George Pitcher: Time to take the bull out of the thundering herd

The investigation into Merrill Lynch has put equity analysts under an uncomfortable spotlight. Not before time: most were guessing in the first place, says George Pitcher

The world economy is prospectively in good shape. The recession – if there was one, as we conventionally understand it – has turned out not to have been as bad as we anticipated. The US looks sound and Europe has, by and large, taken to the euro like a duck to orange sauce.

So why the shake-out in the City of London? Some of the biggest names in town are behaving as if we’ve just been through a monumental market crash – if not of the proportions of Wall Street in 1929, then certainly on a par with the recession of the early-Nineties or the melt-down of 1987.

Merrill Lynch, the largest fund manager in the UK, has lost 14 of its senior executives in the past three months. Last year, Merrill lost two of its most high-profile figures, when Stephen Zimmerman retired early and Carol Galley walked – following the firm’s humiliating &£70m out-of-court settlement with Unilever, after the consumer goods leviathan took legal action over allegedly poor pension-fund performance.

The air of gloom is compounded by the prospect of copycat actions from disgruntled clients, ranging from the Co-op and J Sainsbury to pharmaceuticals giant, AstraZeneca. And there can be little doubt that the image of Merrill has been further damaged by investigations in New York of allegations that star analysts have been peddling stock recommendations to investors, while advising its own corporate financiers to steer clear.

Litigation and the Wall Street debacle may be the driving force behind the departures at Merrill’s asset management arm, but it is by no means alone in losing stars. At HSBC, equity research staff have been stampeding to the doors – the company has lost its head of global research, Mark Brown, as well as its banks analyst, Michael Lever, and a swathe of top-rated performers.

The departures might be easier to explain at HSBC – the bank has decided to cut costs by declining to pay bonuses this year. In the curious world of City remuneration, this is tantamount to telling equity analysts that they are no good. So they’re taking their liabilities elsewhere.

It is important to differentiate between the asset-management departures and the resignations of the equity analysts. They are separate functions – notwithstanding that Merrill has tested that distinction – and are judged by separate performance criteria.

But both financial disciplines are in the management of risk – the fund manager by managing clients’ investments and the analyst by judging the potential performance of stocks. And the fact is that they’ve not been very good at it.

For proof of fund management folly, look no further than the litigants lining up behind the embittered Unilever. As for the analysts, there is a growing recognition that behind the wretched clowns that push dubious stocks to investors, while conceding that such tips are excremental (to put it politely) to their pals in the same company, there are the ranks of the incompetent and vacuous.

For every Henry Blodget – the high-tech analyst at the heart of the Wall Street inquiry – there are hundreds of Henry and Henrietta Botch-Its, whose stock-selection has been utterly dismal in recent years.

The most apparent cases of dismal analyst performance emerge from the US. According to the research of four economists in California, quoted in the respected Journal of Finance, in the decade between 1985 and 1996 stocks that were most highly rated by analysts produced average annual returns of 18.8 per cent, against a market average return of 14.5 per cent. The stocks least rated by analysts returned 5.8 per cent.

Investors who bought top-rate stocks and sold short the lowest rated would have beaten the market average by nine percentage points a year. So far, so very good. But if you update that research to 2000, the year that the dot-com bubble burst, you find that the most favourably rated stocks under-performed the market by 31.2 per cent, while those least recommended stocks out-performed by 48.7 per cent.

So much for “the new economy”. Furthermore, it is worth noting that between 1996 and 2000 some 68 per cent of analysts’ recommendations were “buy” or “strong buy”, 29 per cent were “hold” and only three per cent were “sell”.

It is easy to be wise after the event, but it is also easy for clients to see that those they pay to provide sound investment advice haven’t been very good at it in recent years. On this basis, it is hard to be very sympathetic about analysts getting shirty when their employers stop paying bonuses.

In the final analysis (if there can be one), it demonstrates that equity analysts – and the fund managers who rely on them – never actually know anything. They’re in the business of taking punts. Sometimes they’re right; sometimes they’re not. It’s as simple as that.

The significance of that rather obvious point is that an index of leading shares, such as the FTSE 100, provides an average position between those who are right and those who are wrong on any given trading day. Since recent history shows us that no one can know into which category analysts are going to fall, investors are better off tracking the market, rather than trying to do anything flash.

This, of course, takes no account of analysts, or fund managers who consistently beat the market. Now, they would really deserve their bonuses. But, on available evidence, there are precious few of them about.

George Pitcher is a partner at communications management consultancy Luther Pendragon


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