Wednesday, November 16, 2005

Stretching It Thin

There is a tenuous but symbiotic relationship between a bold and persistent securities analyst and the bold, persistent speculators and investors who heed his advice. And at it's most bizarre, it resembles a James Dean-like games of "chicken" where two cars proceed in head-on directions to each other, with the loser being the one who veers off first. The difference in the game of chicken between the analyst and sympathetic investors is that the winner is typically the one who bails out first.

In the Shangri-La world of the "perfect market" such dilemmas rarely arise. The analyst there, is unbiased, prescient, and if it weren't for the salary that he was drawing, one might even venture that he was altruistic. And in that magic kingdom, the investor has access to infinite liquiidty at a price, and has nothing more to do than to placce his bet, and wait for the spin of the wheel which will decide whether he is a living legend or a schmuck. He is pitting his wits against the invisible hand of the multitude of faceless investors, all with their fingers on the trigger ready to make a rational investment decision on the turn of a price.

[Camera Fade from the paradise of Shangri-La, to the Labrea Tar Pits, replete with flames, bubbling and oozing black slime]. Now back in the real world, companies pay analysts based upon commission revenue generated and possibly upon banking and advisory fees earned. And investors certainly can't access sufficient liquidity at a price. In fact, the price moves when Fidelity or Cap Research even LOOKS at a stock. In the Labrean tarpits, contrary to economic theory (particularly in Japan), much stock has no elasticity of supply. Whether the shares are held for strategic purposees, in trust, for control purposes, or whether capital gains may simply be "too large" to realize, supply is far more insensitive to price than modeled or poipularly believed. Then there are the umteen trillions of dollars to invest, which in combination with the aforementioned, are ever-tempted "to cheat" by using one's investors money to move the price of a security a great distance from its starting point in the generally desired direction.

So far so good. At this stage, not only isn't there a conflict of interest between the analyst and the investor, but there is a genuine alignment of interests. This is the symbiotic part where an investor, having acquired a position in a company, benefits from favorable analyst reports and comments, and the analyst benefits from the investor's subsequent market impact of more more shares at higher prices, thereby enhancing the analysts reputation for timeliness and prescience. At this point it is important to say that both the analyst and the investor are better off if "the story" is not completely fabricated, and has a modicum of plausibility, be it a rising earnings or revenue trend, new product(s), the spectre of product price increases or increasing market share, hidden value, etc., something than can be pointed which engenders hope and expectation. Failure to heed this important point typically results in both critical inverstor and analyst casualties. So long as the analyst doesn't transgress this point, his toolkit is virtually unlimited. He can claim a stock is cheap to its growth, cheap to itself, cheap to its history, cheap to similar securities, that it possesses unique growth qualities, better management, increasing sympathy to shareholders interests. And as things get whackier, he can even make comparisons to the most ludicrous of peers in an attempt to justify a rising price in the future. For this is what is required for the financial equivalent of Pax Romana, a prerequisite to keeping those commission dollars rolling in.

This may go on for many months. The analyst reiterates his "buy" recommendation, and raises his price target)s). The investor buys more. And more. By this point, the investor has accumulated a rather large position and has "taken out" most of the real marginal price-sensitive sellers as he's bought (it's definitely a "he", as "she"'s rarely do this) more stock at higher prices. The "story" is still in tact as the earnings trend is rising, the new product is still expected to come on line some time next year or the year after. Hope spring eternal. But the "rating" as our friends at the FT's Lex likes to call it, has doubled or tripled. What might have been cheap at 12x FY2 earnings is now 25 or 30x. Admittedly the ranks of the shorts are not what they once were. Famous US short-seller David Rocker admits to having learned lessons "the hard way" to "never short on price".

Yet there is a nascent but growing conflict here between the analyst and the investor. Just as it is likely that the sun will rise in the east tomorrow, so to is it likely that the higher the "rating" (or valuation premium) a security achieves, the lower the expected economic return. This is not pessimism, bearishness, liberalism or communism,(as certain Libertarian trend-followers would have you believe) but rather simple and objective mathematics - the physics of finance, so to speak. This is the this point tensions emerge., for what is good for one is bad for the other. Their optimal strategy is to maintain the status the quo. But the rewards for breaking ranks are high and the penalties for NOT breaking ranks are also severe. The analyst can issue another "buy" recommendation, but at 30x or more FY2 estimated earnings, what will justify this? Now the analyst must begin worrying about HIS reputation, and his I.I. or Starmine ranking. For the investor he too is trapped. As the largest marginal buyer, he might have tripled the rating. Now other buyers are few (maybe a few shorts, some momentum junkies, and some index or benchmark buyers). But nowhere near the demand required to move the position currently on his shelves. Should he try? One thing is certain: he has a better chance of moving SOME if he does it when the momentum guys are buying AND when the analyst is reiterating his support. When these reverse, the only net will be the price at which he (the investor) desires to throw good money after bad.

And how does this game of "chicken" typically end, the curious might ask? The Pax Romana ended with barbarian hordes systematically pillaging the "civilized" empire culminating in the sacking of Rome. Janus was similarly savaged by the market in 2002 during their puking of THEIR technology positions. Henry Blodget was fired, as were many of his contemporaries who fabricated similarly outrageous stories and comparisons to justify seemingly conflictual committments. My suspicion is that in the absence of motivating factors to the contrary, both analyst and investor will "veer away" from the head-on collision because it is in their interests to do so. However, vocal reiterations of past recommendations will become less intense and less frequent, while purchases at even higher prices by the investor will also cease outside of important month-end and quarter-end portfolio valuation dates. They have become, in effect, inseparable, in their prisoners' dilemma, and will, whatever, happens sink or swim together because they have little other choice....

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