Another Reason Wall Street Won’t Tell You the Truth

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Wall Street always seems eternally optimistic about even the dodgiest of companies. Here is chart from FactSet showing that at the beginning of this year only 5% of the stocks in the S&P 500 had a sell rating from analysts.

Why is Wall Street research so positive? The usual answer given is that there is a huge conflict of interest between the research analysts and the investment banking arms of large financial institutions.

When companies need access to the capital markets to issue stock or debt or need “advice” and “expertise” about mergers and acquisitions, they turn to investment banks. In return for giving business to these banks, many companies want analysts to say positive things. It’s especially important if the company is issuing stock or selling debt. You need to hype up the investment so you have buyers. It’s hard to find buyers when an analyst in the research division is writing bad things about the company. Even if an analyst isn’t affiliated with a large investment bank, the analyst still needs access to company management to gather information for accurate quarterly earnings predictions. Here again, saying bad things about a company or saying investors should sell the stock is likely to get that analyst cut off from management.

This explanation is certainly correct, but I think it only partially explains the reasons for the lack of “Sell” ratings. For example, there are some truly independent research firms, such as ValueLine, that, to the best of my knowledge do not depend on access to management for the research and writing of their reports. (I’ve never heard any ValueLine analysts ask questions during conference calls.)

I think there is another, often overlooked, reason for the lack of critical analysis and sell ratings. Before I detail my hypothesis, I want to show some examples of stocks where every analyst should have known problems lurked beneath the surface.

The first is Questcor (NASDAQ:QCOR). Questcor is a pharmaceutical company that bought a drug developed in the 1950s from Aventis for $100,000. The drug was traditionally used to treat a rare condition, Infantile Spasms, also known as West Syndrome. Questcor obtained orphan drug status for their drug, which allowed it to raise the price from several thousand to several tens of thousands. It then began to market the drug for a variety of other uses, including as a second-line treatment for MS. In January of this year, the website StreetSweeper.com wrote a scathing expose on the company and raised numerous red flags. Then in July, noted short seller Andrew Left posted a negative research report on Questcor on his website CitronResearch.com. Both websites are widely followed on Wall Street.

The reports pointed out numerous problems with Questcor and the many very serious risks the company faced. The reports were made public for everyone to see, so you would expect serious analysts to look into the allegations (truly, they should have known about some of the risks before the reports if they were covering the company, as some risks were obvious). The analysts should have made investors aware of the risks. So what did they do?

According to Thompson/First Call three months ago (this is after the reports came out), the nine analysts following the stock all rated it a buy, with seven rating it a “Strong Buy” and the remaining two a “Buy.” While traditional Wall Street research is known to be biased and of dubious usefulness, you might expect more even-handed coverage from an independent source like ValueLine. ValueLine had a three-to-five-year price target of $70 to $110 on Questcor. ValueLine says, “Questcor Pharmaceuticals’ top and bottom lines should experience healthy growth over the next two years.” They go on to say “Questcor’s 3 to 5 year prospects are bright.” Finally, they end with this: “These shares are well suited for long term investors.”

Nowhere does ValueLine take time to mention the implausibility of Questcor’s business. Questcor bought the rights to a drug that was discovered in the 1950s from Aventis for a mere $100,000 and somehow turned it into a multibillion-dollar business. This was also despite the fact that the synthetic version of the drug was widely available in Europe and Questcor’s marketing practices were widely known to be very aggressive. The business defied basic economics: Either a competitor would emerge using the synthetic version or insurance companies would crack down on reimbursements. ValueLine does not inform their readers of any of those risks, or even the main risk, which is that H.P. Acthar Gel® is Questcor’s only product. With news of Aetna limiting reimbursements for H.P. Acthar Gel® to only one condition and other insurers starting to follow suit and the government starting an investigation of Questcor’s marketing practices, the stock now trades around $25.

Another example is Green Mountain Coffee Roasters (NASDAQ:GMCR). Green Mountain Coffee Roasters has been an ongoing accounting train wreck for years. The former criminal CFO of stock fraud Crazy Eddie’s turned accounting fraud fighter, Sam E. Antar, has been blogging about accounting problems at the company for years. About a year ago, superstar hedge fund manager David Einhorn gave a 100 plus page presentation detailing numerous allegations of poor business practices and possible accounting issues at Green Mountain. Again, all of the blog posts and the presentation were public. As usual, nobody listened.

