Monday, March 31, 2008

Credibility crisis on Wall (and Dalal) Street

The recent near meltdown of the American economy & the demise of a few financial institutions has put the spotlight on Wall Street analysts. Many are questioning their credibility. And it is not baseless.

Bear Sterns, a casualty of the sub-prime crisis, earned a ‘buy’ rating until barely a few weeks before it went belly up. Something similar was the case with quite a few companies that crashed, but the analysts on the Wall Street failed at them too, in the process losing a lot of money for a lot of small investors.

The big investors aren’t hurt much; they have hedged their investments sufficiently & have diverse portfolios, besides having access to a lot of inside information. But it’s the small investors that lose a lot of money in a downturn. Often these are ordinary folks with day jobs & trying to make an investment for a profit so they can see their savings swell (sooner than other means of savings). They do not have sufficient funds to invest freely; they often have to sell other stocks to buy good stocks, in the process losing out on stocks they ought to have held on to longer. Money poured in by the small players is their own savings or borrowings from friends & family.

Many times analysis means nothing. Case in point being Blackstone. Last year, this company was turning healthy profits every quarter, yet the share price kept sliding down. How can a company doing well see it’s share price drop? The reason is the big investors. In collusion, they drive the share price down, when it goes down sufficiently enough, the start buying copious amount of shares driving up value, in the process killing all the small players. The smaller ones are usually driven by financial news, quarterly reports, analyst guidance & their own research. They do not have access to information & people that the big folks have, hence are at a disadvantage.

CEOs are equally guilty of not communicating the truth to their stakeholders. The Bear Sterns CEO publicly claimed there was nothing wrong with the company. Yet, barely a week later we heard news of it’s sale. Was it because of his ignorance of the situation inside, or was it pressure from Wall Street, we may not know. The CEOs have to heed to Wall Street, it being their biggest source of funds. The pressures of making profits quarter over quarter are high & companies are judged on this basis. This drives the companies to seek ‘innovative’ ways of making money, every quarter. New plans & strategies are devised to keep the investors on Wall Street happy & they can sometimes lead to bad decisions in the long run. Business is governed by Wall Street. This was evident during the early 2000’s when many corporations went bankrupt yet hid that fact by innovative accounting & the current situation in the US.

How effective are the analysts on Wall Street anyway? Most of the times, they are driven by making a quick profit. Contrast that with revered investors like Warren Buffet. When asked what his style of investing was, how he was different from Wall Street, his reply was simple. Buffet believes in long term. If he sees value in a company or a sector, he invests in it & sticks with it. He has patience, which is severely lacking in Wall Street.

It’s hard to believe nobody saw the sub-prime meltdown coming. There were smart fellows shouting their lungs out, but they lost. I guess Goldman Sachs & Lehman Brothers were among the smart ones. Unfortunately, they were a minority.

No comments: