Analyst All-Stars

Howard Rudnitsky -- Electronic Business, 10/1/1999

Some securities analysts are so biased and promotional they could wear signs saying "The hype starts here!" They are selling incite rather than insight.

On the other hand, some analysts' reports offer an admirable combination of sanity, objectivity and genuine concern for investors. Their work, occasionally, is so accurate and timely that you can make a bundle following their advice. In 1998, some made spectacularly successful calls, earning their generous salaries. As they did the year before, they had the wind of a bull market at their backs as the broad Standard & Poors 500 stock index soared by 28.6%.

Trouble is, there are several hundred stock analysts forecasting earnings and picking stocks of technology companies. Whom do you believe?

To find out, Electronic Business engaged Zacks Investment Research in Chicago, IL, which compiles a database of analyst performance in 55 industries each year on behalf of the Wall Street Journal. (Note: "Return" means the increase in the price of the basket of stocks an analyst recommended last year, from the day an analyst first recommended each of them to either the day the analyst canceled his or her buy recommendation or the last market day of 1998--if the "buy" recommendation remained in effect). With the raw data in hand, EB then did its own analysis of analysts in eight technology industry sectors. We wanted to do more than find out who were the best-performing analysts. We also wanted to compare the analysts, as a group, who cover different industries, to find out which group did best or worst and to see which sectors' analysts had the widest variability in their results.

One of the biggest surprises was the number of technology analysts' recommendations in 1998 that resulted in negative returns.

That's quite a trick, when you consider that the median average stock gain last year for the eight technology industries we surveyed was 63%. Even if you exclude the sizzling Internet stocks, the median gain still averaged 33%. Yet the clients of these poorly performing analysts would have been better off investing in Treasury bills offering a safe 4% return.

After we found the best stock pickers and earnings forecasters, we asked them how companies could improve their dealings with the analysts who follow them. Few were willing to say which companies do a poor job. But they did offer a number of suggestions that can help you prevent your company's stock price from sinking like a rock.

The results by sector

Not surprisingly the clear winners last year were the analysts who covered the Internet sector. All 16 Internet analysts generated triple digit investment returns. The leader, Frederick Moran of ING Baring Furman Selz (New York, NY), recorded a phenomenal 492% return. Moran hit it big by riding the craze for Internet service providers such as America Online Inc. (Dulles, VA), on which he chalked up a 589% return last year with his timely recommendation.

The median return for all 16 analysts was by far a technology industry high of 274%. Even the lowest-scoring analyst, Michael Wallace of Warburg Dillon Read (New York, NY), managed to chalk up a 127% return in just the nine months in which he recommended Internet stocks. Wallace did manage to rank at the top of the heap with his accurate earnings projections.

The computer hardware and PC sector, with an overall median gain of 67%, was another strong performer. Nearly a third of the 25 analysts in the group recorded gains of 100% or more. Many of them picked Dell Computer Corp. (Round Rock, TX), which was a strong performer last year, up some 250%.

In addition, strong gains on stocks such as Sun Microsystems Inc. (Palo Alto, CA), Compaq Computer Corp. (Houston, TX) or Apple Computer Inc. (Cupertino, CA) helped propel analysts Lou Mazzucchelli of Gerard Klauer Mattison (New York, NY), Richard Chu of SG Cowen Securities (Boston, MA), David Wu of ABN Amro (San Francisco, CA), Daniel Niles of BancBoston Robertson Stephens & Co. Inc. (San Francisco, CA) and Andrew Neff of Bear Stearns & Co. Inc. (New York, NY), to well above average results.

Wu, who had been covering both PC's and semiconductor stocks, and faring well at both, says he decided to drop the former because the PC business has become more like a commodity. By contrast, he says, with semiconductors much more technical innovation is involved, and the industry is in the early stages of a three-year growth cycle.

Wu says he did well in semiconductors by investing in EPROM companies such as Linear Technology Corp. (Milpitas, CA), Maxim Integrated Products Inc. (Sunnyvale, CA), Xilinx Inc. (San Jose, CA) and Altera Corp. (San Jose, CA). He compares being successful in investing to being a good cook. "Why does one cook make a better meat loaf than another if the ingredients are very well known? It's all in the combination."

