Security analysts as biased tools

Robert P. Gray, University of Sydney

Benjamin Mark Cole The Piped Pipers of Wall Street: How Analysts Sell You Down the River New York: Bloomberg Press, 2001. ISBN: 1-57660-083-1.

The Piped Pipers of Wall Street by Benjamin Mark Cole is investigative journalism about financial (security) analysts. True to his chosen genre, Cole starts with a premise then states numerous striking, and sometimes lurid, examples to support his premise. He asks are financial analysts unbiased? (Answer: no). Is the direction of the bias is predictable? (Answer: yes). Are financial analysts ever unethical? (Answer: often). Are there any ‘good’ analysts? (Answer: a few).

Cole states his premise, or what would be called a theory in academic literature, on pages 92 and 93:

  1. Analysts first tell their trading departments and large institutional clients that they will soon issue a ‘buy’ recommendation; this is almost always done prior to an Initial Public Offering (IPO).
  2. The trading departments and institutional clients accumulate stock leading to a price rise.
  3. This stock run-up is artificial since it based almost entirely on new buying demand instead of any fundamental change in the company—Cole accepts the efficient market theory that everything relevant is already known about the stock.
  4. The ‘buy’ signal is released to the public and the brokerage stockbrokers bring retail customers into the stock, raising the price further.
  5. The brokerage and institutional clients sell.
  6. The stock falls.

In support of this thesis, Cole offers many examples, perhaps the most persuasive coming from David Dreman’s book, Contrarian Investment Strategies: The Next Generation. Dreman analysed 1,500 U.S. stocks between 1971 and 1996. Dreman ‘found that when analysts picked their own favorite stocks one year ahead, they wound up underperforming the market a whopping 75 per cent of the time’ (page 92). Considering that it is as difficult to be wrong 75 per cent of the time as it is to be correct 75 per cent of the time (vis à vis the market averages), this statistic is noteworthy.

Cole aims to warn small investors that the advice given by market analysts working for brokerage firms is highly biased. He develops this theme in stages.

In the first section he gives a specific, and extreme, example of analyst Hemant K. Shah of HKS & Co., Inc. lying and trying to manipulate the market for stocks in Toronto-based drug company Biovail Corp. Shah went so far as to claim that George Soros was a client of his. (Cole consistently specifies individuals and firms by name and only rarely uses a pseudonym to protect a source.)

Next Cole shows how Wall Street’s analysts became so biased. He traces the crucial event to May 1, 1975—the day fixed brokerage commissions were eliminated. Before that time, brokerages made their major profits on commissions; brokers were ‘customers’ representatives’ while analysts gave relatively unbiased reports, relatively free from pressure from the investment banking side of the business. To show how dramatically the economics of commissions changed, Cole gives the example of a trade of 100,000 shares of a stock priced at $98 per share. In 1972 that trade cost $28,000; in the late 1990s the price was between $500 and $1000. As a consequence, large brokerage firms like Goldman Sachs and Merrill Lynch increasingly emphasised profits in investment banking, service to institutional clients, and trading profits for the firm’s own account.

Cole details the different ways that investment banking operations in a brokerage firm are profitable. He highlights the rapidly increasing number of IPOs with the dot.coms and the role of the market analysts in the firms obtaining IPO business. For example, he writes that the publicity generated by the ‘buy’ recommendations of Internet analysts Mark Meeker of Morgan Stanley Dean Witter and Henry Blodget of Merrill Lynch directly affected their firms’ ability to generate business. The analysts’ recommendations were offered as a package to obtain the deals before the event. The firms made money on fees, taking a position in pre-IPO stock and selling the stock after the ‘buy’ recommendation started to lose its effectiveness.

There is no effective regulation of financial analysts.

Cole asserts that financial analysts give their largest clients, such as mutual funds, advance notice of a ratings announcement on a stock. To give an idea of how large mutual funds have become in the United States, Cole reports that by year-end 2000, mutual funds managed $6.97 trillion. This equates to approximately $25,800 for every man, woman and child in the United States (page 61). Obviously, their trading business is extremely attractive.

