Readers,
I'm very happy with your responses. As always thanks for the words of encouragement and see you tomorrow.
Best,
Miguel Barbosa
Part 2: SimoleonSense Interviews Warren Buffett's Biographer, Alice Schroeder.
Copyright 2010 Alice Schroeder & Miguel Barbosa
Please do not repost without asking for permission.
Miguel: Can you comment (without stepping on anyone's toes) on the experience of being an analyst at Morgan Stanley? Take us behind the scenes of coming up with an idea, monitoring a company, and issuing a rating.
Alice: Oh, I'll comment freely. When I left, I did not sign a separation agreement. It would have required me to get written permission to speak or write about Morgan Stanley and would have subjected me to liability if I said anything that they, by their unspecified definition, considered criticism.
I would have been paid much more for agreeing to this, but I didn't want to be muzzled.
So what is it like to be an analyst…When I started at Oppie it was very free form. Analysts used their judgment. Over time, as I moved through the different firms, especially Morgan Stanley, more and more requirements arose. There were things you had to write every time you published on a company. The financial models became standardized. Like any other business, the more you standardize something, the more you stamp out creativity.
This was more than just compliance. Through this process, big firms like Morgan Stanley were also trying to brand themselves. The firm wanted to be the brand, and discouraged its analysts from doing distinctive enough work to result in them becoming a brand themselves.
You may wonder why analysts at banks hedge themselves so much – on the one hand this, on the other hand that. Partly it can be lack of courage. But someone is always trying to lawsuit-proof your opinion. Decisive statements are lawyered into "may, can, could, might, potentially, appears" instead of "is, does, should, will," much less "look out below."
The time pressures that work against quality research are also well-known. You write up a lot of inconsequential things, especially what I call "elevator notes" (this quarter "X was up and Y was down"). Instead of writing original or probing views, you are really incentivized to spend as much time as possible marketing.
Also, if you adhere to consensus, it does protect your career. There's an old saying that no one ever got fired for buying from IBM. Nobody ever got fired for making a wrong estimate that was within sell-side consensus.
Whereas, if you break from consensus, you really can't afford to be wrong very often. That phenomenon really drives the sell side. It can be overt, such as when we were judged on how "commercial" our work was. This is a veiled threat, because, of course, our work has to be marketable in order for us to have a job. The firms essentially want two things that are incompatible. They really do want you to do nonconsensus work that's attention-getting enough to be of interest to clients, but it also has to be right to be commercial, or you are punished. The fear of punishment nearly always beats the desire for reward, so this creates constant pressure to pull in your elbows.
Finally, of course, there's the well-known banking conflict of interest. My team had its encounters, especially over Aon, at the time a disaster of a stock. Once, we were told "Pat Ryan [then CEO of Aon] is reading your reports, and he's not happy," as if our job was to make Pat Ryan happy. Aon was so beaten down that it always looked cheap. It repeatedly head-faked investors. Management would claim victory on a turnaround, then it would blow up again. Our refusal to recommended Aon no matter how cheap it got frequently put us in opposition to Gary Parr, the banker, who was a fierce advocate for his client. The day Gary left Morgan Stanley, we literally gathered in the hallway and celebrated.
With that said, ultimately Morgan Stanley backed me up. It backed me up on many occasions. My research director, Mike Blumstein, was very supportive. A number of bankers were supportive. On one memorable occasion, Joe Perella intervened directly with a banker after I talked to him about a proposed GE deal. He killed the deal, which probably saved us a huge lawsuit.
From what I understand, pressure still exists. For one thing, if there's a layoff, analysts who are needed and liked by bankers are protected. The 20% of the department that is getting fired will be chosen from the rest. You can do the math on that.
Miguel: You jumped in front of my next question. I didn't realize the pressure you faced on the sell side. Are there any firms that you recommend as staying true to their research and escaping the perils of groupthink?
Alice: Boutique investment banks and broker-dealers by definition are better if you are looking for stockpicking advice. In effect, they're performing a different service than a large bank. They don't send their analysts on constant marketing trips to discuss their sectors and the banking work is distributed among more people. They're more heavily staffed for research in general, and usually commit all their resources to a one or two industries. They follow small caps.The risk you have with boutiques is their dependence on access to managements and industry sources. They're like journalists who follow a beat –- they live and die by their sources.
In terms of groupthink, first, it's part of human nature. There's a lot of research that shows this, such as the famous Milgram experiment. Let's translate this to a stock. If a company is obviously broken but no one else is saying that, then an analyst who thinks so will begin to question his or her judgment when the market continues to disagree. Another way to put this is to say that bystander apathy is powerful on Wall Street. Bystander apathy is the famous psychological propensity of people to ignore disasters happening right in front of them when they're in a crowd, if no one has made the first move. Analysts think, "Who am I to try to rescue investors from impending disaster. I'm no smarter than these other 18 people covering this company."