In contrast to the Internet and computer industry's rich gains, the industry sector with the smallest median stock picking gains last year, at 10%, was the semiconductor equipment group.

Fortunately for this group of analysts, last year Zacks decided to separate them from the group who cover semiconductor manufacturers. So the former wouldn't suffer from being compared directly to the latter, who had a hot industry to cover.

Last year, the highly cyclical semiconductor equipment makers were still mired in a recession and hoping for badly needed new orders from semiconductor manufacturers, which didn't begin until late last year. Even the best stock gain, made by Frederick Wolf of Boston-based Adams, Harkness & Hill, was a modest 44%. That happened largely because he invested in Veeco Instruments Inc. (Plainview, NY), a maker of components for the disk-drive industry.

The Veeco investment netted a 141% gain, giving Wolf a leg up on second-ranked stock picker Susan Billat (first in earnings accuracy) of BancBoston Robertson Stephens Inc. (San Francisco, CA). Last October, she was the first analyst, she boasts, "to call the recovery in chip-equipment stocks." That helped her record a 28% return by recommending companies such as Novellus Systems Inc. (San Jose, CA), Applied Materials Inc. (Santa Clara, CA) and KLA-Tencor Corp. (San Jose, CA).

What had Ms. Billat seen before her competitors? She says "it was many pieces of information, like a jigsaw puzzle and you get them by talking to the companies and their customers."

"I was at a trade show," she continues, "when the industry was still in the throes of the downturn, but a number of the people I talked to said, 'you know I got this unexpected order out of the blue.' Then I heard the same thing from a number of companies in different regions, in different types of equipment. Suddenly, I realized, that what might look like an anomaly to one company, was really a trend."

Unfortunately putting all the pieces together proved more difficult for Ali Irani of CIBC World Markets (New York, NY), whose semiconductor equipment stock recommendations last year resulted in an 18% decline and the bottom spot.

A number of semiconductor chip producers had weak sales part of last year, but, when the turnaround began last fall, the stocks rose faster than those of the equipment makers. The chip makers who ignited fastest were primarily those focused on communications and programmable logic chips used by companies engaged in building up the Internet.

Clark Westmont, then with NationsBanc Montgomery Securities LLC (San Francisco, CA), now at Salomon Smith Barney Holdings Inc. (New York, NY), saw that early on. He recommended Applied Micro Circuits Corp. (San Diego, CA), PMC-Sierra Inc. (Burnaby, British Columbia) and Vitesse Semiconductor Corp. (Camarillo, CA), which were big winners and helped him achieve the best stock return--90%. Other winners were Ken Pearlman at CIBC World Markets (San Francisco, CA) (81%) and Joseph Osha at Merrill Lynch & Co. Inc. (New York, NY) (78%), well above the median return of 44% for the 24 analysts covering this sector. Pearlman and Osha also ranked near the top in earnings estimates.

Says Osha, "You try to be good at both. Still, getting earnings pretty close doesn't mean you can get the recommendations right. But the really good people I've seen in this industry tend to get them both."

He strongly recommended buying Broadcom Corp. (Irvine, CA) last year, saying, "being aggressive helps when the stock quadruples. Last year, I hit a couple of home runs, but I also like it when I get a lot of singles and doubles. I try to be consistent."

However, Osha's well-known sidekick, Thomas Kurlak, had trouble even getting to first base last year. The highly influential analyst recommended LSI Logic Corp. in mid-1998 and its share price fell by one third in just two and a half months. Kurlak wound up with a dismal 33% decline on his stock picks, upsetting his investors. He left Merrill Lynch early this year, going to Julian Robertson's Tiger Management.

The spread in investment results from top to bottom was even greater among the 54 analysts in the telecommunications and network equipment sector. The top three gainers for their stock picks got returns of around 100%, or more, while the four lowest-rated analysts lost from 39% to 48%. The top stock picker in this area was Scott Heritage of Warburg Dillon Read. He had a 127% return, mainly the result of his selection of Cisco Systems Inc. (San Jose, CA), whose shares rose around 170% last year.

