Article Shows That Sell Side Analysts Still Suck

An article entitled "Behavioural Bias and Conflicts of Interest in Analyst Stock Recommendations" published in the Journal of Business Finance & Accounting examines these issues:

"Whether sell-side analysts are prone to behavioural errors when making stock recommendations as well as the impact of investment banking relationships on their judgments. In particular, we analyse their report narratives for evidence of cognitive bias."

The conclusions:

"New buy recommendations on average have no investment value."

I think everyone already knew that, although I would add that in the short term they can drive the price of a stock up.

"Whereas new sell recommendations do, and take time to be assimilated by the market."

Again, fairly logical since sell side sell recommendations are fairly rare, they are likely to be more noticed.

"We also show that new buy recommendations are distinguished from new sells both by the level of analyst optimism and representativeness bias as well as with increased conflicts of interest."

Just as a review, representativeness bias refers to "A cognitive strategy for quickly estimating the probability that a given instance is a member of a particular category. We use it to judge the likelihood that something or someone belongs to a specific category."

"Successful new buy recommendations are characterised by lower prior returns, value stock status, smaller firms and weaker investment banking relationships."

Small Cap Value stocks with little or no analyst coverage rule.

So what does this all prove? That sell side analysts are humans just like the rest of us and suffer from deviant investment behavior despite what is arguably a higher formal education.

Mokoaleli-Mokoteli, Thabang, Taffler, Richard J. and Agarwal, Vineet,Behavioural Bias and Conflicts of Interest in Analyst Stock Recommendations. Journal of Business Finance & Accounting, Vol. 36, Nos. 3-4, pp. 384-418, April/May 2009. Available at SSRN: http://ssrn.com/abstract=1400370 or DOI: 10.1111/j.1468-5957.2009.02125.x

A Typical Energy Cycle

The Energy Sector is inherently cyclical and a typical cycle moves in this fashion (beginning at the top):

1. Companies are flush with cash due to great pricing, and/or high commodity prices. Earnings and price momentum is also superb, and everyone is happy. Most companies can't decide what to do with the excess cash - dividends, stock buybacks?

2. Customers begin letting rig contracts roll over as high day rates and service costs cause exploration to be less economical. Smart money starts to exit positions, while the economy weakens a little bit and demand for the commodity drops due to high prices.

3. Rig utilization and day rate declines start to show up in official reports as capital budgets of customers are cut back due to a further drop in commodity price, possibly due to an unexpected dip in demand. Smaller Exploration and Production companies cut back almost immediately as cash flow decreases. The larger independents swear that they will "drill through the downturn." Integrated oil companies adopt a wait and see attitude due to more diversified cash flows, secure balance sheets, and a more disciplined capital program. Stock prices begin to flatten and even decline in some cases.

4. Sell side begins marketing push to prop up stock prices in the sector during conference season, claiming that "valuations are compelling."

5. Stock prices weaken materially as the sell side begins to cut earnings estimates and commodity price assumptions.

6. Extra supply of oil or natural gas hits the market due to the high level of drilling activity in the preceding 12-24 months. Commodity price weakens further, leading to another round of estimate cuts. Stock prices “fall off the cliff.”

7. Sell side throws the towel in on the sector.

8. Utilization and day rates plunge as contracts rollover and are renewed at lower rates or not at all. Industry starts “cold stacking” rigs. Majors begin cutting capex budgets.

9. Commodity prices bottom and industry bumps along the bottom for six to twelve months as malaise sets in over industry. Drilling falls to an all time low. Late cycle companies (international and construction) see earnings peak.

10. Commodity prices begin to strengthen as demand recovers and little supply is added due to a lack of drilling.

11. Rigs begin to be put back to work again as cash flow improves. Day rates and utilization inches up.

12. Debate erupts as sell side breaks into two opposing camps: (1) Time to invest or (2) Is it too early?

13. Cycle is in full upswing as more rigs are put back to work which leads to increasing day rates for drillers and pricing power by service companies. Commodity prices strengthen further.

