Sorry Fortune, Meredith Whitney Is Just An Average Analyst (You Even Said It Yourself!)

Remember when Henry Blodget made his $400 call on Amazon stock back in the late 1990’s? He will be known forever for that call more than all the other ones he made combined. Fast forward nearly a decade and Oppenheimer banking analyst Meredith Whitney has achieved similar rock star status. The August 18th issue of Fortune Magazine has her on the cover.

Now, I like Fortune a lot. In fact, aside from an online subscription to the Wall Street Journal, my subscription to Fortune is the only periodical I actually pay for. But this Meredith Whitney hoopla is really getting old, and quite frankly, it’s too much.

Like Blodget, whose $400 price target came to fruition despite the controversy surrounding it, Whitney’s early warning on Citigroup (C) stock last year definitely deserves kudos. She got death threats after suggesting the banking giant would be forced to cut their dividend and raise capital. At the time it was a minority opinion, but she was right and deserves credit for a very bold and correct call.

That said, let’s not get carried away. Investors and the media should not judge an analyst on a single call, but rather the entirety of their work. There are great analysts out there, but the track records of most are mediocre at best. When I have the chance to guest lecture undergraduate and MBA students, I often refer to a study that showed the stock picks of sell-side analysts, like Whitney, consistently underperform the market and do so with more volatility.

So, does Meredith Whitney deserve all the attention she has been getting lately from investors and the media (she is on CNBC all the time)? I have nothing against her, but I doubt it. She should be commended for the Citigroup call, but treating her as the “go-to” analyst on banks would only be reasonable if her track record beyond that one call was overly impressive. Unfortunately for investors, it isn’t.

In the Fortune cover story, in fact, it is mentioned that according to Starmine (a company that tracks the performance of analyst recommendations against their industry peers), Whitney’s stock picking ranked 1,205th out of 1,919 analysts in 2007 (the year of the Citi call). During the first half of 2008, Whitney’s picks ranked 919th out of 1,917 analysts.

The only conclusion I can draw from those numbers is that Whitney is no better than an average bank analyst. In the world of sell-side research, “average” is hardly something to get excited about.

Does this mean you should completely ignore what Whitney and other analysts say? No. They put in long hours and often can provide a lot of information that is helpful in conducting stock research. Still, we should not drop everything and hang on every word whenever Whitney is on CNBC or lands on the cover story of a magazine. She just isn’t going to make us rich.

Need proof? Consider her recent downgrade of Wachovia (WB). Whitney downgraded the stock on July 15th from “market perform” to “underperform.” For those who prefer to translate Wall Street lingo, that means she went from a “hold” to a “sell.” Good call? Umm, hardly.

Wachovia stock actually bottomed that same day at $7.80 and closed at $9.08 per share. It never traded lower than that, completely reversed course, and traded as high as $19.48 on August 1st. That is a gain of 150%, peak to trough, in just 13 trading sessions! Just imagine if you shorted Wachovia because Whitney put a sell on it!

Just as we should not judge Whitney solely on her Citigroup call, we also should not judge her solely on the terrible Wachovia downgrade. Still, since her stock picks rank her as an “average” analyst within a mediocre group of stock pickers, I can safely say the attention she is getting these days is a little over the top.

I still love Fortune and CNBC and all the other outlets going gaga over Meredith Whitney. I just think she’s pretty overrated and want people to understand the facts along with the hype. People just love a good story on Wall Street and right now, she’s it.

Full Disclosure: No position in Citigroup or Wachovia, long a subscription to Fortune at the time of writing

Merrill Lynch Somehow Cuts Target Price on GM by 75% in 1 Day

Academic studies have found that Wall Street analyst stock recommendations trail the market and do so with more volatility. As a result, investors who use sell side research should be careful to pay attention to certain data points that analysts have spent hours putting together, but to completely ignore price targets and ratings and instead coming up with their own opinion on the ultimate value of a stock.

The latest example that illustrates this point is the call we got out of Merrill Lynch today. ML’s auto analyst downgraded shares of General Motors (GM) from “buy” to “sell” and slashed the price target from $28 to $7 per share. That’s right, this analyst thinks GM is worth 75% less than it was 24 hours ago.

