Black shadow cast over the research industry

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You might have thought that the dot-com fiasco would have taught the research houses a much-needed lesson.

For the past 18 months, technology shares everywhere have been plunging, but the number of "sell" recommendations by analysts has barely flickered upwards.

And as the market has fallen, evidence of the fallibility of analysts has flooded in. Every year, the US data agency Zacks creates a sample portfolio containing the 10 stocks with the most "sell" notes on them, and compares these with one made up of the best "buys". Last year, for the second year running, the "loathed" officially trounced the "loved".

But the Enron scandal has generated even harsher condemnation of the research industry. In pre-Enron days, most people in the market knew how the game worked. Analysts were reluctant to make their commentary too critical out of a double concern: that they should continue to have access to the management, and that they shouldn't be a thorn in the side of the corporate finance department when it was pitching for lucrative deal work.

The only antidote to that was a noble, but tiny, handful of analysts who bucked their masters when they really believed a stock was bad, including the famous Cannot Recommend A Purchase call that caused its author to be fired from UBS.

The pattern continued relatively unchecked until last year when Merrill Lynch found itself being sued by an enraged private investor. He claimed that by following the tech analyst Henry Blodget's recommendations he had lost a fortune. It gave the industry a jolt, but not nearly enough of one to undo the malaise.

The Enron debacle has cast a far blacker shadow over the research industry. Last week, Daniel Scotto claimed that he had lost his job as a bond analyst at BNP Paribas after recommending against investing in the company. John Olson, a Houston-based researcher, received a personal letter of condemnation from Enron's chairman after putting out a "sell" note last June.

All of a sudden, the game doesn't seem quite so much fun. Investors are panicking at the prospect of another Enron lurking in the market, and there is little confidence that analysts would be able to identify it before it collapsed. Even if they did, there is still every reason to expect that the banks would suppress the naysayers for the usual reasons. At the back of the market's mind is the sheer number of "buy" recommendations still sitting on the stock when its downfall was in full cry. Some houses even held their positions when the stock dipped below $1 per share.

The scandal has dealt an especially massive blow to the credit ratings agencies, principally Moody's and Standard and Poor's, whose reputation and market power is based on their supposedly unparalleled access to companies. Both houses were slow to cut Enron's credit rating, moving only when it was too late.

"There is only one way to look at it," a senior analyst at Nomura said. "This is a massive embarrassment for analysts. Researchers across all sectors are going to have to start questioning whether pro forma earnings and the like are the measurement tools they should be using."

Richard Dale, joint head of equity research at Citigroup, last week gave a presentation to his analyst team entitled "Time for forensic analysis".

"There is a generation of analysts who have grown up in the bull market ... and never had to look at a balance sheet. That is where the real story is, and they have to learn what alarm bells sound like," he said.

To a market that has been, in places, devastated by Enron, there will be serious questions over why this tyre-kicking approach was not adopted years ago.