In the Belly of the Beast

This continues an occasional series about the decades of the 1990s and 2000s,
when so much about the investment business changed.

The previous posting in this series (“The Star Analyst Years”) concerned a wild period of time on Wall Street, especially within the stock research departments of the major investment banks.  Norms were broken and a few analysts gained great fame.

That account was from the outside.  In contrast, this one tells the stories of two people who were directly involved.  Personal accounts like these are necessarily biased, but each of them gives a fair representation of the times, albeit in different ways.

Dan Reingold

A 1996 New York Times article called Jack Grubman (whose story was recounted previously) and Dan Reingold “the Siskel and Ebert of telecom investing.”  Mostly focused on their differing views of companies in that sector, the piece referenced their competition to be the best on the Street, but said, “As for their rivalry, Mr. Reingold and Mr. Grubman say they are not obsessed with each other.”

The evidence suggests otherwise.  Emails discovered during investigations of Grubman clearly showed his obsession with Reingold, whose case against Grubman’s methods and mischief was one aspect of his 2006 book, Confessions of a Wall Street Analyst.

As can be inferred from the title, Reingold didn’t spare himself (or the firms he worked for or the industry) from blame, even as he called out Grubman for using inside information from companies to ingratiate himself with investors and to further the interests of his favored companies.

The telecommunications industry

In addition to the cultural changes that were occurring on Wall Street during this time — which are compelling on their own — the telecommunications industry was being transformed, making it a worthwhile case study.

The breakup of AT&T on the first day of 1984 set the stage.  It created the seven Baby Bells as local operating companies, leaving AT&T with long-distance services and a variety of other businesses.  Add in other independent phone companies and there were suddenly different business models and strategies to parse (with more choices coming by way of subsequent acquisitions and recombinations) — presenting telecom analysts with a variety of stories to tell and stocks to push.

The individual analysts got known for their often opposing points of view on the prospective winners and losers among industry clusters and companies.  Changes to their ratings, targets, and buy lists were big news, moving the stocks (and raising eyebrows in situations where it looked like the new opinions were calibrated to bring in investment banking business).

Another factor was the privatization of telecom providers around the globe.  Country after country went that route, again providing the Street with banking fees and the analysts with new narrative possibilities.

Then came the internet explosion, suddenly opening up new opportunities to telecom equipment manufacturers, firms laying cable and fiber, and independent telecommunications startups, who were rolling up capacity as fast as they could get investors to finance it.

A sell-side analyst’s role

Reingold recounted those developments and — our focus here — captured what it was like to be a prominent sell-side analyst in the middle of it.  There were benefits:

I’d lived the lush life, traveling on private planes around the globe, eating in the finest restaurants, and sitting in front row seats at World Series games, US Open championships, and Madonna concerts.

But it was mostly a grind.  (For example, those visits to foreign lands to win the privatization deals were often just a few hours on site and lots of travel time in between.)  All the while, everyone was lobbying you:

There were the bankers wanting bullish opinions on their client companies and institutional investors wanting the price of their stock holdings to go up.  There were the hedge funds, many of which bet against certain stocks, hoping for negative calls from analysts.  There were the in-house traders and retail brokers pushing for calls that made stocks rise or fall and therefore generated lots of commission-generating trades.

And then there were the pressures from the company executives themselves.

Those pressures started from day one:  “The first visit to a public company is a weird combination of brownnosing and shoe-leather detective work.”  From then on, you had to play nice — including having favorable opinions — to get the best access, to be able to ask questions during earnings calls, and to have the CEO show up at your gala conference for investors.

Maintaining that balance was hard.  “The analyst’s job, it turned out, was a lot more complicated — and personal — than simply writing reports and rating stocks.”  As the pace quickened and the demands intensified, the analysis part started withering away.  Reingold struggled with that:

I hate what this job has become, I thought.  Everything is rumor, leaks, and guidance.  Is anyone doing primary research anymore?  Am I?  Not really.

Relatively early in his career, MCI stock dropped five percent one morning, with no obvious news that might have caused it.  When he called the company, he was told that the CFO and director of investor relations “are in Boston today, visiting investors.”  The first stop for companies was always Fidelity, the most important investment firm of the era.  That day, it was clear that those in the meeting didn’t like what they had heard, and they had an opportunity to sell before others got the company’s altered guidance.

While Regulation FD is supposed to take care of such selective disclosure now (although there are doubts about whether it really does), it was an accepted way of getting the word out.  The same thing happened when companies dealt with analysts; the favored ones got updates first, rather than everyone finding out at once.

“The power of the poll” was an ever-present concern.  That is, the naming of the Institutional Investor All-America Research Team, voted on by institutions (although not all did, providing some smaller entities that were known to vote with attention that they otherwise wouldn’t have received).  Contacting clients regularly and entertaining them were mostly jobs for a firm’s salespeople, but analysts were expected to do so too.  (The “power of the poll” is greatly diminished these days, but all of this still applies to a lesser extent.)

The unwinding

The banking conflicts were the most pernicious.  Reingold blamed the escalation in those conflicts to the SEC willingly looking the other way, citing a 1997 story about Grubman in which the SEC enforcement chief said, “There are no hard and fast federal laws that say you can do this and you can’t do this.”

The SEC also provided cover later that year by sending a No-Action Letter to Merrill Lynch that allowed analysts to issue opinions on stocks when their firms were involved in pending deals, something previously not allowed.  (That No-Action Letter has gotten little mention over the years; Reingold saw it as pivotal event that led to many of the abuses to come.)

While the conflicts were getting greater, the mania for the stocks was growing, and (as always happens), the research was getting sloppier.  A common thread with other booms that turned to busts also became evident:  The promises of the companies (and the analysts covering them) were out of line with the real fundamentals — and soon the reported numbers were being goosed by a range of accounting shenanigans to fill the gap.  Then it all fell apart.