You have to have enough of an ego to believe you're smarter, and, this will sound corny, but it helps enormously if you have crusader streak. Crusaders will suffer all kinds of slings and arrows in the name of whatever they believe is justice. That's how you become a Steve Eisman.
People who gravitate to short-selling also innately have this personality. It's kind of interesting that some of them now have almost cult-like followers. In recent years, we've been living in a time when being a crusader and being negative is handsomely rewarded and respected. A decade ago, that certainly wasn't true. Someday the pendulum will swing back.
Miguel: How did this pressure play into the shortsighted nature of company guidance and quarterly estimates?
Alice: You know, I don't see that being linked to the time pressure of sell-side analyst work as much as the fundamentally short-term nature of investors' quickened expectations. If you're a hedge fund manager who's being judged, not just quarterly but monthly, weekly, and even daily, then every minute matters. The brokerage firms all have at most 1 year rating systems. And, often you are judged in shorter increments than that for your stock picking.
The rating systems are a major criticism I have of Wall Street research. When the firms began to judge analysts for things other than their banking skills and client popularity, they migrated to stock-picking. Now, there's a big difference between stock-picking –that is, continuously making predictions about exactly which companies in a particular group will do the best over the next few months — and investing, which is a profession in which it pays to realize most of the time you don't have a good answer to that question.
One of the several reasons I left the Street is that I was tired of being a short-term market prognosticator. Almost by definition, that's a silly thing to do.
Miguel: From what you tell me, what I hear is that they (short-sighted analysts) are not thinking like owners.
Alice: They don't have the luxury of thinking like owners. Neither the buy side or sell side, with the exception of a handful of value managers, the majority of whom continue to manage relatively smaller funds by Wall Street standards.
Miguel: So let's bring Warren Buffett into the picture. You're an analyst covering insurance companies. When is the first time you come across Berkshire Hathaway? Do you still remember the day you released the Paine Webber report?
Alice: Oh yes. I came across Buffett when Berkshire bought the second part of GEICO, which was a major event. It never occurred to me to begin following it until several years later, when Buffett announced his bid for General Re. At that point, a number of my clients asked me to follow Berkshire Hathaway. They were going to own the stock and they wanted research coverage.
These clients knew I liked complex difficult things to analyze. That I was interested in doing things that were different even if there was no obvious commensurate reward for the extra effort. The sell-side had limited interested in following Berkshire, to say the least. The stock didn't trade. At the time, Warren essentially didn't pay bankers and frequently expressed a negative attitude toward the Street.
So, I went to my research director at PaineWebber and made a case that our retail brokers would appreciate this coverage because their clients were interested in Berkshire and Warren Buffett. Being able to call and talk about Berkshire was a service for retail clients that did not involve asking for a transaction. It was something their financial advisors appreciated being able to offer. To its credit, PaineWebber gave me a thumbs up.
Miguel: What was the next step? Did your director just say 'go for it'? What was it like discovering Berkshire Hathaway?
Alice: Warren always said he revealed everything investors needed to know from his financial statements, but that was not the perspective of many analysts. I find it interesting that Buffett has criticized Wall Street for being over-dependent on private information from management. When I started taking Berkshire's public disclosures and merging them with my earnings model on General Re, I quickly learned what so many people already knew, which is that investors had been struggling for years trying to value Berkshire. I ultimately based my valuation on three things: insurance, the group of other little businesses, and the publicly traded investment portfolio. I just started putting it together. There really was not a lot of information to do a detailed valuation and frankly there is still a lot of ambiguity. But I assumed that anything would be value-added to investors versus what they had, and that turned out to be right.
As an aside, at the time and continuing to this day, it's not uncommon for money managers who are vocal champions of Berkshire's attractiveness as an investment in public to take me aside in private and wring their hands over the problem of how you value Berkshire stock, and whether it is over- or under- or fairly valued.
People get stuck in this position because they trust Warren philosophically, and they believe the empirical track record, yet, for lack of information, they're prevented from living up to the professional standards of analysis that that they apply to their other investments and that Warren applies to his own investments. As security analysts, this makes them uncomfortable.
Warren has always had the attitude that investors should trust him enough to let him operate in privacy. People were fine with that for a long time, and were rewarded for their trust. As he's gotten older, they're less fine with it, which is reasonable.
Tune-in Tomorrow for Part 3: Alice Describers Her Experiences With Buffett
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