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Conflicts in 'Independent' Research


It's important to not let the entertainment value of this particular case get in the way of reality.


With the question of independent research grabbing headlines and fingers pointing each and every way, let's not lose sight of the larger picture: Research is in just as much trouble now as it was prior to Eliot Spitzer's last crusade against conflicts.

I wish two more respected companies other than Biovail and (OSTK) were on the front lines of this battle against conflict-laden research. It's too easy for critics to laugh and write the whole thing off as so much smoke and mirrors to distract investors from a company's fundamental problems. I do not deny it is true that companies who squawk the loudest about short sellers are often those where short sellers have struck close to the truth.

But let's be absolutely clear here for the sake of the investor education mission that Minyanville is founded upon: Big funds skew research opinion every day, just like investment bankers skewed research opinion before the Spitzer settlement.

In the last year, nearly every analyst I've spoken with admits off the record to greater and greater pressure from their trading desk to align their research opinion with major institutional client positions. This pressure probably always existed, but it takes on new importance since the post-Spitzer business model has the analyst's only remaining source of pay coming from the trading desk.

I've never met an analyst who publishes fundamental research who hasn't gotten "The Call" from some very large hedge fund. "The Call" usually works in one of two ways for those of us who are independents:

1. We were thinking about subscribing to your research, but your view on [insert company here] makes us think twice. I want to pass you to our lead internal analyst on that company to see if he/she can change your mind.

2. Would you be willing to work with our internal analysts to create reports on specific companies? We'd pay extra for that.

Neither of those two scenarios may seem particularly problematic unless you happen to be in our business. When you're on the other end of the phone, as I have been more than once, you instantly know you're not in for a friendly exchange of ideas. You're in for the hard sell.

Depending on your response, you're setting yourself up to be a pariah, or you take the first step down the slippery slope to find yourself in the same boat Gradient finds themselves in now.

If you're lucky, the voice on the other end of the phone is just testing you. They want to see if you can be bought. If you prove you cannot be bought, they might even become subscribers. Luckily for me, that's happened once or twice. The alternative, which we've also experienced, is not much fun.

I know I am more sensitive to these issues than most. I also know that makes me an easy target for those who like to joke at my expense about how I'm a paranoid newbie to the market. That's OK with me. Really. Most people who believe that about me were never in my target market anyway. They're more interested in being fed whatever is in line with their current book, judging their research providers and market commentators by how often they agree with their pre-determined view of the world.

There are two reasons why I'm more sensitive to these issues than most: First, my business partner Alan Leong and I created our company in 1999 as a reaction to the badly conflicted research we saw being pushed down the throats of investors. 1999, please recall, was pre-Spitzer. Too many "independent" shops were anything but, serving to do nothing more than provide an easy way to make money by front running their picks.

I can remember when I wrote my first diatribe on how conflicted research was due to investment banking conflicts. I was called a paranoid heretic and actually lost a couple of subscribers (even though we were making them money hand over fist). Now everyone accepts that conflict as fact. I'm confident that someday they will accept the conflict that 60 Minutes described.

The second reason is I work in a very narrow corner of the market where the number one trading rule is to follow the psychology. It's impossible to accurately value the companies we cover. Compounding this odd fact is all these companies are beholden to the markets for their very survival because of their need to constantly raise cash. Finally, these companies are small in market cap and float and are easy to move around.

This is, in other words, exactly the type of trading environment where conflicted research can thrive. And yes, I do see it nearly every day.

Research is in just as much trouble now as it was just prior to Eliot Spitzer's crusade against banking conflicts. In fact, I firmly believe that Mr. Spitzer went after the wrong conflict. Our market would be in much better shape if he had erased the conflicts between research and the trading desk. It's much harder for the average investor, who bears the brunt of this deceptive practice, to see than the conflict between bankers and analysts.

What I find most intriguing about this issue is the people who were the most vocal about the banker/analyst conflicts (short sellers, generally) are the most vocal that there is no conflict between the trading desk and research analysts. When the research analysts were goring their bear due to banker-conflicted research, they made a big deal about how real and damaging these conflicts were.

Now that the shoe is on the other foot, the tune has changed. When the research conflict goes their way, they argue there is no conflict. "Don't look behind this curtain," they seem to say, "nothing to see over here."

That didn't work well for the Wizard of Oz and, I suspect, someday it will quit working for those people who are willing to skew their research to the whims of the trading desk or for "special" deals for favored clients.

We're all adults here in a high-pressure environment. It's important, for the sake of the investor education mission we have here at Minyanville, to not let the entertainment value of this particular case get in the way of reality.

Just because the research is negative, doesn't mean it is not laden with its own kind of conflicts.

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No positions in stocks mentioned.

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