14. Majors begin to announce increases in capex budgets.

15. Companies start to beat earnings estimates, and momentum money gets into the stocks.

16. “Boom” mentality takes over in the industry. First articles are circulated claiming “we are running out of oil and/or natural gas.” Alternative energy companies begin to get a lot of press and attention.

17. Federal government announces “Energy Policy.”

18. Go to number 1.

So the two questions I have are - Where are we now in the cycle? And is it different this time?

Why I Hate EBITDA - Part III

The street has slowly shifted over time to using Enterprise Value to EBITDA (EV/EBITDA) as a measure of valuation for a stock. The ostensible reason given is that EV/EBITDA takes into account the entire value of the firm. The real reason is that since so many companies are unprofitable, there is no "E" to put in the price to earnings formula. Wall Street had to come up with another measure to use.

So what is wrong with EV/EBITDA? It gives a false sense of cheapness – I can still hear the voice of the sell side analyst ringing in my ear

"The stock only trades at 5 times EV to EBITDA – my god that’s cheap."

But is it really cheap. Here are two companies, which one do you think is cheaper?

Company 1

Mkt Cap $ 60.0
Bond Value $ 40.0
EV $100.0
EBITDA $ 13.0

EV/EBITDA 7.7

Company 2

Mkt Cap $ 60.0
Bond Value $ -
EV $ 60.0
EBITDA $ 6.0

EV/EBITDA - 10.0

Well come on Eric, you say to me, the first one is cheaper you idiot. Well look again below.

Company 1

EBITDA $ 13.0
Interest $ 8.0
Free Cash $ 5.0

Price to FC 12.0

Company 2

EBITDA $ 6.0
Interest $ -
Free Cash $ 6.0

Price to FC 10.0

It doesn’t really matter what the EBITDA is because we all know that what really matters is the cash a business produces after it reinvests to maintain its business.

Don't be fooled by EBITDA. Wall Street hates you. Don't ever forget that their job is to separate you from your money.

Why I Hate EBITDA - Part I

I said in a previous post that I was convinced that there is a special place reserved in hell for EBITDA, and that one day, God willing, it will be there. I just wanted to write a little on why I believe that.

First, for those that don’t know the term – EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is used as a measure of financial performance by much of Wall Street. So why does it belong in Hell? It has many problems that are never talked about by the financial media or those who use the term.

EBITDA is calculated before interest is paid, so it gives an artificial view of the financial strength of a company. Analysts and managements love using this number, they usually put it in the headline of a press release. After that they can't leave it alone - it has to be "adjusted." How? Usually to exclude some expense that management found inconvenient.

However, at the end of the day, bondholders do need to clip their coupon every six months and get paid. Unless, of course, they were talked into buying a covenant lite or pay in kind bond.

You can bet that Worldcom and Enron had positive EBITDA...right up until the end.

The Death of Liquidity – Part I

Liquidity…it’s Wall Street’s excuse for everything. Why does the stock market keep going up? Liquidity. Why do real estate prices keep going up? Liquidity. Why haven’t we had a significant correction in months? Liquidity. Why do the skirts of CNBC anchorwomen keep getting shorter? Liquidity.

Recent articles in the financial press represent an obituary for this pesky little word that has come to mean so much to so many people.

The Wall Street Journal, reported today that Wall Street investment banks are having trouble placing debt to finance the latest round of private equity buyouts. They even had to extend bridge loans with their own capital since bond investors seem to have finally realized that covenant lite and toggle bonds are dirty words.

Will the end of liquidity knock out one of the legs that are propping up this market? Time will solve that mystery. Could it be that it is not really the death of liquidity, but just investors demanding a higher yield for the risk that they finally realized they are taking?

I am a Moron

Here is a cautionary tale of what happens when you ignore illiquid and micro cap stocks, and your investment philosophy. Two years ago I was researching banks and I stumbled across the Pink Sheets web site at

http://www.pinksheets.com/index.jsp

It was a particularly slow day at where I used to work, so I figured why not? I’ll waste a few hours and have a laugh.