As for how to value GM, I think it is simply too difficult to do so. It is nearly impossible to estimate future legacy costs, and trying to figure out what a reasonable profit margin on cars should be is simply a guess because they are not even making money at all and their competitive position has deteriorated since they were last in the black.

Besides, if an analyst can tweak their model and get $28 one day and $7 the next, that is a pretty clear signal to me that valuing GM right now is just not something anyone can do with a large degree of confidence.

Anybody think GM is a buy at 10 bucks? If so, why?

Full Disclosure: No position in GM at the time of writing

Prudential Shuts Down Research Department

>One of the themes I have written about on this blog is the worthlessness of most sell side equity research. Most firms use their research departments to push stocks they have underwritten, and most investors understand that and discount their opinions as a result. Prudential (PRU) didn’t believe in that model, and they were right. They decided a while back to put their equity research group out on its own, not joined at the hip with investment banking. I’m sure the thinking was that their research will carry more weight since it is unbiased, and therefore will be a valuable product.

We learned Wednesday that Prudential has shut down its equity research, sales and trading business known as Prudential Equity Group. This move speaks much more loudly than my comments ever could regarding the value (or lack thereof) of analyst research. If the product was valuable, people would buy it and it would make a profit. The fact that sell side research is given away for free to clients should tell you just how valuable it is.

I really do think it is that simple. The last study I read showed that analyst recommendations not only trailed the returns of the S&P 500 index, but did so with more volatility. Hardly a ringing endorsement. Expect other research departments to be shut down now that someone got the ball rolling by being the first.

Full Disclosure: No position in PRU at the time of writing

Morningstar Analysts Seem Confused

I’ll gladly send a complimentary Peridot Capital 2007 Select List to the first person who can explain how this graphic from the Wall Street Journal Online (“When Buying a Stock, Plan Your Goodbye” – 01/14/07) makes sense. Put another way, how can Morningstar analysts justify calculating the fair value of a stock and then recommend investors not sell the shares when they reach that level?

Which Group of Analysts Will Be Right About Earnings?

Glancing over earnings estimates for the duration of this year and 2007, I noticed a very interesting dichotomy. Bottom-up analysts are still quite bullish on corporate profits, forecasting year-over-year growth in each of the four calendar quarters during 2007. Top-down analysts, conversely, are predicting annual declines in earnings beginning in Q3.

Which group will be correct? It’s simply too early to know. I would tend to side more with bottom-up analysts in general, merely because they are basing their forecasts on what actual company management teams are saying, as opposed to merely taking a broad macroeconomic view of the world.

That said, I am worried that earnings growth will be difficult to maintain. Over the last couple of years a majority of the gain in S&P 500 earnings have come from the energy and materials sectors. As we head into next year, contributions from these groups could be minimal, if not negative. Commodity prices seemed to have peaked for the short term, and although I do think we are in the middle of a secular bull market in the group, there is no reason to think we could not see a breather in the run during 2007.

If energy and other commodity stocks find it difficult to grow earnings, other groups would have to see accelerating profit growth to make up the difference and continue to boom in corporate earnings. I can’t really see what areas would be up to the task.

What is the implication for stock prices going forward? Depending on what earnings number one uses for the S&P 500, we are currently trading between 15 times (operating) and 16.5 times (GAAP) 2007 earnings estimates. Market bulls suggest that P/E multiples should expand given the outlook for economic and earnings growth. However, if corporate profits begin to see year-over-year declines in the back half of 2007, such multiple expansion is unlikely.

With multiples staying flat or declining, and profits peaking, it would be hard to make the case that stock prices have a lot of room to run next year. Perhaps that is why the S&P 500 seems to be having trouble breaking past recent highs in the 1,390 area. As it stands right now, I don’t see the S&P breaking meaningfully above 1,400 in the short term until we have increaased confidence that a more bullish scenario could play out.

GE to Banc of America: Thanks for Trustreet

GE Capital must be very happy that most Wall Street analysts don’t have a clue how to value the companies they follow. On 10/30 they announced a deal to buy Trustreet Properties (TSY) for $17.05 per share in cash. Investors were rewarded nicely, as TSY investors are being paid a 36 percent premium to TSY’s closing price of $12.51 on 10/27.

