What's Next For Wall Street...

And why the only thing worse than the mess in the markets may be the campaign to clean it up. Andy Kessler is a former hedge-fund manager and Wall Street analyst, and the author of a recent book, Wall Street Meat: Jack Grubman, Frank Quattrone, Mary Meeker, Henry Blodget and Me (Escape Velocity Press, 2003). In a Web-only interview, he provides an insider's guide to the wild past and uncertain future of the world's most important source of capital.

From: Web Exclusives | July 2003 | By: Polly LaBarre

In the last two years, some of our most celebrated CEOs have traded in their cufflinks for handcuffs. Wall Street analysts have morphed from oracles into pariahs. Our irrational exuberance has devolved into a kind of serial indignation. The bursting of the bubble (and the accompanying psychological whiplash) opened up the field to a posse of lawyers, regulators, and one crusading attorney general, whose reformist zeal and professional ire on behalf of defrauded individual investors most recently resulted in a $1.4 billion settlement between Wall Street's biggest firms and securities regulators.

The debate on how to reform, restructure, and otherwise clean up Wall Street rages on. And it has inspired the ultimate insider to expose some of the myths and half-truths that muddy the efforts to "fix" Wall Street -- and the conflicts of interest that continue to rule it.

Andy Kessler has worked on Wall Street for close to two decades. He's been an analyst at some of the best-known investment banks. He's made venture investments in a collection of Silicon Valley startups (some of which actually made it through the start-up phase.) He's run a hedge fund and sits on the board of several private companies. He's worked with some of the most famous (or infamous) characters from the front-page scandals of the last few years. And now he's published his first book, Wall Street Meat: Jack Grubman, Frank Quattrone, Mary Meeker, Henry Blodget and Me, a radically honest account of the real crimes and misdemeanors of Wall Street and a breezy good read.

Of the settlement and its chief architects, New York attorney general Eliot Spitzer and SEC enforcement chief Stephen Cutler, Kessler says, "With all due respect to sheriff Spitzer and sheriff Cutler, I think they strung up the wrong guys. Fixing the analyst problem doesn't remove conflict from Wall Street. The analysts were just the hot air that inflated the balloon. There are still the deep structural issues that put the balloon there in the first place. The problem is, everybody wants a fall guy -- and structural issues don't play well on television. They went for the easy targets. There's a face people can point to. People look at Jack Grubman and say, "That guy lost me money."

Kessler's not arguing for the defense, he's proposing a new way to look at "changing how business gets done in the most powerful, complicated, and mysterious financial market in the world." In a series of conversations with Fast Company, Kessler offered a true insider's perspective on what makes the world's most important source of capital tick.

In the efforts to reform Wall Street, all fingers are pointing to analysts and their cozy relationship with the investment banking side of the business. They may not be responsible for the bursting of the bubble and the market massacre, but they're not exactly innocent. What's the reality when it comes to the role analysts play in moving the market?

There are two half truths at the core of the attack on analysts. First, there's the notion that analysts know everything. If they recommend a stock that tanks, then they must be in the tank with management. The second assumption is the opposite: analysts know nothing.

Let's look at the first. An analyst's job is to predict the future, so knowing everything about today's trends is critical. But companies are so damn secretive about what they do, and only release earnings and information every 3 months. As an analyst, I would talk to customers, go to trade shows, read technical specs, but I was still always in the dark. No one opens up their R&D labs and talks about future inventions for fear of tipping off competitors. So analysts, me included, made it up.

I learned this lesson my first day on the job as an analyst at Paine Webber in 1985. When I met Margo Alexander, who ran all of research, she reiterated that my job was to predict the future -- that I only needed to be right "51% of the time." I was dead wrong for my first six months, and almost lost my job, but then my stock picks were dead right for several years, and I became a ranked analyst. It's not so much what you know (although that helps). It really is how good you are at predicting the next two years.

Of course, an analyst's job is not only to predict the future, but to find stocks that will go up or down in that same future. Eventually, you get proved right or wrong, but until then, real investors want to know your vision of things to come. If you don't have one, you're worthless. Oddly, most analysts don't even bother with their own version of the future. They are just spoon-fed one by management, which is less than worthless. Figuring out for themselves takes too much work and takes away time from schmoozing with the investors who pay the bills. But that's what led to the problems of the bubble. Everyone listened to management -- "going off message" risked lucrative investment banking fees. Investors stopped being the client, replaced by management. The future rarely pans out the way someone raising money spins it.

So, what do analysts know?

Analysts work 24/7 to know everything about their industry. Boring conferences, millions of frequent flier miles, dinners with marketing managers, mind-melting factory tours, back-to-back conference calls. This is no glamorous life, but I can guarantee that most analysts know more about the industries they follow than most CEOs. Analysts are wide, CEOs are deep.

Now, knowledge doesn't equate to being a great stock picker. I would venture a claim that most analysts suck at finding stocks that go up. They get blinded by their industry knowledge, figuring they know more than anyone. But stocks don't pay respect to anyone's knowledge. Stocks are exactly the sum of what every one already knows about a company and what it thinks about its future on that given day. It's that future thing again. Crystal balls don't work.