After clicking through the site I found the listings page for all pink sheet listed banks. I was stunned to find that there were so many bank stocks that trade off the main exchanges – there were literally hundreds of banks listed here. So I decided to pick one at random. Well it wasn't really at random, it was one in Atlanta, which is nearby where I live so I figured I would take a look at it. It was the North Atlanta National Bank (NANB). It traded both on the OTC Bulletin Board and the Pink Sheets.

It was selling at $10.00 a share, but there was very little news or financial reports on Bloomberg about it. So I dug some more and I found that they had a web site where they post shareholder reports. The bank had a single branch in Fulton County, Georgia. This is a northern suburb of Atlanta that is growing like a weed. I dug further. The loan and deposit growth was unbelievable – a compound annual growth rate of more than 100% since 2000. They were well capitalized.

And then the bombshell hit – its tangible book value was $9.03. I did a double take – was this a misprint? Fast growing, well-capitalized banks don’t sell at tangible book value. So I checked at the government web site where the banks file their call reports, and it was confirmed. So there it was, a fast growing, safe bank selling at slightly over tangible book value and what did I do? Absolutely nothing. I didn’t buy it. It wasn’t liquid enough I said. Its market capitalization was only $10 million. There wasn’t that warm cuddly feeling of being surrounded by other investors. There wasn’t some sell side analyst around to make me feel safe at night while I owned it.

I kept it on my screen though and watched it the next two years. It only traded twice a month but every time it traded it seemed to go up a buck or two. I lost track of it for a while, and the next time I looked it was at $17, and then $22 a few months later.

Then on June 29th, 2007, my nightmare reached a climax as I saw the headline – Shinhan Bank America to acquire North Atlanta National Bank at $23.44 a share. A South Korean bank looking for a foothold in a fast growing American city had bought it.

So what’s the point of all this? There are hundreds of other Pink Sheet and Bulletin Board Stocks out there in Banking and other industries that are being ignored by most mainstream investors. If you do this you will reduce your opportunity set immensely. There are some great stocks here so don't be a moron like me. They are hard to trade sometimes, but if you are a long term investor that shouldn't be a worry.

A great investor once said that there is a lesson to be learned in every mistake and I think I learned from this one.

Top Sell Side Clichés

So I worked on the buy side for nine years and like all buy side people, I read my fair share of sell side research reports. After a while, they all began to blur together into an unending mass of paper. I noticed that there was a common set of terms or cliches that all the analysts used. Here is my list and my spin on them

“Management gave an upbeat presentation.”

Well, what the hell else are they going to say?

“The session was well attended.”

The herd is stampeding into the room so what are you waiting for.

“The meeting was constructive.”

Another confidence boosting cliché designed to whet our appetite for the stock.

“We are cautiously optimistic.”

This is used when something bad is about to happen but the analyst can't do anything about it except watch.

“Valuation is compelling.”

This cliché is for classic value traps that are cheap because they should be cheap, or for highflying stocks that are selling at ridiculous valuations, but look cheap compared to their peers or history. (i.e. a technology stock trading at only 40 times earnings)

“The company is hitting on all cylinders.”

A vehicle hitting on all cylinders means it is going pretty much close to its fastest speed. If you apply this to a stock, doesn’t that mean it’s time to sell?

“We view the deal as positive.”

Is there ever a deal that is not positive to them?

“We still like the company.”

A disaster has just occurred but I can’t change my opinion in writing because the company will kill me.

“Long-term fundamentals are still intact.”

Used primarily for companies where it is so obvious that fundamentals are declining, along with the stock price, but the analyst must still say something positive about it so the company will still talk to him.

“At the margin.”

I’m not sure where to put this because I don’t even know what the hell it means. It seems to signal that whatever follows is really not all that important but is incremental news. Well, if that’s the case, then why mention it at all.

“We believe the company is at an inflection point.”

An inflection point is a point on a graph at which the sign changes concavity or curvature. That means the stock can go either way.

“The company has reached the sweet spot of the cycle.”

Just the time to sell, so change your rating before the stock goes down 60%.

“No new news”

Terrible news has just come out on a stock and it is selling off but the analyst is trying to convince anyone who is listening that the market already knew this.

“Our thesis is still intact”

Ninety-five percent of sell side analysts don’t have a thesis so stop pretending, you’re not fooling anyone.