Clients of Banc of America Securities, however, are far from thrilled. The investment bank initiated coverage of TSY in February with a “neutral” rating with the stock trading at $13.85 per share. By August the stock had dropped 17 percent and the analyst covering Trustreet, Ross Nussbaum, downgraded the stock to “sell” with the shares at $11.44 each. Oops.

Less than three months later, GE Capital swoops in and offers 49% more than where TSY was trading at the time of the “sell” recommendation. How these people keep their jobs baffles me. How can an analyst, whose sole job is to value public companies, be off by a whopping 50% when doing so? Clients who sold their shares at $11 and change must be fuming, as are those who shorted it after a rare “sell” call.

Meanwhile, smart value investors are smiling. The sell side analyst community continuously gives them gifts, like TSY at eleven bucks. GE Capital, too, must be thrilled that Mr. Nussbaum keeps his job despite being incredibly bad at it. After all, without so much analyst negativity, TSY shares might have been trading much higher, and GE Capital would have had to offer more than $17 to persuade Trustreet management to sell the company.

As usual, investors who listen to analysts get the worst of it. I know many of my readers are familiar with my advice to avoid paying attention to sell side analysts, and many of you do just that. Still, when things like this happen, I can’t help but mention them just in case some of you are suspect of my opinion.


Same Ol’ Sell Side Crap

From the New York Post:

The New York Attorney General’s office and the Securities and Exchange Commission have launched full-fledged probes of a small but influential Wall Street firm that fired an analyst who tried to publish a report critical of one of its clients.

Subpoenas have gone out over the past week to Rodman & Renshaw over the departure of Matt Murray, a biotech analyst who said he was not allowed to lower his stock rating of a company once it had reached its price target.

Shortly after broaching the subject of downgrading Halozyme – a Rodman banking client – he was fired, he said.

A law enforcement source told The Post that a subpoena launching a New York AG investigation into Murray’s February departure had gone out to Rodman; this source also said the SEC had also subpoenaed the firm.

Murray told The Post he was “grateful to learn that the Attorney General is continuing the important work on supporting analyst independence.”

At the time of his departure from Rodman, which specializes in underwriting controversial PIPEs – or private investment in public equities – Murray was a high-profile analyst of small-cap pharmaceutical companies.

Murray said that once his request to downgrade the shares of Halozyme was turned down, he asked Rodman’s compliance chief to remove his name from its coverage.

This set in motion a series of ugly confrontations between Rodman executives and Murray that led to his departure.

Analysts and the Fed

Two completely separate points I’d like to make this morning.

The first is regarding an analyst call on Garmin (GRMN) yesterday, one day before the company was slated to report second quarter results. As many of you know, GRMN is the leading maker of global positioning systems (GPS). American Technology Research decided that it was a good idea to initiate coverage of the stock yesterday, ahead of earnings, with a “sell” rating and a $75 price target, with the shares trading at $95 per share.

These types of calls are always intriguing to me. First, Garmin has blown away numbers for the past couple of quarters. The company is taking market share and the GPS business is growing rapidly. If anything, the company would have better odds of having a great quarter than a poor one. It’s true that Garmin’s competitors posted bad quarters already, but that is likely due to Garmin kicking their butts.

Second, why would you want to make a call without any information on Q2 or the outlook for the rest of 2006? With Reg FD in effect, there is no way a company is going to leak to anybody how the quarter went. Essentially, the analyst is completely in the dark about current fundamentals at Garmin and yet still is sticking his/her neck out to recommend investors sell.

This is yet another example of why investors shouldn’t worry if an analyst issues a negative report on a stock they own. If you have done your homework and believe in your investment thesis, use the weakness generated by these analysts (Garmin was down $5 per share yesterday to close at $90) to buy the stock at a cheaper price.

Garmin’s Q2 report this morning was another blowout. Earnings per share came in at $1.10 versus estimates of $0.94 and the company raised guidance for all of 2006. The stock has traded up as much as $15 per share in pre-market trading this morning.

On a completely unrelated note, the Fed Funds futures market is now indicating that traders are pricing in a 34% chance that Bernanke will raise interest rates on Tuesday. I am afraid that this assumption is highly optimistic. I would take the “over.”

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.