Retail Investing: Unsuitable for Retirees

Buying Retail is Almost Always More Expensive

If your broker has ever called you to pitch a specific stock or a mutual fund run by his company, you’ve experienced sell-side investing. If you’ve ever gone online to look up research reports, you’ve looked over sell- side research. Welcome to the world of retail investing.

As the name implies, retail investing relies on advertising, cache and glamour in order to move product to consumers. For investment bankers and for too many stock brokers, stock is a product. Like retail stores, various wirehouses sold the product to customers (there is no such thing as a retail client, is there?)

At the turn of this century, retail investors naively gobbled up these research reports. They assumed that unbiased researchers developed the information in them by looking at various aspects of each company and its prospects for the future. It wasn’t until well into the fall of the dot com’s that the public woke to the reality that these reports were sales literature. Scandal struck Wall Street as personal emails from these researchers showed that they personally considered the touted stocks to be worth much less than their glowing reports purported them to be.

An initial public offering creates the product. After that, anyone can trade it in the secondary market. The creators and "servicers" of stock product constitute the “sell-side." The sell-side is composed of a group of players, listed here with their respective roles:

• Investment bankers: Bring the company public.
• Analysts: Write research reports and make recommendations including upgrades and downgrades.
• Market Makers: Agree to trade the stock continuously at any price, profiting from the bid- ask spread.
• An investment bank may perform all of these functions under one roof.

The Sell-Side Bias is to Sell Stock to You

The sell-side, obviously, sells stock. Higher stock prices best serve the interests of the sell-side brokerages. Stock brokers employed by the brokerage tell compelling stories as a way of standing behind their product, but they offer no guarantee. If you get into the stock early enough, their sales prowess may appear to coincide with your best interests.

As with any product salesman worth his salt, the sell-side agent will service and support her product. Since stock certificates don’t have moving parts, the support consists of analysis and ratings of the stock she has sold.

You may begin to see a bias towards "pushing" stock. However, this is where the financial services industry differs from other industries. Your stock broker and all the other players mentioned above have no real control over how well a company performs. No matter how good the ratings or how compelling the sales story, the stock price will eventually reflect the true performance of the company. So a stock can only be held up for so long before it must stand on its own.

Investment Banks Sell, Retail Investors Buy

Retail buyers, like individual investors, sometimes take large blocks of stock in aggregate. But the buy-side players, like mutual fund and pension managers, make the largest price moves possible. (For a more in depth discussion of Buy-Side Intelligence, see the article in Institutional Standards [Link])

Sell-side analysts present as positive a picture as possible for stocks their investment banks have brought to market, through their brand of analysis and research publications. They ostensibly work to envision the future and bring to market new stocks, as well as support existing stocks that will benefit from that vision.

In an ideal world, every stock that an investment bank brings public becomes profitable and stable in the long term. The bright future predicted by the analyst comes to pass and everyone wins.

Ultimately, the sell-side bias is countered by a desire for a good reputation. A firm that continually pushes low quality companies is quickly known as such. But a firm whose sales pitch actually turns out to be accurate generates loyalty from the buy-side customers.

Some Spectacular Sell Side Results

A state investigation of Merrill Lynch's stock analysts revealed that its analysts regularly used words like "crap," “junk," "disaster," and "dog" to privately describe stocks that Merrill recommended to their clients. The language appeared in subpoenaed emails, along with 100,000 pages of documents showing that Merrill Lynch encourages its analysts to give favorable stock recommendations. These favorable recommendations helped Merrill obtain more investment banking deals.

The company refused to admit misconduct, paid a nominal fine of $100 million (their approximate earnings for a single day) and in spite of the investigations, continued to see business soar.

The National Association of Securities Dealers (NASD) filed charges against top telecommunications analyst, Jack Grubman. The suit is in response to the increasingly strong evidence that Salomon Smith Barney "traded" favorable analyst reports for investment banking business.

Specifically, the NASD investigated evidence that indicates quite clearly that Mr. Grubman gave positive research reports on the communications company Winstar, despite the fact that the company was in serious financial trouble. These misleading reports artificially inflated the stock prices of Winstar and companies like it, damaging hundreds of investors.

In response to these claims, Citigroup Inc. has allocated $1.5 billion to cover legal related expenses, but nevertheless reported a net income for 2002 greater than any other company in the world.

''Not a bad performance when you consider what we had to face,'' said Citigroup CEO Sanford Weill to reporters.

Credit Suisse First Boston and Frank Quattrone

During the IPO (Initial Public Offering) boom, Credit Suisse First Boston was the top underwriter of technology IPOs. Under star tech banker Frank Quattrone, they underwrote $6.08 billion worth of IPOs on 62 separate issues. In 1999 and 2000, Credit Suisse First Boston earned more than $700 million in fees alone for helping bring technology companies public.

Investigators allege that Credit Suisse First Boston underwriters helped create a frenzy as to which favored customers would get access to the high tech IPOs. This deceptive hype inflated the after- market price paid by individual investors. Then, just as small investors were rushing in to buy the new stocks, insiders and favored customers were selling so that the small investors suffered huge losses when the stocks collapsed. It is also alleged that certain underwriters gained profits from the IPO boom not only through the bloated fees they charged for their services in making the companies IPOs, but also by conducting kickback schemes with their favored customers.