Heritage, who also ranked fairly high for his earnings estimates, realized that the network equipment industry is rapidly consolidating through mergers, leaving relatively few pure network companies to follow. So this year he's decided to cover the electronic contract manufacturing industry, which, he says, "is young and the fundamentals are growing" as the telecom equipment companies increasingly outsource to them.

Other top performers were two SG Cowen Securities analysts, Christopher Stix (105%) and Wotjek Uzdelewicz (88%). They stand in stark contrast to two underachieving analysts whose stock picks in the same category were down 40% or more last year: Sharon Ward (-40%) at William Blair & Co. LLC (Chicago, IL) and Brent Williams (-47.5%) at Needham & Co. Inc. (New York, NY).

A similar pattern of wide variability in results occurred in the computer software sector. With close to 60 analysts plying their trade, the group managed to generate only a mediocre 21% median return last year.

SG Cowen Securities analyst Rehan Syed scored a lot better than that. He lead the herd with a robust 170% return, achieved largely as a result of his extraordinarily well-timed pick of New ERA of Networks Inc. (NEON) (Englewood, CO), which last year rose an astonishing 682%. New Era's area of software expertise is "enterprise application integration," a software area that a growing number of corporations are using.

However, this year things appear to have abruptly gone awry for New Era and for Mr. Syed. The company pre-announced a substantial revenue shortfall in its second quarter as a result of more than 60 deals that were expected, but didn't come through, resulting in a reported loss instead of an expected profit. New Era's stock, from its $78 a share 1998 high, has been mauled and by mid-August was selling for around $15. Obviously he will have a tough time repeating last year's performance.

That's unlikely to be the case with Melissa Eisenstat of CIBC World Markets, who rang up a 120% return last year. Her big score last year came from recommending Peregrine Systems Inc. (San Diego, CA), a software provider of so called "infrastructure-management" products, which rose more than 246% in 1998 and is up this year as well.

Another triple digit gainer was Sanjiv Hingorani of ING Baring Furman Selz, whose performance was attributable in large part to his pick of Compuware Corp. of Farmington Hills, MI. Says Hingorani, "I was lucky last year with my big winners. I certainly don't think it was genius." Still he looked like a genius when compared to Aaron Scott of Sands Brothers (New York, NY) and Robert Austrian of Banc of America Securities (formerly called NationsBanc Montgomery Securities) (San Francisco, CA). Both were down 31%.

The computer peripheral industry's 25 analysts chalked up a 37% median return. Virtually all of them had positive returns. The leader was Mark Jordan at A.G. Edwards Inc. (St. Louis, MO) (he also scored high in computer services). Jordan won by avoiding computer peripheral companies, in contrast to his closest rivals: Gillian Munson of Morgan Stanley Dean Witter & Co. (New York, NY) and Andrew Neff of Bear Stearns.

Both invested in EMC Corp. (Hopkinton, MA), which was a star performer last year. Nonetheless, their gains in EMC--partially offset by other weaker peripherals investments--weren't enough to beat Jordan. He bought into two small contract manufacturers, Plexus Inc. (Neenah, WI) and ACT Manufacturing Inc. (Hudson, MA), that were emerging from a downturn, enabling him to be first with an overall 82% return. Says he, "I avoided the disk drive marketplace because it's so cyclical." That paid off.

By contrast, six of the 32 analysts who cover computer services had negative returns. As a result, the overall median gain was a modest 26%. Thomas Browne, Jr. of Prudential Securities Inc. (New York, NY) stood out, with a 71% gain derived from picking American Management Systems Inc. (Fairfax, VA) and Affiliated Computer Services Inc. (Dallas, TX). The fifth highest, at 55%, was A. G. Edwards' Mark Jordan, who was a standout in this industry too, with good gains in Computer Sciences Corp. (El Segundo, CA) and Paychex Inc. (Rochester, NY), which he sold late last year, after it had spiked to well over 50 times earnings. Says he, "As good as the company's management is, you also have to know when to fold them." Paychex's stock hasn't done much since then, he says.

What companies want from analysts is coverage that presents the company fairly and points out its sustainable value without being distorted by investment fads or unfounded industry gossip. In many cases that desire is no more than wishful thinking. Even the best analysts are fallible human beings. But, because they have such an effect on the market, we asked the leading ones what senior technology executives could do to make sure their company was presented with understanding.

