the brokerage houses an edge that was worth something to their customers. But technical analysis stripped them of this edge, as it is entirely rooted in mathematics and pattern recognition.

Anyone can look at any chart; there is no fee to be paid at the door or secret handshake required.

These days, there are as many market practitioners using technicals as there are adherents to the fundamental approach. The net result of this has been a more level playing field and yet another reason to tune Wall Street analysts out.

Between research going in-house, technicians capturing more mind share, and trading commissions shrinking to nothing, brokerage firm analysts now find themselves under siege and in danger of extinction.

The irony is that just as brokerage firm research is hitting its nadir in popularity and influence, its actual results are improving in a meaningful way! If only people were paying attention …

Barron’s and Zacks Research do a semiannual survey of “focus lists” of the major brokerage firms. They measure how these stock picks have done versus each other and the overall market. Over the last four of these surveys, picks from the brokers have actually beaten the market on average. Even more encouragingly, for the five-year period ended December 31, 2010, the brokers’ picks returned an average of 14.89 percent versus only 2.29 percent for the S&P 500.

Now for many reasons, the individual investor following these picks would not have the same results. When a broker buy recommendation comes out in the premarket, the stock does not open flat with the prior night’s close; it usually opens higher. The buyer of that stock on the open of trading is already behind the curve. But still it’s nice to know that The Street’s legions of stock pickers are a step above the old “thousand monkeys on a thousand typewriters” cliché.