The Great Independent Research Debate

There is a very simple reason why Peridot Capital does its own research; there are very few people I trust more than myself to implement my investment philosophy. As much as so-called “independent” research claims to be such, experienced investment professionals know that research is often far from independent. All you have to do is ask yourself, is there reason to believe that this research is independent?

In the case of a buy-side firm like Peridot, there is every reason to believe that our research is independent because it is solely used internally to make investments on the behalf of clients. If clients do well, the company will prosper, and if they do poorly, clients will leave.

But what if a company doesn’t manage money? What if they are solely in the business of selling research? Do they have to be independent? What is keeping them from doing whatever it takes to sell the product? After all, selling research is their only line of business. It’s the same reasoning that some journalists print things that might not be completely accurate. They are in the business of selling papers, or magazines, or whatever their product is. How do tabloids stay in business? Is it because their stories are always accurate? No, it’s because people buy them.

I decided to write this piece after reading a transcript of testimony given by Kim Blickenstaff, CEO of Biosite (BSTE), a small medical diagnostics company based in San Diego. Her testimony was part of a Senate Hearing this week entitled “Hedge Funds and Analysts: How Independent is their Relationship?” Below is an excerpt:

“In the ten months from February to December 2002, the number of shares [of Biosite] controlled by short sellers increased from 690,000 to 7.1 million shares, which represented nearly 50% of our outstanding stock.

During this same period, Sterling Financial Investment Group, a Florida-based research firm, issued at least seven negative research reports on Biosite, each carrying a Sell/Sell Short recommendation, and an $11 target price. We believe that these reports contained numerous inaccuracies or false and misleading statements, which ultimately lent volatility to the stock’s performance, thereby harming many of our long-term, fundamentally-based investors.”

There are many issues I have with this testimony from Biosite’s CEO.

First, short sellers do not “control” shares of stock. They borrow shares from other investors and immediately sell them in order to raise cash proceeds. The investors who have sold the stock short no longer control the stock, they simply owe it to someone, and will have to buy it back at some point in the future to repay the loan.

Second, Blickenstaff claims that negative research reports issued by Sterling between February 2002 and December 2002 were successful in “harming many of our long-term, fundamentally-based investors.” This is interesting given that Biosite stock was $18.37 on February 1, 2002 and closed December 31, 2002 at $34.02 per share. So, even as the number of shares sold short increased more than 10-fold, the stock price soared by 85 percent. How exactly long-term investors in Biosite were hurt by this I’m not exactly sure. Sounds like these types of investors should beg short sellers to target their stocks!

What can we take away from all of this?

One, short sellers do not cause stock prices to go down. If a stock can rise 85% as half the outstanding shares are being borrowed and immediately sold, such as argument is easily discounted as silly.

Two, independent research is not always independent. Merely listening to Sterling’s negative view on Biosite stock (which did prove to be inaccurate) would have lost you a lot of money if you were in fact a long term investor who wanted to “invest” (versus “trade”) in BSTE shares.

Three, if you are an “investor” then you should, by definition, have a long-term view. Traders focusing on the short term probably were hurt by these negative research reports because they likely caused a quick drop in the stock price upon being published. In the short term, any kind of report can influence stock prices, accurate or not.

Over the long term, however, company fundamentals will matter above all else. Since the research Sterling published turned out to be incorrect, the stock price went up, not down. That is why someone who bought the stock in February before all the short sellers and negative reports came out of the woodwork, and held it throughout all of this sketchy behavior, would have made 85% on their investment in less than a year.

Hopefully you can see why people should do their own research and invest for the long term. If your analysis proves accurate, you will make money, no matter whatever anyone else out there is doing. That is the philosophy I use when managing my clients’ money, but it is valuable for anyone who doesn’t want to be adversely affected by the inherent conflicts of interest on Wall Street, whether you are a Peridot client or not.