“Financial advisors should not rely on analyst recommendations,” says Erik Gordon, professor of the University of Michigan’s Ross School of Business. Gordon’s convictions are shared by financial advisors and registered investment advisors who Financial Advisor spoke with following Valeant Pharmaceuticals’ calamitous stock crash last week.“When a stock is zooming to the moon, analysts trip over each other trying to be the analyst who is most loudly behind the company,” says Gordon.
The company—whose business model is acquiring established drugs and then jacking up their prices—became manna to Wall Street’s high-flying hedge funds, who invested heavily in it. Pershing Square, the legendary hedge fund owned by Bill Ackman, reportedly lost $900 million of its investment before noon on March 15 (the Ides of March). Things quickly took on the aspect of a Shakespearean farce that day, as analysts who followed the stock continued to issue buy or hold ratings right up until the 47 percent plunge of its share price—all before lunch.
In fact, 21 out of 23 of those financial analysts continued to trumpet the stock, despite plenty of ominous signs: the company’s rising debt and declining quality; investigations by Congress, the SEC, and U.S. Attorneys in Massachusetts and the Southern District of New York; the company’s own declining growth forecast; its inability to organize its financial picture sufficiently to meet an SEC filing deadline; and a rising tide of public disdain toward Valeant’s “gouging” drug prices.
The skeptics were Dimitry Khmelnitsky, from Canadian firm Veritas, and David Maris of Wells Fargo, the only analyst from an investment bank to issue a sell.
Why would anyone believe positive calls under these conditions? That is the sell-side defense, says James M. Sanford, founder and portfolio manager of Sag Harbor Advisors in New York, an RIA with $25 million in assets under management.
“They’re saying no one believes the reports anyway. But investors must believe them or the analysts wouldn’t still be in business,” says Sanford, a CFA who, as former managing director of hedge fund credit sales for Credit Suisse, learned how conflicted analysts’ opinions can be. It follows that advisors wouldn’t pay if they didn’t think the information worthwhile. “Absolutely,” says Sanford.
“Isn’t that what [analysts] get paid to do?” asks Tom Meyer, of Meyer Capital Group, a $700 million advisory firm in Marlton, N.J. “Analysts say these are the best buys and then the price plummets,” he says. “They’re like economists—for the very short term.” Meyer sympathizes with small advisors. “There’s no way a two- or three-person shop can take the time to do the kind of research needed to put clients’ money into these. This is especially true of underfollowed stocks.”
Sanford and Meyer note that most small and midsize advisory firms invest in mutual funds rather than individual stocks. But the Sequoia Fund’s 8 percent loss on that fatal Tuesday revealed the crack in that strategy. Steer clear of funds with concentrated holdings, warns Meyer.
His firm uses independent research, the “big guys”: “Morgan Stanley, Credit Suisse. And we look at a company’s bond holdings.” Bond analysts tend to do better research, says Meyer.
Sag Harbor makes use of models and research data, but not analyst calls, says Sanford. Neither advisor was holding individual Valeant shares.