These days, Richard Kelertas, a financial analyst at Dundee Securities,isn’t saying much about Sino-Forest, the beleaguered Chinese forestrycompany at the centre of a fraud investigation by regulators. “I’m notspeaking with the press or anyone, unfortunately,” he says. That isunfortunate, because a lot of investors who followed Kelertas’s adviceto buy Sino-Forest’s shares—either before the company got into trouble,when he insisted Sino-Forest was a “class act in timberland managementin China,” or after, when he called the fraud allegations a “pile ofcrap”—no doubt have a few choice words for him.
The Sino-Forest debacle has the potential to be the biggest stockmarket scandal to hit Canada since the Bre-X gold-mining fraud in themid-1990s. Until June, Sino-Forest was the most valuable forestrycompany on the Toronto Stock Exchange, with a market capitalization of$6 billion. Then Muddy Waters Research, a U.S. investment firm, issued adamning report that claimed Sino-Forest “massively exaggerated itsassets” and is nothing more than a Ponzi scheme. Muddy Waters said itwas short selling Sino-Forest, or betting that the company’s share pricewould plunge. It did. By the time the Ontario Securities Commissionsuspended trading in the stock on Aug. 26 and raised its own concernsabout fraud, Sino-Forest had shed three-quarters of its value.
At this point none of the allegations have been proven. The OSC’saccusations of fraud at the company could ultimately prove unfounded.This still may turn out not to be “Tree-X.” Even so, investors would beright to wonder why a company with the potential to completely collapseon the basis of a single critical report was regarded so highly byanalysts in the first place. Kelertas wasn’t alone in his effusivepraise of the company in recent years. Of the 10 analysts coveringSino-Forest before the Muddy Waters report hit the street, nine ratedthe 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 haveblown it. Again. Wall Street analysts completely missed the frauds atWorldCom and Enron, while closer to home, Nortel’s accountingshenanigans went undetected. In the case of Bre-X, several analystsembarrassingly insisted right up to the bitter end that the company’sBusang 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. Thecredit rating agencies, such as Standard & Poor’s and Moody’s,infamously gave their most-coveted blessing to worthless debt securitiesduring the U.S. housing bubble and played a leading role in deep-sixingthe global economy. (The rating agencies also missed potential problemsat Sino-Forest, slashing their ratings and eventually ending coverageof the company’s debt only after Muddy Waters made its fraud allegationspublic.) As for the economists who accurately foresaw the recentfinancial crisis, they’re as rare as the northern hairy-nosed wombat.
Whether watching the stock market or the economy, those who are paidto figure out what will happen in the future and inform investors haverepeatedly shown they’re unable to get it right. It’s not just that it’simpossible to consistently and accurately predict the future. Financialexperts are saddled with conflicts of interest and psychologicalbaggage 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 aday-to-day basis, though, analysts are still often way off the mark withtheir research. Last year, the consulting firm McKinsey looked at aquarter-century of analysts’ earnings forecasts and compared them to theactual earnings companies eventually reported. The focus of the studywas on sell-side analysts, meaning those employed by brokerage firmsthat 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, andprone to making increasingly inaccurate forecasts when economic growthdeclined.”
The tendency for analysts to be cheerleaders for stocks rather thanskeptics is reflected in the overwhelming number of buy recommendationson stocks, which consistently outnumber sell recommendations by a ratioof nine to one. Last month, after the headphone maker SkullCandy debutedin a US$190-million IPO, six analysts from the firms that underwrotethe 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 toconsider. Earlier this year, Bloomberg analyzed the performance ofS&P 500 stocks since the market bottomed out in March 2009. It turnsout those stocks with the most buy recommendations dramaticallyunderperformed 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 missthem, it’s not clear they share in the pain with investors. In the daysbefore Bre-X was exposed as an utter lie, analysts remained bullish onthe company despite widespread rumours its gold ?nd was a hoax. EgizioBianchini, a mining analyst at Nesbitt Burns, told investors he’d beento the exploration site and testing labs and could vouch for their work.The rumours, he said, were “so preposterous, I am not even going toaddress the possibility.” He added, “The gold is there.” While Bianchiniwas eviscerated by investors and their lawyers when the fraud wasexposed, he retained his job. Just this past April, Bianchini waspromoted to vice-chair at BMO Capital Markets (the renamed Nesbitt Burnsdivision). Meanwhile, other analysts who also defended Bre-X continueto be mining analysts or are directors of mining companies.
None of this explains why analysts can’t seem to get it right. Manyargue it’s because of conflicts of interest. Sell-side analyststypically get paid based on the trading commissions generated by theirresearch, 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 rateworthless mortgage-backed securities by the very investment banksselling the ticking time bombs to investors. “It’s in the interest ofthe financial industry to sell certain products and it’s not in theirfinancial interest to see problems with those products,” says ErmannoPascutto, executive director of FAIR Canada, an investor rightsorganization.
Having said that, Pascutto admits it is the nature of the marketsthat analysts will sometimes get it wrong, even when they act in goodfaith. The potential for errors is just that much greater for analystscovering companies in emerging markets, such as Sino-Forest. “TheCanadian financial industry doesn’t have much expertise in thesemarkets,” says Pascutto, who in the 1990s helped set up the Hong KongSecurities and Futures Commission. For all the visits analysts made toSino-Forest’s operations, language and cultural barriers make itimpossible to do the same level of due diligence as in Canada. “Youcan’t just apply the knowledge you have about a business in a developedeconomy and assume the same rules apply in an emerging market,” saysPascutto.
Aside from all that is the simple fact that analysts and economistsare human beings, plagued by the same psychological biases as everyoneelse. For instance, the herd mentality is a powerful force. Wheneconomists’ models all point to another year of GDP growth, or all theother analysts covering a stock are bullish, taking a contrarian viewwill invariably draw attention, particularly if that contrarian argumentproves wrong. Even those who do stick out their necks are prone toself-defeating mistakes. For a recent paper published in the Journal of Economic Behavior and Organization,John Beshears, an assistant professor of finance at StanfordUniversity, sifted through thousands of earnings forecasts for examplesof analysts who broke from the pack. In cases where their divergentforecasts were proving to be wrong, the analysts were reluctant toadjust their estimates to reflect new data. The more their forecastdiffered from consensus, the more stubborn they became and the more theyescalated 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 theante in the hopes of being vindicated in the long run, even if thechances are they won’t.” Which could explain why analysts are oftenreluctant to admit they missed a fraud. After researching a stockfaithfully for years, admitting there are problems means acknowledgingnot only that you missed them, and unwittingly mislead investors, butthat 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 asaccess to management at companies. So there is value in therecommendations of analysts, but it needs to be viewed with anunderstanding of their weaknesses.
There’s another thing to consider when weighing the quality of thefinancial experts. If they truly believed they knew what the futureheld, 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 WallStreet it’s: “Those who don’t completely trust their own advice, sell itto others.” Having skin in the game is no guarantee for success—thefact that several prominent billionaire investors lost hundreds ofmillions of dollars on Sino-Forest proves that—but it’s much easier todispense advice when it’s other people’s money at risk.
Ultimately, analysts are the storytellers of the financial world, andfor years Sino-Forest was a terrific and exotic story. Until it wasn’t.Investors just shouldn’t have relied entirely on analysts to tell themthat.
source:
https://www2.macleans.ca/2011/09/13/really-bad-advice/