Back in January 27, 2012, after a 30% drop in the stock price (to $51), ValueLine had this to say, “…at its current quotation GMCR offers above-average recovery potential for the pull to 2014-2016.” In fact, ValueLine slapped a three-to-five-year price target of $120 to $180 on Green Mountain. The comedy continues, as their report says, “The overall financial position is in good shape.”

Since when is having quarter after quarter of inventory growth outpacing sales considered “good shape”? Inventory and sales growth is something any analyst following a company should be tracking closely, and when inventory growth outpaces sales it is a very serious problem. Stale inventory is certainly not good for a food products company. There is simply no excuse for the ValueLine analyst not to point out the problems with Green Mountain’s inventory and previous accounting problems. Green Mountain now trades at around $25.

Why can’t even independent analysts write critically about companies? I think part of the reason is that if you do, everybody, and I do mean everybody, will hate you. I write negative articles about companies, so I know.

Below is a recent sampling of the nasty e-mails or feedback I’ve gotten from the articles I’ve written. These comments aren’t even close to being the worst (or funniest). (I regularly delete all my hate mail; I didn’t realize I might be publishing an article like this, so I didn’t save them.) Most of the truly awful comments on my articles have been deleted by site moderators. I’ve highlighted the parts of the feedback below that I think are the best.

I have written many articles about Green Mountain. Most were published after the large drops in the company’s stock price. Here is one comment I liked because of its creative insult:

Your article is a bugle to all investors, to destroy GMCR and you will get the word out when to stop. Nothing new here, just a message to rally the troops to stay short. As your post hits the airwaves they all obey and adjust the algorithms with a more negative bias. Yesterday, JCP and GMCR were the same price. Look at them now. Your negative message is robbing the innocent community of the profits and energy of a strong market. I hope the future brings you the same heartache you bring to the world a hundredfold
Comment from: krr711

Here is another sample of feedback that I’ve gotten on my articles:

I’m pretty sure you’re the guy who decided about 12 companies in China were publishing fraudulent cash balances based on their balance sheets based on the amount of interest income that they were showing. I don’t know if any of them are committing fraud, but it seems to me it’s a pretty flimsy argument without ever having talked to any of the cfo’s about how they did the bookings. I have spoken with 3 of them and the Bank of China. You are either dangerous, or just a totally transparent shill for shorts, which is fine. Nothing wrong with it. Those who do their homework stand to make a lot of money.
Comment from: Larryl

This comment was from an article I posted looking at the oddly low rate of interest income some Chinese companies reported earning on their purported cash balances. The idea behind the article was that companies that “rented” cash to pass audits and make their books balance would report lower interest income, since the large cash balance was not there year round. To be fair, you probably could have used any method (alphabetical, darts, etc.) on a list of all Chinese companies and found many frauds and companies that ended up being delisted. Whether or not my statistical look at interest income was valid is unknown. In any case, here is where the companies on that list were two years later:

China Agritech [delisted, trades OTC for 16 cents]
China Shenghuo Pharmaceutical [delisted, trades OTC for 14 cents]
Yucheng Technologies [down 5%]
China Education Alliance [delisted, trades OTC for 52 cents]
Tiens Biotech [apparently taken private at $1.72 per share]
China-Biotics [delisted, trades OTC for $2.20]
Fuqi International [delisted, trades OTC for 86 cents]
China North East Petroleum [delisted, trades OTC for 28 cents]
Gulf Resources [changed ticker symbol, down 84% since change]
China Infrastructure Investment [delisted, trades OTC for 10 cents]
China Security & Surveillance [taken private at $6.5 per share]
ATA Inc [up 61%]
China Sky One Medical [delisted, trades OTC for 35 cents]
Universal Travel [delisted, trades OTC for 85 cents]
Deer Consumer Products [halted at $2.26, will be delisted]
Biostar Pharmaceuticals [down 86%]

So that’s ten companies delisted and two trading at major losses out of sixteen companies. Only one of the sixteen companies actually gained in share price, and that was ATA. The rest were all losses, some complete and one immaterially small (5%). It would have been wise for investors to listen to the many bloggers and hedge fund managers who sounded warnings about the risks of investing in many Chinese companies.