Reingold came in “as an idealist and left a cynic”:

I was burnt-out, exhausted, and depressed about the current state of affairs.  I’d been both very right and very wrong in my career, but my industry was in a shambles, thanks to a potent mix of overcapacity, underwhelming demand, and good old-fashioned fraud.

He offered a long list of recommendations as to how to reform sell-side analysis (which by and large haven’t been implemented).  He ended the book with the admonition that

for people who don’t have access to this inner sanctum, Wall Street is not a game at all.  It’s deadly serious, and it’s rigged against most of its participants — everyone but the few with a seat at Wall Street’s special tables.

Andy Kessler

A much different book, Wall Street Meat, describes Andy Kessler’s adventures as an analyst (and then a hedge fund manager) during the same time.  It’s shorter and punchier.

When Kessler first interviewed for a job on Wall Street, he tried to convey that his technical expertise in electrical engineering would make him a good consultant for those doing stock research at the firm.  The response:  “We don’t need no stinkin’ consultants.  We need an analyst, someone to follow the semiconductor industry.”  (That was very much the approach then and even today, which involves trying to turn subject matter experts into analysts, often unsuccessfully.)

On his first day, he was introduced to others in the research department, including a person with whom he was to spend quite a bit of time, “This is Jack Grubman, our hot telecom analyst.”  As Kessler wrote, “It was the start of a very wild ride.”

Like others getting into the business, he figured it would be more formulaic than it actually was.  He was told that “there is no real answer of how to value stocks.”  It was about how the numbers hung together as part of the story to be told — and about the current mindset of investors, how myopic or expansive their vision was at any point in time.

He figured out that for an analyst “the trick to longevity is picking a theme that can last a decade and finding new little spins on it.”  One chapter title summed it up, “You’re in the Entertainment Business.”

Many of the ideas and themes of the Reingold book (he makes a cameo appearance in this one too) were told in a more, well, entertaining fashion by Kessler:

It was that stupid I.I. poll.  Get ranked.  Get votes from the buy-side.

Affectionately known as “dialing for dollars,” analysts are required to call the top 100 institutional accounts once a month.  This is tracked, put into a database, and correlated against results.  Bizarre, but all of these highly paid, highly qualified industry experts spend over half their time calling places like The First Bank of Neenah monthly because someone once heard that they vote in the I.I. poll.

There are (sometimes withering) portraits of well-known market players and the salesmen who prove the point that “Wall Street is infatuated with athletes.”  Of special interest are the buy-siders, like the Piranha, who “chews up and spits out every analyst who comes into his office.”  And those who really knew their stuff:  “It was exhausting, but when you were done, you either held your own, or needed to go back and rework your thinking.”  Much of it, though, could be like “the Metroliner special,” a thirty-hour mandatory marketing trip through the mid-Atlantic.  (Get ranked.  Stay ranked.)

Kessler captured the times and the characters.  And the conflicts.

Beholden to the companies for information, analysts could easily be played.  Kessler relayed the story of a Microsoft analyst meeting where it talked down estimates (no doubt to make it easier to beat them).  One by one the analysts left to call their firms to get the word out.  The stock went down.  Kessler happened upon Bill Gates and Jon Shirley outside the room later, “laughing as hard as they could.”  Gates said, “What suckers.  This is too much fun.”

But the big conflicts were building within the investment banking firms themselves.  The battle between analysts and bankers “would play out again and again on the Street.  The bankers usually won.”

That intensified as the most common question in the business became, “How do you play this Internet thing?”  As the old saying goes, the ducks were quacking and it was time to feed them.  A frenzy ensued.

Leaving the Street

In 1996, Kessler left to co-found a hedge fund.  He was out of the confines of the sell-side analyst role, but not out of the frenzy.

There was a “Pavlovian response.  Bring deal — trade up.”  The momentum pulled in all kinds of investors, but one group stood out above all the others in their willingness to play the game, to throw caution to the wind:

Momos didn’t care.  They quacked and quacked.  The more hot IPOs they bought, on the deal and for months after they went public, the better their performance.  The better their performance, the bigger the ads they could run in the Wall Street Journal and they more money they would take in.  They just needed more deals to feed into their insatiable machine.

Then the machine went into reverse, despite the visions of a glowing future proclaimed by analysts and companies.  In early 2000, CEO Naveen Jain said, “I predict that Infospace will be the first company ever to have a one-trillion-dollar market capitalization.”  (Kessler pointed out that it was $300 million three years later.)

After the stocks got hit hard that spring, Henry Blodget (covered in the first posting in this series) said the downturn was almost over and talked about the bind he was in:

You’ve got to understand.  If I stop recommending a stock, and the shares keep going up, there is hell to pay.  Brokers call you up and yell at you for missing more of the upside.  Bankers yell at you for messing up their relationships.  There is just too much risk in not recommending these stocks.

At every level, expectations were out of whack.  So far out of whack that there was much more damage to be done.

Kessler also offered perspectives on being a hedge fund manager.  For example, “Trading with the Street is a perilous activity.  It is easy to get ripped off.”  Also, if your numbers are good, people are going to show up at your door, wanting to throw large amounts of money at you.  Some of them are unsavory characters.  (Don’t take it.)

Looking back

Just like Reingold, Kessler did some soul searching:

Everyone on Wall Street gets these “What is this all about?” moments or “Why am I doing this?”  The deep types even ponder, “What does this all mean?”

On one hand it means everything.  Wall Street is where capitalist rubber meets the road.

On the other hand, no matter what your specific job is, I can guarantee you that it doesn’t mean anything.  You are a cog, a pawn, a foot soldier.

Would he do it again?  “Yes, in a heartbeat.”