Putting shoe leather to asphalt

If you want to rile Steve Sakwa, pose the following question: “Are analysts too close to the companies they cover to put ‘sell’ ratings on stocks?”

Sakwa, a director and senior REIT analyst at New York-based Merrill Lynch & Co., bristles at the suggestion. Merrill Lynch has “sell” ratings tagged to two companies right now — clients of the firm no less, Sakwa points out. “This stuff never gets out into the paper because that's not sexy,” he said.

To Sakwa's chagrin, what has been getting into the papers lately are questions about the reliability of securities analysts. Analysts are presumably neutral observers paid to dispense investment advice to brokers and investors about companies they follow. Their recommendations, positive or negative, can move stock prices dramatically. And perhaps the greatest source of potential conflict for the analyst is that most of them work for firms that make much of their money from investment banking — advising large companies on acquisitions and other strategic moves, underwriting stock and bond offerings. Thus, there is concern that analysts go easy on companies in hopes of securing their investment banking business. Finally, questions have arisen about analysts owning stocks and, therefore, writing glowing reviews of those companies in order to inflate their own portfolios.

For those reasons, and because of the wild run-up and subsequent plunge of share prices in the late 1990s and 2000, analysts have come under increased scrutiny from regulators.

The Securities and Exchange Commission last October adopted Regulation Fair Disclosure (Reg FD), a rule that requires publicly traded companies to release information to all investors at the same time. Traditionally, companies frequently clued-in favored analysts first about earnings projections, for example. Now, they can't.

In part because of the new SEC rule, two major brokerage firms — Credit Suisse First Boston and Merrill Lynch — in July announced policies prohibiting stock and bond analysts from owning securities in companies they follow.

What's more, the U.S. Justice Department is conducting a criminal inquiry into how investment banks doled out shares in initial public stock offerings (IPOs) during the late 1990s. At that time, newly public stocks, especially tech shares, often rocketed in their first days of trading, making it highly lucrative to obtain the shares at the IPO price, before that price soared. Securities regulators are also investigating whether Wall Street firms sold new stocks to big investors who promised to buy more shares after the stocks started trading.

Other questions hover over analysts: Why so few “sell” ratings? Are they afraid of being shut out by executives at the companies they follow? Are they encouraged to simply cheerlead for a company to help their firm land lucrative investment banking business? Do analysts sometimes even try to pump up the prices of stocks they or their firm own?

Ezra Zuckerman, an economic sociologist and assistant professor of strategic management at the Stanford Business School in Stanford, Calif., has conducted a study that adds a new twist to the debate. Zuckerman concludes that Wall Street analysts seldom issue “sell” recommendations not only because they fear being cut off by the companies, but also because they fear appearing out of step with their peers.

Poking back

So Sakwa and his fellow analysts have been getting poked at plenty. Ask him about it, and he pokes back.

Sakwa points to Spieker Properties, a company that has been acquired by Chicago-based Equity Office and which Merrill Lynch did not do business with but consistently rated highly in research reports. “It's easy to paint with a broad brush and say analysts aren't independent,” Sakwa said. “I would beg to differ, substantially. We here are very independent, and I think the record speaks for itself.”

The issues of potential conflicts of interest within investment banking firms are complicated. But there are a couple of elements most can probably agree on, said Ross Smotrich, managing director and REIT analyst at Bear Stearns in New York. First, there should not be a conflict between the stocks an analyst recommends publicly and those in which he invests. Second, there should be a wall between research and banking. Conceptually, that's easy to follow.

“The implementation is more difficult,” Smotrich explained. “Some analysts do not buy the stocks or sectors they follow because they don't want to compromise their analytical integrity or independence. On the other hand, some buy-side clients do like to see the analyst invest in the stocks he is recommending, thereby putting their money where their mouth is.”

While both arguments have merit, the real point is that good, fundamental analysis is inherently independent, said Joel Gomberg, who follows real estate operating companies for Chicago-based William Blair & Co.

“We pride ourselves on in-depth, independent research,” Gomberg said, “going out, talking to as many people as we can, and drawing our own conclusions and not just listening to what management has to say.”

