By Ian Fraser
Date: 28 September 2011
Why does anyone rely on ‘sellside’ research? The investment analysts who produce it, for free, tend to work for investment banks that also have some very big ticket services to sell, such as the underwriting of IPOs, to the very companies whose performance they are supposed to be evaluating.
The scope for conflicts is immense. We saw this during the dotcom bubble in 1999-2000, when technology analysts such as Citigroup’s Jack Grubman and Merrill Lynch’s Henry Blodget slapped strong “buy” recommendations on tech firms which they privately described as “junk” or worse. Both received lifetime bans from working in the securities industry, while their employers, found to have issued fraudulent stock recommendations, had to pay a $1.4bn settlement following an action brought by New York attorney general Eliot Spitzer.
Sellside research does not appear to have become much more reliable over the past decade. Three-fifths of all ratings in the UK are “buy” recommendations, while “buy” and “hold” ratings together outnumber “sell” recommendations by nine to one, according to Bloomberg data. Instances of extraordinary and ill-timed bullishness have continued.
Merrill Lynch analyst John-Paul Crutchley issued a “buy” note on UK lender Northern Rock — on September 14 2007, the day the bank’s shares collapsed as thousands of customers besieged the branches and commenced a multi-billion pound run on the former building society. The bank had to be nationalized the following year and shareholders lost their shirts.
Well, an unexpected player has emerged on the investment analysis scene, which promises to shake things up. Anonymous, the ‘hacktivist’ collective, has branched out into investment research with the launch of Anonymous Analytics. They have kicked off with a truly stunning research note on Chaoda Modern Agriculture.
Chaoda, which has been listed on the Hong Kong stock exchange since 2000, has a market capitalization of $460m and is one of dozens of Chinese companies that have been accused of fraud in recent months.
In its research note, which can be downloaded in full here, Anonymous points out that Chaoda has changed its auditors with alarming regularity over the past seven years and alleges that the company’s management syphoned $400m out of Chaoda “under the cover of inflated capex spending and related party transactions”, having raised more than $1.1bn from investors since the firm’s IPO in 2000
The research report claims that:
- Chaoda Modern Agriculture is one of the Hong Kong Exchange’s largest, and longest running frauds.… management has time after time misled investors about the Company’s capital requirements.
- … Chaoda is overstating its cash balance, exaggerating its revenue, and falsifying its financial statements.
- … payments made to a ‘major supplier’ owned by the CEO [were] transferred to a shell company with no business operations and de minimis assets.
- … Chaoda is paying another fraudulent company to provide it with positive marketing exposure.
- … management is actively paying ‘fees’ to a questionable company to place Chaoda on a illegitimate [brand value] list for bragging right
If the claims are true, the episode would be a major embarrassment for the Hong Kong stock exchange and the SAR’s Securities and Futures Commission, given their seeming failure to detect the alleged fraud. Eric Yip, a spokesman at Chaoda’s public relations agency, said the company is looking at the report and may issue a clarification statement later. On September 26, the company said that its shares were suspended from trading pending the release of price-sensitive information.
In an emailed interview with the Financial Times’s Tim Bradshaw, an anonymous Anonymous spokesman said:
“… There are several reasons we chose to start with China. First, there are an asymmetric number of frauds coming out of China. When you have a country that’s growing at a reported 10% clip, you’re also going to get a lot of easy-to-detect frauds. That’s just the nature of the beast.Second, it’s an issue of money and resources. We don’t have enough of either to start attacking a major Western entity on an effective scale. So we have to start with smaller companies, gather enough resources and expertise, and slowly work our way up the food chain.
“We would love to take down the next Madoff, but we have to make sure our reach doesn’t exceed our grasp.
“We also hope that our work will encourage individuals who have information, but are either too scared or don’t have the investigative network we have to approach us. We have a secure dropbox on our website for anyone that wants to tip us.”
However, the funding model and exact motivations of Anonymous Analytics remain unclear.
Further reading on investment analysis and the shortcomings of ‘sellside’ research:-
- The Investment Banks Are on a ‘Stairway to Heaven’ by Philip Augar
- How a deceptive report from Merrill Lynch sank Ireland by Ian Fraser
- The Changing Role and Regulation of Equity Research by Simon Taylor
This article was first published on QFINANCE on September 28, 2011