Byron Wien on Integrity in the Money Management Profession

The following is an excerpt from Morgan Stanley Dean Witter’s "US Investment Perspectives", by Byron Wien, 2/27/2001, reproduced here with Mr. Wien's permission.

The Issue of Integrity

Where have all the heroes gone? When I was growing up parents told their kids that if they worked and studied hard and lived a good clean life, they might grow up to be president. Nobody really believed it, but it was nice to think opportunities were limitless. We also had our sports idols, who were thought to be people whose lives were worth emulating. The press was less probing then. We all heard stories about how some player got drunk, and there was the Chicago White Sox ("Black Sox") scandal of 20 years earlier, but in general we looked up to professional athletes.

I know times have changed. On the whole, I’m glad of it, but there has been an erosion of integrity in American society, and the diminished number of heroes is evidence. The Clinton pardons, the gifts, and the moving-day indiscretions have dominated the news and stifled any further discussion about the confusing outcome of the election itself. As for sports, there is not much good news there. The MVP in this year’s Super Bowl was implicated in a still-unsolved double-murder after last year’s game, to cite one example. Commercialism has clearly had a role in this. Smash-mouth football may be good for television ratings, but it is unlikely to produce any heroes. I won’t even bring up Mike Tyson.

In business, there was some hope for heroes a year ago when Amazon founder Jeff Bezos was named Time magazine’s person of the year. It is doubtful that he would have made the list of candidates this year. Jack Welch is clearly a hero, but he is retiring. Warren Buffett and Bill Gates have hero status, and John Chambers, Steve Case, and Scott McNealy are candidates. But the list doesn’t strike me as long enough for a $10 trillion economy.

In "The Mind of the CEO", Jeffrey Garten points out that leaders are shortsighted and "badly underestimating the rise of global problems that will affect their firms and the environment in which they operate." Many executives believe their mission is solely to maximize profit. One prominent executive is quoted as saying, "It’s dishonest to pretend otherwise." This is not the stuff that heroes are made of. A true business hero is practical about profit but has a nobler objective as well — trying to build something great.

The flexibility of today’s accounting may contribute to the erosion of integrity. You have to be an expert willing to spend lots of time studying the numbers to really understand what’s happening at a company based on published reports. There have always been business frauds, and analysts always had to probe the numbers, but almost everyone believes the situation is worse now. Numerous accounting firms have settled claims resulting from overly permissive auditing decisions and procedures. Xerox is one recent big-name example of accounting problems, but many new chief executives announce substantial write-offs in their first year, raising questions about the accuracy of the company’s historical accounting. In the past, chief executives would hold their jobs for two decades, as Jack Welch has, but turnover in top jobs has increased. It’s almost as if the new person gets the job, cleans up the old problems in the first two years, creates problems of his own in the next two years, then gets out. I know this sounds too cynical, but in many cases there doesn’t seem to be enough time to build something important.

At a recent hedge fund conference we held, one manager said that he had been able to identify profitable short sales simply by studying accounting practices. Whenever a company made an accounting change that inflated earnings, he sold the stock short. This almost always resulted in a profitable trade, although it didn’t work every time (no generalized discipline does). Our accounting guru, Trevor Harris, gave me a list of the most common transgressions:

Much has been written about these, but imaginative accounting continues because Congress, corporations, and the investment community haven’t been tough enough clearing it up. It seems to me some accountants and chief financial officers must have trouble living with themselves, but I am reminded of a confidence man in David Mamet’s "House of Games" who, when confronted by someone close whom he has betrayed, says simply, "It’s what I do for a living."

There is an appearance of conflict of interest when companies pay auditors’ bills. Accounting is a service business; if auditors don’t please the clients, those clients may seek a firm that will. Shareholders expect auditing standards to result in an accurate statement of operating performance and balance sheet strength, but too often companies get auditors to sign off on financial results that depart from reality.

Finally, we get to securities analysts. There is no question that investment banking has changed over my 36 years in the business. In the 1960s we had relationship banking, and companies were loyal to their bankers of record, but it’s much more competitive now. For years the bankers brought in the business and the research analysts wrote about the companies, but analysts weren’t as important or powerful as they are now. Today, influential analysts can be rainmakers for banking business, and their opinions can make or break a stock even though many institutional investors say they don’t take their comments seriously. Individual and some institutional investors react abruptly to ratings changes, which is why stocks have sharp moves despite the skeptics.

While the buy side and journalists complain that there aren’t more sell recommendations, analysts worry that if they recommend selling, companies will stop talking to them and portfolio managers who hold the stock will also be angry. As one of my colleagues observes, the risks are now asymmetric. In the 2000 Reuters Survey, a surprising number of companies admitted they’d withhold information from analysts who downgraded their stocks. And Steve Leuthold points out that the buy side loves sell ratings, "but not on the stocks they own." As a result, the scale of recommendations has been reinterpreted, with "neutral" or "hold" really meaning "avoid" to many investors. Analysts themselves are often confused about their role. Some believe their function is to help the client understand the industry and the companies in it; they believe it is up to the client to decide whether to buy or sell the stock. They don’t see themselves as stock pickers.

In my view, analysts have real value if they can help portfolio managers make money. Buy recommendations and rating changes are important. The analyst has to be intellectually honest and independent. You shouldn’t gratuitously offend a client, but it is imperative that you not gloss over a negative change in the fundamentals of a company.

To do this well, an analyst must draw information from many sources outside a company. The SEC’s new Regulation FD encourages this as well. Taking surveys, asking probing questions at trade shows, and talking with suppliers, competitors, and customers all help develop insights into what is happening to a company or industry. The goal of an analyst is to identify long-term trends and to anticipate change, to be ahead of the news. Analyzing earnings once released or reacting to product or industry news is of marginal value. Few can anticipate; anyone can react.

It is clear that the profession has some serious work to do to rebuild confidence. Investment bankers may believe they will have better relationships with their clients if analysts say nice things about the companies they cover, but they must realize opinions have little value if the person delivering them has no credibility. Analysts must honestly and openly express their views or their franchises will erode and they will ultimately be of no use to investors or bankers. Softening a negative stance will prove to be a shortsighted strategy. Calling things as you see them may involve some risk for analysts, but not doing so is even more dangerous.

We are fortunate to be in this business. The compensation is generous; the work is always intriguing and continuously changing. What’s more, you learn and grow intellectually throughout your career. But it is open-ended work; unless you are disciplined, you can find yourself on the job endlessly. To be strong enough to be effective, you must feel good about yourself. For intelligent people to approach the analysts’ job with zest and enthusiasm, they must not feel they are compromising. No amount of money is worth that.

I hope George W. Bush will reestablish integrity in the presidency. Over time I hope the personal behavior of professional athletes would justify the adulation of America’s sports fans, but I am less optimistic here, because big money and youth are an unhealthy combination. I would like to believe that accounting will become more rigorous and that more business people will become role models. In our own field, it is time to reestablish conviction about the integrity of Wall Street research. There is probably no firm, including our own, that doesn’t have something to do here. It is doubtful that security analysts will become heroes in American society, but they can become heroes to themselves, their clients, and their co-workers. For most of us, that will be a satisfying achievement.

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