That's what a good analyst does. And while, of course, not all analysts are created equal, those who follow the real estate industry have improved as the industry has matured, Smotrich said. The real estate industry as a part of the public stock and bond markets is still relatively young, as most publicly traded equity REITS didn't emerge on the scene until the 1990s.

“This might sound self-serving, but I would say just as the management teams themselves over the last several years have matured, so too has the analytical community,” Smotrich added.

Many executives of public real estate companies who climbed the industry ranks as private real estate operators have learned how to handle the demands of communicating with the varied constituencies of a public company, Smotrich said. Likewise, many of the REIT analysts have now been at their craft long enough to have refined their methods.

Consider the source

Real estate company executives and fund managers interviewed for this story — professionals who work with analysts regularly and feel the effects of their reports — generally say skepticism about analysts is healthy. Be mindful of the conflicts at work in investment banks — the tension, for example, between independent reporting about companies and courting underwriting and merger and acquisition advisory business from those same companies — these industry players say. But, the executives and fund managers are quick to add, the existence of these tensions hardly means analysts are mere pawns.

Thomas Corcoran, president and CEO of FelCor Lodging Trust, a publicly traded REIT based in Irving, Texas, said that big securities firms disclose in their comments and reports whether they have banking relationships with companies their analysts cover. The point, he said, is to be aware of an investment firm's various motivations. But don't automatically discount what an analyst says just because his or her employer has other relationships with a company the analyst follows.

“You won't, for example, ignore your doctor when he tells you you need to get cut open, even though you might say he's just doing it for the money,” Corcoran said.

Likewise, Kim Redding, a former portfolio manager with the Chicago-based RREEF Funds, says the overriding point concerning the advice of analysts is to know where they are coming from.

“You just have to recognize where the various pressures are and what their job is,” said Redding, who is investing his own money and preparing to launch a new venture. “None of the good buy-side players (investors) rely solely on Wall Street analysts.”

Moreover, it's important to remember that analysts are human. Analysts covering real estate companies are dealing with executives who run those companies. And everyone will like some management teams more than others, said Andrew Davis, president and portfolio manager of The Davis Funds in New York, which manages $40 billion, $600 million of which is invested in real estate. Securities analysts, he said, are no different, and will therefore sometimes get too close to companies they cover.

Furthermore, there's no question it's difficult for analysts to slap a “sell” recommendation on a stock, said Davis, a former analyst himself with Paine Webber. Still, he observes that when analysts are seriously down on a company, they convey that message in their reports, even if they don't often flat-out recommend that investors sell a stock.

“If you do more than screen for just a ‘sell’ versus a ‘buy’ rating and you actually read, I think you can hear pretty clearly what the tone of the analyst's interpretation of the company is,” Davis said.

And in most cases, Davis believes, analysts are bringing real value to the marketplace. “I hesitate to be overly critical because good sell-side analysts are purveyors of information. And in the real estate industry, there are a lot of very good analysts who disclose great amounts of information,” Davis said. “And that, I think, is a very important service.”

Reg FD: make 'em work

Beyond questions of independence and ethics, Reg FD might make the analyst's job tougher. If everyone gets the information at once, and thus the investing public need not turn to analysts for golden nuggets of intelligence, how does the analyst add value? Some believe a democratization of information will force analysts to work harder to justify their jobs. Others say the job really won't change much, at least for quality analysts who have built their reputations on being thorough.

Then there's also a view that Reg FD is causing companies to simply clam up and disclose less information. This reaction could hurt analysts by cutting off the flow of intelligence, but could make it easier for them to uncover hidden nuggets about markets or companies because less information is available to the marketplace at large.

Even if management teams go silent, the conscientious analyst still goes about his business much the same way, Sakwa said. Now that the real estate market has softened and deal flow has slowed, analysts have more time to delve deeply into acquisitions and individual industrial or commercial developments.

“Whether management wants to talk about it or not,” Sakwa says, “our job is to still go out, analyze and assess which office markets look healthy and which don't; which apartment markets look healthy and which don't. And we do that whether management is talking to us or not.”

This new environment potentially makes analysts' views even more important, Gomberg argues. “If you can do the field research, talk to as many operators in the business as possible and know your business well, you can identify trends and earnings issues before they might occur,” Gomberg continued. “And so there's the opportunity to add value.”

