The one thing I am certain of after 20 years of dealing with Wall Street analysts, including 14 years of being one, is that the investing game is played on a very uneven field. Information flows at different speeds, often unfairly — and sometimes even illegally. I am equally certain that the “reforms” that followed the bursting of the tech and telecom bubbles did little to change that: You and your clients will rarely, if ever, be in the inner circle that obtains market-moving information before it is publicly disseminated.
Let's face it: Those in the inner sanctum — corporate insiders, favored analysts and select institutional investors — will always have better and more-timely information. Thus, they will be steps ahead of the vast majority of investors. I fear the “insider game,” as I call it in my forthcoming book, Confessions of a Wall Street Analyst (HarperCollins, 2006), is still played every day. This is despite high-profile government investigations (including those by New York Attorney General Eliot Spitzer) of Wall Street research and Regulation Fair Disclosure, the 2000 SEC rule that was intended to end selective disclosures.
Some might believe that cases brought against notorious analysts Jack Grubman and Henry Blodget or the $1.4 billion “global” settlement that Spitzer exacted from the top Wall Street firms had made the rules clearer and cleaned up the mess. But, I think that is mistaken. Take Martha Stewart. She went to Camp Cupcake for obstruction of justice; she was not charged with criminal insider trading, which remains a murky area and difficult to prove, especially among big players. Also, Spitzer chose to settle with Grubman and Blodget (and their employers) for multimillion-dollar fines that were minor compared to their boom-time salaries. So, we'll never get a clear read on exactly where they went wrong and whether our laws, regulations and sanctions are sufficient to deter such behavior in the future.
Trials could have answered some important questions, such as whether analysts like Blodget and Grubman acted on their own or followed a script written by their bosses? The trials also might have helped establish what constitutes “independent research” and if firms are obliged to furnish it.
Spitzer's reforms have helped, at least temporarily, to insulate research departments from the overt influence of investment bankers and corporate executives. But, the inherent conflict of interest in Wall Street's business model remains in place. Wall Street firms serve two client types — issuers of securities and investors in securities. They collect fees from both sides.
Unfortunately for investors (and advisors), Wall Street firms make more money, a lot more money, from banking — underwriting securities, restructuring businesses and advising on M&A. Even the $1.4 billion in fines paid by 10 Wall Street firms were small when compared to the roughly $80 billion in profits made by these firms over the bubble years. So when conflicts arise, as they do virtually every day, the temptation remains to put the interests of the issuer first. And remember that sell-side analyst bonuses are still paid from pools that include investment-banking profits. So while the settlement and associated NASD reforms preclude the direct tying of an analyst's bonus to specific banking deals, analysts still have a good sense of where their bread is buttered.
The settlement has brought about rigorous internal compliance and surveillance systems — to the point where a banker cannot talk to or have lunch with a research analyst unless chaperoned by an attorney. But these reforms don't eliminate conflicts. At some point, the chaperones go away. And analysts and bankers will find ways to connect, like at their children's soccer game, which I did (see Confessions). The kind of information that really moves a stock will always travel first to people in the inner circle. Now that I am on the periphery, I see that even more clearly.
And as long as this is the case, it seems to me, individual investors (and their advisors) should forget about picking individual stocks; they can crunch the numbers, study the trends and dissect the businesses, but they can't get the information that the pros do — not in time to exploit it, at least. Better to focus on asset allocation and invest in index funds or broad-based mutual funds. It's not good to have so many unanswered questions after a scandal and its investigation. But we do, and thus those of us not in the inner circles of Wall Street should be ever vigilant as a result. That's why I wrote my book.
Writer's BIO: Dan Reingold is author of the forthcoming Confessions of a Wall Street Analyst: A True Story of Inside Information and Corruption in the Stock Market (HarperCollins, on sale Feb, 7, 2006). He was a top-ranked Wall Street telecom analyst from 1989 to 2003, first at Morgan Stanley, then at Merrill Lynch and Credit Suisse First Boston. He is currently project director for telecom finance at Columbia's Graduate School of Business. Write to him at [email protected].