An astonishing fact is revealed on page 205, ‘Analysts who receive material disclosures before the market can trade in their own accounts on those disclosures, or tell their major clients.’ This seemingly blatant violation of insider trading rules was affirmed by a U.S. Supreme Court decision (1983) concerning Ray Dirks and the Equity Funding Case.

To balance a litany of greed and stock manipulation, Cole dedicates a chapter to listing some truly independent analysts that he thinks an investor should consider. The analysts include Value Line, Standard & Poors, and Finally Cole proposes some options for reform, particularly for the Securities and Exchange Commission. The first is to state publicly that there is no effective regulation of financial analysts, the argument being that ‘ineffective regulation may be worse than no regulation’ (page 211). The second option is to force a separation of investment banking from brokerage. Although somewhat attractive to Cole, he acknowledges that this option is probably a political and functional impossibility. Finally he suggests that the regulations governing shorts should be less severe. He states that short sellers are one of the few countervailing forces against manipulation by financial analysts working with investment bankers.

There are some specific shortcomings in this book. Even taking into consideration the title, it is striking that there is only one mention of a stock exchange outside the United States in the entire book and that is a passing reference to Japan of only one paragraph. Clearly what has happened in the United States has implications elsewhere.

Here in Australia our per capita managed fund business has been quite small compared to the United States. Most people in Australia have the great preponderance of their personal assets in their home. In 1991 there were AUD91.816 billion in superannuation funds outside of Life Offices, which equates to AUD5,448 per capita. In 2001 this figure rose to AUD354.713 billion, or AUD18,324 per capita (RBA 2001). Although this figure is still substantially lower than the US$25,800 per capita in mutual funds in the United States, the growth in Australia has been very rapid. Also it is likely that an increasing number of Australians will be able to direct the management of their funds. If that is so, then there will be pressure on funds managers to improve performance that, in turn, could lead to pressure on market analysts in brokerage firms. Since more owners of superannuation funds would have a choice of the fund in which to place their assets, the fund managers would have an additional incentive to increase their yields. Some managers may choose to gain a competitive advantage by working closely with investment banking firms and those firms’ financial analysts in ways analogous to practices in the United States.

Australia’s per capita managed fund business is quite small compared to the United States.

With a growing amount of an individual’s assets in his/her superannuation fund, and if that person is able to direct the management of those funds, there will be a temptation to diversify those assets outside of Australia. Some of the principal funds managers in Australia are wholly-owned subsidiaries of companies in the United States—for example BT is owned by Principal Financial Group in Des Moines, Iowa and Ord Minnett is owned by J. P. Morgan Chase in New York. These funds managers are institutional investors, which may have relationships with securities analysts in a manner described in the book. Even if an individual cannot direct his/her funds, the funds manager chosen often uses large mutual funds in the United States, such as Fidelity and Vanguard and is therefore subject to the activities of securities analysts.

Another shortcoming is the lack of explanations of the jargon in the book. This book is directed at a general audience; it published by Bloomberg Press that targets general, money-related books. Terms such as ‘IPO’ are not defined. A glossary would have been an excellent addition to this book. Another excellent addition would have been a bibliography; there is only an index.

Overall, this book is very good at presenting an argument by examples and if a reader enjoys lively examples of financial misdeeds, he or she should enjoy this book. Australians should find this book germane to their personal financial situation since almost all working Australians have superannuation plans.


Dreman, David N., (1998) Contrarian Investment Strategies, The Next Generation: Beat the Market by Going Against the Crowd, New York: Simon & Schuster.

Reserve Bank of Australia, June 2001, ‘Superannuation Funds – Outside Life Offices’,

Robert Gray is Lecturer in Accounting and Business Law at the University of Sydney. He was a commercial banker for 24 years, and a member of the Board of Directors of the American Bankers Association and of the Seattle Branch of the Federal Reserve Bank of San Francisco.