Ironically, the effect of the settlement is that within the next year, more analysts on Wall Street will know everything than know nothing. The people that are left live and breathe their industry and often know more about it than the people in it. The problem is, it's going to be very hard for them to get paid as analysts.

If fixing the "analyst problem" won't do much to fix Wall Street, what's really wrong with it?

A bubble is both hot air and a membrane that expands to contain it. Analysts were just the hot air. There are still plenty of structural problems on Wall Street to create more bubbles. Fixing analysts fixes almost nothing.

My boss at Morgan Stanley, Rod Berens, taught me the Wall Street birds and bees. Wall Street is about allocating capital. Great companies can get money easily. Bad ones have to pay more for it. Wall Street gets paid by controlling access to that capital, and charging fees to get it. Companies pay via banking fees and investors pay via trading commissions. That's the easy part. The dirty little secret is that the people on Wall Street keep half of all the revenue they generate. If you look at Morgan Stanley's or anyone else on the Street's profit statements, you'll see that compensation is half of their expenses. Communications is around 10%. There is interest expense. There is overhead for buildings and lights. And whatever is left over is reported to shareholders of the firm as profit. But the biggest expense is compensation, the famous bonus pool.

If you are inside a Wall Street firm, the trick is to associate yourself with as much revenue as you can, and make your case for as close as possible to 50% of that as you can for yourself. That used to be easier to do. Most of it came from trading commissions. Before 1975, commissions were 75 cents a share. After the Big Bang that ended fixed commissions, they dropped to a quarter or an eighth (12.5 cents) per share. By 1989, when there were more firms on Wall Street with big trading operations, commissions were five or six cents a share. By 2003, they were often a penny a share.

Wall Street responded in a few different ways. Banking became much more important. You could charge a 7% fee for taking a company public. You could charge 2% to raise money for a company that was already public. Wall Street is a great racket in which the participants keep half of revenues that are generated. Hmm. Think there is pressure to generate fees? Jack Grubman may have taken the heat for being conflicted on Teligent, but the entire firm of Citigroup Travelors Salomon Smith Barney was conflicted on Teligent.

That's an obvious conflict of interest. What are some of the other, less obvious structural problems that resist reform?

I hate mutual funds. I'm a huge believer that the only way to invest is to look management in the eye and ask them a question, and another question, and another question. That's the only way to ascertain the company's future and generate superior, long-term returns. And a portfolio manager at a mutual fund fits the bill, meeting with management and buying and selling stock. Joe Six Stock (you and me) can't do that -- we don't have the time and Jack Welch doesn't return our calls. So mutual funds are great, right?

No way. They are structurally corrupt. Mutual funds charge based on how much money they manage, usually 1-2% fees. If you manage $100 million, that's 1-2 million bucks. If you manage $10 billion, that's $100-200 million. So guess what mutual funds #1 goal is? Duh. Gather assets. How? Have a decent enough track record so you can run ads in the Wall Street Journal and Barron's and attract new money. Of course, managing $100 million vs. $10 billion is a huge difference, more money makes it harder to find great returns. But so what, the way to get paid is to manage more, not manage better. This led directly to momentum funds, I call them momos. Only buy stocks that are going up. In good times, that leads to great performance numbers, attracting more capital. In bad times, well don't ask.

On one grueling marketing trip, Mary Meeker and I found ourselves in Wayne, PA, in the offices of Pilgrim Baxter meeting with none other than Gary Pilgrim.

"Tell me the Intel story," Gary said to me. "Well, the stock has already doubled off its bottom, but their new 486 microprocessor ..."

Gary Pilgrim cut me off. "Perfect. Let me interrupt and tell you what we do around here. We like fundamentals all right, but we only buy stocks that are already going up, that have momentum. Our success is based simply on finding these momentum stocks and buying them in size. Stocks that go up keep going up. Stocks that don't go up keep not going up. Now what was that about Intel?"

This guy was crazy, but apparently this style of investing and these so-called momentum funds were the hottest thing on Wall Street. Pilgrim Baxter had been posting great performance numbers using this method and lots of other funds were becoming momentum funds. It didn't make much sense to me.

At the end of our meeting, I sheepishly asked Gary, "Wouldn't you want to find stocks that are about to go up, rather than ones that are already going up?"

"We don't have the patience for that," he answered.

There it was in a nutshell. Momentum funds needed performance NOW, and couldn't wait around for a stock to work. Instead, they bought stocks that were "proven," even if they had already doubled. This struck me as more like gambling than investing. Blackjack cards or a craps table gets hot and gamblers at the surreal Caesar's Palace flock to it and bet more.

Wall Street as a casino is an overused metaphor, but an apt one. I am always asked what stocks to bet on, what are the odds that something will work, should the investment be doubled-down? I hate the tie-in. Casinos are for losers. Gambling is a sucker's game. Everybody knows the games are rigged against gamblers -- the odds are set so the house always wins. Wall Street is about access to capital for great companies. If you do your work, you can find these great companies that do better than the market. Gary Pilgrim was impatient. He and momentum investors just wanted to find the hot table.

