How the crash went off with a bang

I remember Black Monday very well. It was dark. The hurricane three days earlier had knocked down the power lines to my house, so I found myself on the Monday evening enjoying a candlelit telephone conversation about that day’s stockmarket slump with one of my clients in New York, a Frenchman.

He held a large number of shares in merchant bank group Schroders – or, as he called it, “Schraudeurs” – and we had often discussed selling his holding. My client always insisted that he was perfectly “appy” with his stake.

When, on that Monday night, he told me he wished to sell, I said, “But I thought you were perfectly ‘appy with your Schraudeurs.”

“Terry, I would be ‘appier wiz cash,” he replied.

“Fair enough,” I said, as I scribbled his sell order on a piece of paper in the dim light of my kitchen. “By the way, how is Wall Street doing tonight?”

“It is down 500 points,” he said. My Frenchman was clearly not the only one who was ‘appier with cash.

This was crunch time for a new era that had begun almost exactly a year earlier, with Big Bang. Analysts’ standard valuation models went out the window as share prices fell 10% on Monday, and the same again on Tuesday.

The problem wasn’t just that their clients’ own portfolios were getting hammered. Their employers – such as, in my case, BZW – were taking it broadside on their market-making desks.

Life was simpler for an analyst before Big Bang. What you had to worry about was researching the companies until you thought you had a story which would make the clients buy or sell the stock. Then you could either call them yourself or tell the salesmen who made the call. When the clients traded, commission arrived.

But as one of the market-makers at BZW explained to me just before we started trading as an integrated house: “Today you get an order and the firm makes money from the commission. Tomorrow you get an order and the firm may lose more on the trading book than the commission – that is if the client pays any commission.”

This suddenly presented analysts with a massive conflict of interest.

Before Big Bang no analyst worried about whether the client orders based upon his research would lose the jobbers money. In fact, if it did, so much the better: firstly, because the jobbers were the enemy, and secondly, it meant the share price would move sharply in the right direction if the jobbers were wrong-footed by the order, making the analyst look like a genius, albeit briefly.

After Big Bang, the same tableaux were played out in every dealing room.

An analyst would hot foot it back from meeting the company with a story.

He rushes to the microphone in the dealing room and announces to the salesforce the latest piece of information. Before you know where you are, the salesmen have more orders than they can trade, the share price has shot up and the trader is busily trying to garrotte the analyst because he was short of the stock and has lost a fortune.

Slowly and painfully the lessons were learned. After losses and scuffles the penny finally dropped with most analysts: when you have some information you tell the market-maker first. The clients come second.

The other main conflict of interest post Big Bang had always been present in the analyst’s life. It just became much worse. I am, of course, referring to corporate finance. Analysts had always had to cope with a certain amount of pressure in this area. If your firm was appointed brokers to a company you had to be wary what you wrote.

There was a sort of code. A research note on a corporate stock with the word “buy” might mean buy, or it might mean “buy if you want to lose money”.

There were grades of “buy” on corporate stocks. A client had to read between the lines carefully. But a “hold” meant sell, and “sell” was never, ever written.

I know because in January 1987, just after Big Bang, I wrote one of the first sell recommendation on a corporate stock in London. Just to compound the felony, it was on Barclays Bank which owned the firm I then worked for, BZW. Barclays share price fell 50p on the day, and that was when 50p was worth something.

Barclays did the right thing. They gritted their teeth and made public utterances through those clenched teeth about how wonderful it was to have such independent analysts at their investment banking subsidiary.

In private, strenuous efforts were made to stop me writing any more research on Barclays. Or anything. Or breathing for that matter.

Oh yes, things have got much worse since Big Bang. There are regular tales of analysts being pressurised to write positive research on the most dire corporate junk. This pressure was not always obvious to outsiders.

A non-executive director of a company will bring pressure to bear on an investment bank’s analysts to write a buy via the threat of them losing the brokership of another company of which he is chairman. The investment bank’s fund managers may lose the management of a company’s pension fund if its analysts don’t toe the line. The more tentacles your investment bank employer has, the easier it is for someone to find a means of twisting one of them until your analytical eyes water.

Please don’t get me wrong. I’ve little or no sympathy for the analysts who find themselves between a rock and a hard place. They make the choice to be in the investment bank with their high salaries, guaranteed bonuses (which get paid even if the shareholders lose money), company cars, pensions and health insurance. And don’t forget those phantom equity schemes, they’re far better than owning some real equity – after all, then there would be some danger of losing money. No. Today’s analyst is no buccaneer willing to live by his wits. He’s on his way to becoming a highly paid civil servant.

There is further evidence of this in the research process. In some respects it has become more scientific since Big Bang. In the early to mid-1980s it was still possible to find some pretty amateur analysis going on in London. Take two anecdotal examples.

When NatWest had a rights issue in 1984, I discovered that the analyst at its broker, the late and unlamented Scrimgeour Vickers, did not know how to calculate the weighted average share capital of a company after a rights issue.

The second is about a building analyst who got up to tell the whole dealing room about a rights issue in the sector he covered. “These rights issue shares are very cheap,” he said. “They’re at a 20% discount to the existing shares, so clients should buy them.” It didn’t seem to have dawned on this budding Warren Buffett that you needed to own the old shares to be offered the rights at the subscription price. I kid you not.

You won’t find mistakes like that any more. Analysts can all cope with the basics of investment arithmetic. And then can mostly write a competent if rather boring research note with a divisional analysis and two-year forecasts. In fact, there is now an outpouring of paper from most analysts.

Life as an analyst in most integrated security houses has become a bit like being on a treadmill. You have to produce pre- and post-result notes on each company you cover, contribute your forecasts to the firm’s book which it publishes of equity forecasts, write sector reviews, and thematic research, and company reviews, and …

The problem with this is that an analyst doing all this doesn’t get much time to do something which has been shown to have quite a high correlation with successful analysis: think. There is no evidence that the amount of original thought has soared post Big Bang or post the crash (which ought to have concentrated minds wonderfully). But the unoriginal research is professionally printed.

What has happened is that there has been a mushrooming of “me-too” research.

An institutional investor can get roughly the same research note on a company from maybe a dozen brokers’ analysts in the case of a large company.

This phenomenon is made worse by the desire of analysts to ensure their forecasts are not too far out from the consensus forecasts which are published monthly. Surely, the main point as an analyst is to find those times when you do think a company will produce results which differ from the consensus because then your research might actually add some value. But no, that would be risky, and we don’t take risks in the civil service, do we?

Finally, what about analysts’ relationships with the companies themselves?

How have they changed?

Before Big Bang, for a company to have a full-time investor relations professional talking to analysts was still the exception. Now it is the norm, at least for large companies. So an analyst often has the feeling of getting the party line professionally delivered, whereas before you could hope to hear and see what was going on in the mind of the chief executive or FD when you met them.

Companies, analysts and investment banks are much more wary now about the implications of the insider dealing legislation, the Financial Services Act, and the listing agreement. The close period between the end of a company’s trading period and the announcement of its results, when it will not normally see analysts, is an invention of the post-1986 world.

An analyst is now much less likely to see an officer of a company on his own. There will be a minder present in case there is any subsequent query about what was said.

The impact of this regulation is so enormous that I am surprised some analysts manage to publish any research at all. I am thinking of those at (mainly American) investment banks who employ research editors who edit an analyst’s research to ensure it complies with the securities laws, as well as the English language. This often involves editors in the US for research in London, and involves removing any inflammatory language.

In analytical speak, before Big Bang a note would have had profits “roofing it”, now there is “a substantial accretion to earnings”. Says it all really.

Terry Smith is author of Accounting for Growth.