True enough, agrees Corcoran of FelCor. Good analysts will continue doing what they've always done — dissect information about public companies and put it in perspective in terms of the broader industry and a particular company's prospects. The better analysts are those who, after conference calls or other broad disclosures, follow up with detailed questions, Corcoran said.

Reg FD won't necessarily change the fact-finding process. What it's changed at FelCor, according to Corcoran, is that the company no longer briefs analysts after the stock markets close about an announcement to be made the next day. “Now we wait until the press call,” Corcoran said. “With technology today, all shareholders can listen to the same calls. And actually, I think it's fairer.” Fairer, but it makes the job of the analyst a bit more difficult, he added.

Redding agrees. Whereas before the existence of Reg FD, analysts could simply call management teams to obtain the information they need, now they really have to work, he said. On the one hand, information is more widely available than ever, largely thanks to the Internet and the explosion in financial news and chat. That's unlikely to change. On the other hand, Redding observes, a lot of public real estate firms have basically clammed up in the wake of Reg FD, rather than risk saying too much at the wrong time.

“Analysts are scratching their heads and saying, ‘What's my job and what's my turf now?’ ” Redding said.

But these changing dynamics — more information at large but more reticent companies — can also work in favor of intrepid analysts, Redding figures. “You can do work and find out things through legitimate sources that others don't know.”

Going forward, the likely value from the analysts, Redding said, will be superior insight into universal trends, or to “put shoe leather to asphalt” and see first-hand what's happening with particular projects in particular markets.

If analysts already do that kind of conscientious work, they've little to fear from Reg FD, said Davis of The Davis Funds. There's no question that management teams now must be exceedingly careful about what information they discuss with analysts between quarterly earnings conference calls. Specific questions about how revenue is shaping up for a quarter, or whether expenses are moving up or down, have always been difficult for management, Davis said. Regulation FD makes them “pointedly more difficult.”

By contrast, Davis said, executives can still comfortably discuss strategic, longer-term issues, such as returns on capital and the re-investment of cash flow. “If you've always counted on management to bump and grind your quarterly numbers, I think you're going to have a little trouble” because of Reg FD, Davis said. “If you've talked to management about the business … I don't think you're going to feel that much of an impact.”

In any case, more forward-looking, truly analytical work will probably best serve analysts now and in the future, Davis said. “Publish or perish” was the mantra of analysts when he was one of them, Davis recalled. And he points out that the most interesting reading is often not about minor adjustments in projected earnings per share, but rather reasoned predictions about where companies and the broader real estate market are headed.

Assessing analysts' advice

For analysts, the bottom line is, of course, the bottom line. Do they help investors make more money? Blanket generalizations are difficult, obviously. But in a 1999 study, Maureen McNichols, an associate professor of accounting at Stanford University, examined what would happen if investors strictly followed analysts' advice, buying stocks they recommended and shorting issues they shunned.

McNichols and her team analyzed the average recommendations of equities analysts across various industries between 1986 and 1996. First, the authors found that analysts were in fact good at picking stocks and created profits for investors. The researchers found that an investment strategy based on the average recommendations of securities analysts yielded an annual return 12% higher than a benchmark like the Standard & Poor's 500.

A second finding might bode well for analysts' value in a post-Reg FD market. The academics, according to Stanford's Web site, found that a lot of the extra value delivered by analysts came from small- and medium-sized companies for which information was not as widely available. That would indicate that securities analysts have historically done a good job at ferreting out helpful information about more obscure companies.

Ergo, putting shoe leather to asphalt apparently pays off.

All things considered, the life of the real estate analyst is unlikely to bring the mainstream fame of Internet analysts like Morgan Stanley's Mary Meeker or former Merrill Lynch analyst Henry Blodget. (Actually, their fame has become something closer to infamy). At the same time, Davis points out, stock and bond analysts who follow more traditional industries like real estate or timber don't have to worry about companies becoming obsolete overnight.

“Sanity was challenged in 1990, 1991 when real estate companies and real estate owners were going bankrupt by the handful. Every industry has its moment,” Davis said. “I just think real estate in the future will have fewer moments” than more volatile industries like information technology and telecommunications.

Charles Davidson is an Atlanta-based writer.

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