Much of the Wall Street reformers efforts are aimed at leveling the playing field and putting some of the power -- and the profits -- back in the hands of individual investors. What are the chances of that?

Of course there's some well-intentioned work going on here. But, when you do things in a market in the name of individual investors, you're just kidding yourself -- and the individual investors. The individual investors who came in and lost money all had a gambling mentality. They didn't do the fundamental research. So how do you stop individual investors from being speculative? You can't! That's what markets are about -- whether it's the real estate market or the stock market. All you can try to do is make it a fair and open market. And I don't think the reformers and regulators have necessarily done that by restricting analysts and bankers from talking to each other.

Regulators love to do things for the little guy, Joe Six-Stock. The SEC had passed a measure known as Reg FD or Regulation Fair Disclosure. Companies couldn't selectively tell analysts anything. They now had to broadcast their news far and wide, so that individual investors wouldn't be disadvantaged. This sounds innocent enough, except companies used it as a reason not to say anything ever to analysts, except once a quarter. Less news means more volatility, hurting Joe Six-Stock.

In the wake of the Enron and Worldcom corporate and accounting scandals, Congress quickly passed the Sarbanes-Oxley bill, which forced management to swear that their results were true, imposing criminal penalties for false statements. As much as I would like to see a few lying CEO's do time up the river, all that Sarbanes-Oxley will do is keep good managers out of the business. Why risk jail over a penny or two of earnings? Unintended consequences run amok.

Spitzer ended up negotiating a global settlement with the big players on Wall Street, who agreed to pay $1.4 billion in fines and make shallow changes to research in order to make Spitzer go away. Too bad. I think that structural changes on Wall Street are happening anyway. The Virtual Morgan Stanley or the Synthetic Goldman Sachs is going to happen one way or another.

Big, ugly Wall Street firms are hurt and now have to restructure around the new reality of Wall Street. Electronic trading, layers of independent research, and baking only boutiques are here to stay. Unfortunately, the fines to make Spitzer go away will only freeze the field. It seems to me that Wall Street management reached into the pockets of their shareholders and paid big fines so they could keep the status quo. I have a bad feeling that Spitzer's "settlement" will merely perpetuate the old way of doing business much longer than its natural life.

Is there some message to all this? Some note to future generations about how to avoid stock market bubbles, how to keep research honest, how to tame the cycles? Nah. They will learn it the hard way. Wall Street is a business. Analysts and salesmen and traders and bankers all make a living providing access to capital to businesses worldwide. But it's an information business. When you work on the Street, all you have is your reputation. Longevity comes from maintaining that reputation with all your constituents including companies, institutional investors and Joe Six-Stock retail investors. Taint it, and someone else will fill your shoes.

Weird things will happen again, I guarantee it. Manias, frauds, axes, ducks -- get used to them. If you try to legislate them away, you will end up killing the whole system, just as the Small Order Execution System, SOES, enacted in the name of fairness to small investors, killed liquidity.

Reputations trump legislation every day in my book. The tales of Jack Grubman, Frank Quattrone, Mary Meeker and Henry Blodget are important, if only to show how powerful and then how fickle the Street can be. Over time, Wall Street knows how to transform itself to stay a lucrative capital-raising machine. Those that abuse it won't last very long.

So, you know what's wrong with Wall Street. How would you fix it?

I'd propose three changes.

First, I would improve liquidity. Liquidity means that when you want to buy a stock, there is a willing seller on the other side. If there's no seller, the price pops. Wall Street firms used to play a pro-liquidity role, charging a spread (the difference between the bid and the ask) to make up for the risk of providing liquidity. Back in 1998, William Lerach won a $1-billion spread-fixing suit against over-the-counter traders -- and no surprise, liquidity dried up. The New York Stock Exchange discourages liquidity with its antiquated rules. Liquidity will return with incentives to firms that provide it.

When Henry Blodget came up in December of 1998 with a $400 price target on Amazon, he was a second-tier analyst at a third-tier firm, and the stock went up 26%. And it wasn't because he said he had a $400 price target. People thought there was something interesting there so they should buy the stock. But there's no liquidity. No one was willing to step in and bet against it, so boom, it just popped. And that was endemic of the entire market. The fact that Henry Blodget is a name brand isn't because analysts wield so much power, it's because of these structural problems that allow them to amplify the problem.

Second, I would quit favoring mutual funds as the vehicle of choice for individual investors. Mutual funds drive near- term performance to gather assets, and then overcharge management fees. Hedge funds that care more about their performance then how much money they manage are at a disadvantage in this sort of environment. Anyone can invest in a mutual fund, but only the wealthy can invest in hedge funds, and a set of bizarre rules limit how many investors. Let's level the playing field.

Finally, I would get rid of lockups, which restrict entrepreneurs and venture capitalists from selling shares in a new IPO for 180 days. Lockups limit the supply of available shares, which means that even a little demand for new stocks after the IPO drives up prices. No wonder so many IPOs popped in the first days and weeks after their offering.

Once these three problems are fixed, there will be more of a balance between buyers and sellers of stocks. Even if conflicted analysts said "buy, buy, buy," sellers who knew better would keep the markets honest.