Here is another comment I got from an article I wrote about Universal Travel Group (UTA):

I listened to the Conf Call after the first short attack by the Aussie guy. It was long and translated, but they addressed all the concerns. The English website had some problems, not the Chinese version. Less than 1% of their revenue came through the English version. As stated above, UTA has a great niche in catering to the 500 million or so who want to use a real person, agency etc. vs. internet. Their growth rate is as good or better than CTRP at one tenth the P/E. This wiper of bottoms gets paid to gin up a re-hash of non-concerns to help out some big bucks shorts. Pathetic. I made 55% on UTA after the first hit piece, got out and now thanks to Ben the wiper, I’m back in. SA has indeed turned into a soap box for these pathetic kick-back-paid hitmen.

Comment from: Dave Marsh

Investors would have been wise to listen to John Hempton of Bronte Capital (the “Aussie guy” mentioned in the comment above) and carefully consider the points I raised in my article about UTA. Universal Travel Group has been delisted and now trades on the OTC market. Last quote was $.85.

Finally, I recently published an article about Student Transportation, Inc. in which I pointed out what we think is a violation of SEC Regulation G by the company. (We are not short because of this; we actually discovered this possible violation after initiating our short position.) We have many other concerns about the company but choose not to publicly disclose those at this time. Following are two comments in response to my article. Please note that my article was factual and offered no opinion as to the merits of STB as an investment, either long or short.

Apparently, there is no low you will not stoop to to try and make your short work. I try to be as cordial as I can here, but I have to say I have nothing but scorn for your activities.
Comment from: DividendInvestorLA

How’s that working out for ya Ben ? Long day in Lancaster? Trying to get to the big city some day? Start with being credible. Slanted and tainted is no way to go through life.
Comment from: Tony g

If you write a negative article about a company, this is the type of feedback you can expect from the investing public. About 90% of the comments will be from people you’ve never met insulting you, your intelligence, and your article. Not what most people would enjoy or want to put up with.

By now you might be wondering why I bother publicly publishing any articles. Because the one time out ten when I get a positive response, it tends to be from a really smart person (usually smarter than I). And those are the people I want to get to know. I’ve found publishing articles serves as a great introduction to those types of people. I’ve met and corresponded with lots of great investors and accounting and fraud experts because of my articles.

Additionally, the public comments help to refine my investment thesis. If the comments consist overwhelmingly of personal attacks and no one is able adequately to address the content of the article, then that is one more indication I’m correct. As the saying goes, if you can’t attack the message, attack the messenger. If the people buying the stock are a bunch of morons, then that is a trade that I am comfortable being on the other side of. On the other hand, if I get a well-reasoned, detailed response refuting the substantive points of my article, then I know I should take another look at that company as a short and reconsider my original position.

While this article unfortunately reads more like Strubel Investment Management’s greatest hits, that is not my point. (It was easier to write about companies I’m familiar with–not much I could do there.) This article certainly shouldn’t be interpreted to mean we are always correct on our investments (short or long). The point is that we critically evaluate all our investments and consider both the bull and the bear thesis before making an investment.

The point also isn’t that ValueLine is terrible and the other Wall Street analysts are always wrong. Everyone is wrong sometimes. The point is the analysts didn’t bother to take a critical look at the companies. They didn’t bother to inform their subscribers that there may be some problems. It’s okay to say, “Hey, this company has some issues with A, B, and C. But we think that’s okay because of reasons X, Y, and Z.” No problem, everyone does this. No stock is ever perfect. They are analysts and they get paid to analyze. Maybe they presented the issues and their reasoning why everything should be okay and they turned out wrong. It happens to everyone at some point. But not even to make a cursory effort to look at the company, it’s accounting, and its business model is inexcusable.

I can’t assure you that we will always be correct (we won’t, we will often be wrong), but I can assure you that our reasons for being wrong will not be because we ignored the research or opinions of other smart investors, as so many do, who may have been critical of that particular investment.

I can’t promise I’ll be right, but I can promise I’ll try much harder than many seem to do.

Disclosure: We are short QCOR, GMCR