Reputation is difficult to build but easy to lose. How we hope people in the investment industry respect this for a fact. Sadly, most don’t!
“We’ve given you so much information on our business. Now what can you do for us?” I was stumped to hear this from the CFO of a “reputed” mid-size Indian IT services company when I went to meet him sometime in 2009. I had received several such requests from lower rank managers of other companies in the past, but to expect this from a CFO was like too much!
This harmless-sounding question – “What can you do for us” – means a lot when you are stock market analyst who is preparing to write a report on a company. When a top manager asks an analyst as to what he can do for the former’s company, he is indirectly nudging the latter to write a positive report (a ‘Buy’ recommendation) on the stock. Yeah, that’s true!
I’ve been party to several such requests when I was working at my job as a stock analyst during the period 2003-2011. Given that my employer was an independent stock research house, we did not have any brokerage or investment banking business to create conflicts of interest while recommending stocks. In other words, we were never at the risk of losing an investment banking contract – because we never provided this service – by writing a “Sell” report on a company.
But when I looked around myself – at my friends and ex-colleagues working in stock brokerages and especially those with investment banking arms – I saw them going through these conflicts almost each day.
Such conflicts broadly arose (and still do) due to two reasons –
• If the analyst of a particular stock worked for the same investment bank that was underwriting the company’s public issue (IPO or FPO), he/she was inclined to give a positive recommendation to ensure that the offering was successful. This is like the way a car dealership might operate – all cars have advantages and disadvantages, but most car dealers will tell you that their brand makes the finest cars.
Investment banks are like most other businesses. They are always trying to increase profits, and they can attract more business by issuing favourable reports (read, ‘Buy’ recommendations) about their clientele. Such favourable reports keep existing client companies happy and facilitate repeat business. This can give prospective companies the impression that they will benefit from the same favourable reports should they pay for the services of a particular investment bank
Not just investment banks, even analysts at credit rating agencies suffer the same conflicts while issuing ratings to their clients. After all, why would a rating company issue a negative rating to a client who pays for the rating? So in most cases, the rating is good or positive. This is especially true of bigger clients who have the potential to give the rating agency big business in the future.
Consider the rating of 4.0 out of 5.0 that India’s biggest rating agency Crisil assigned to the IPO of Reliance Power in 2007. As per the agency’s definition, the rating of 4.0 indicated that the fundamentals of the issue were above average, in relation to other listed securities in India at that time. Remember, we are talking about a company that had no business at the time of its IPO, and thus no profits to show.
While Crisil may have had its reasons to assign such a high rating to Reliance Power, we knew how much above average the fundamentals of the company were then (and we have seen how the company, and its stock, has fared since then). Not just Reliance Power, most IPOs are assigned average to above average ratings because the companies pay for such ratings, which itself creates the conflict of interest.
So, as an investor, you must know of the other side before you blindly buy their recommendations. Most stock research and recommendation you read or watch on business media has strains of such conflicts – either the business being recommended is also an advertiser with the newspaper, magazine or business channel that is publishing the analysis, or the writer of the report already has an interest in the stock being recommended (who cares about the disclaimers!).
And when you are an analyst yourself, or a fund manager, or just someone known for his stock picking skills (and is thus widely followed), it’s important that you avoid such a conflict that may put your reputation at stake.
How to Get Richer, Faster
When you are an investor and your stocks are doing well, you tend to get a lot of publicity within your close circles. Your friends and colleagues would come to you to ask for stock advice often believing that whatever you suggest could make them rich.
But when you are a widely followed investor and your stocks do well, there’s no better way to get even richer. Just keep ‘talking up’ your stocks so that people who follow you (and thus trust you) buy the same stocks, and you get richer because the prices keep rising (as more of your followers are buying).
Now, this is a virtuous cycle for you. Buy a stock, then talk about it, and when your followers buy it, the stock rises and you get richer. Keep talking more about the same stock at various forums and investor groups, and you are assured of a steadily rising stock price (because more of your followers would be buying on your recommendation). The interesting thing here is that as more people buy because you are talking more and more about your stocks, and the stock prices keep rising, they think it’s your smart stock picking skills that are causing the rise in stock prices, and not their own buying and that of your other followers. The rise is even sharper when you own and then talk up less liquid or illiquid stocks.
How unethical and conflicting can that get? The issue is that when the tide turns, and when your talked up stocks do not do well, that’s the time reality would sink in with your followers, who may not only question your skills, but also your integrity. In 1991, Warren Buffett wrote a simple statement to his business managers that has been essential to his business philosophy ever since –
Do nothing that you would not be happy to have an unfriendly but intelligent reporter write about on the front page of a newspaper.”
Reputation matters above all else. Keep your promises. Be earnest with everyone. When you are a stock analyst or noted investor, treat your readers and followers well and never short-change them. As Buffett tells his managers –
Lose money…and I will be understanding. Lose a shred of reputation…and I will be ruthless.
And then, here’s his timeless wisdom –
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
It’s very difficult for someone working in an institutional setting – like a stock broking analyst or investment banker – to understand and practice this (philosophy of ethics and integrity) because his incentive is tied to doing otherwise.
But if you are individual investor and analyst (even if you are rich and famous), please avoid conflict of interest at all costs, both in letter and spirit. Guard your reputation extremely tight, even if that would mean not becoming an overnight star and getting richer slower. After all, as a wise man once said, “A good reputation is more valuable than money.” Ask those who’ve lost it.