For Bear Stearns' Andrew Neff, consistency and visibility are what he wants most from the managements of companies he follows. For Neff, visibility means more than being responsive. It also means helping make expectations about a company's results that are reasonable.

"Obviously they can't tell you exactly what the earnings are going to be," he adds, "they don't even know themselves. What a company should want to avoid is having 10 analysts with numbers all over the place because they just don't understand the business." If analysts haven't focused on the right things, he says, that's evidence of poor communication. "To the extent you can help to explain what factors are actually important, that's helpful," he says.

In the case of Dell Computer, however, analyst Daniel Niles of San Francisco-based BancBoston Robertson Stephens, feels that the company's management mishandled the disclosure of a revenue shortfall in a quarter ended this past February, and that resulted in its stock falling 20 points in just two days.

Neff disagrees. He thinks Dell "did a credible job of explaining the sales shortfall, though the presentation could have been better. Still it really wasn't a big surprise to me and other analysts, though it may have been to some investors." Even though it didn't surprise Niles either, who got his customers out a day before the quarterly report came out, it surprised other analysts and investors.

Says he, "If they had explained to people when they were going through the quarter that revenues were going to be a little slower and average selling prices were a little less, its shares wouldn't have gone down 20 points in two days. He says investors were lulled into a false sense of security because in the past Dell had exceeded sales projections.

"So the first time they missed it," he says, "it's a doozy. So just tell us the unvarnished truth. That way we are willing to give you the benefit of the doubt when you tell us that it's only temporary. If you build trust with the analysts and investors, I think that's the thing people are looking for."

Dell's management may have learned from that experience. When Dell reported its second quarter results on August 17, 1999, sales and earnings were well above expectations. Analysts and investors are smiling again.

Niles voices much stronger criticism of what he considers Compaq's inadequate disclosure this past spring, when it reported significant revenue disappointments. Says he, "You'll find most investors and analysts, including myself, felt we were definitely not given an accurate understanding of what was going on in that business by its top executives." Says he, "Companies don't wake up one morning and find out that [order] bookings have disappeared. That doesn't happen overnight. The investor relations department should have been conveying that to investors."

Yet many companies tend to clam up near the end of a quarter as they enter the quiet period. They claim that it's difficult for them to notify analysts about recent changes around that time.

Snorts Niles, "That's because many companies have ridiculously long quiet periods. If they've been doing their job [informing analysts] until then, we should have a pretty good sense of what things will look like before the company reports its results."

According to Scott Heritage of Warburg Dillon Read, a swift response to analysts' queries is important. Says he, "The analyst should be treated like a customer, because I, and the people I talk to, are going to be buying that company's stock." Unfortunately, that's often not the case.

"How [a company] deals with me is a reflection on the company, Heritage says. If they're helpful, I'm going to have a favorable view of that company. If you are going to take two or three days to call me back, then you're not treating me like a customer."

Merrill Lynch's Osha views it this way: "It tends to be more helpful to me when management [teams] are good about disclosing historical information like what the sales breakdown looks like. That is as, or more valuable, to me than hearing what the forward looking view is, because I have my own opinions. But what really helps me is when a company is willing to sit down and help me develop a historical framework for understanding the company."

Osays that one company that gets a gold star is Texas Instruments Inc. (Dallas, TX).

Any bad ones? Osha won't be specific, just saying "some companies don't do nearly as good a job. I don't expect any company to give me accurate "guidance" about the future. That's my job. So I don't get upset if a company says one thing and then something else happens. That's part of the business.

But then he adds: "It annoys me, however, when I have a difficult time building a historical model in terms of products and understanding what the end market drivers are because the company won't tell you anything. All I ask is just get me to the starting line in terms of what I need to know, and then I'll make judgments about the future."

ABN Amro's David Wu, says being accurate with earnings estimates really depends on the kind of companies you are covering. It's only one of many ingredients to successful stock investing. "If you follow companies such as Linear Technology," he says, "you're more likely to have a close earnings estimate. If you follow a commodity-type company, such as Micron [Technology Inc.], there's no way you can even be close. What you have to do is guess the trend right."

When asked what analysts like him would want to see more from management, Wu replies, "Run the business better and cut the bull____."*

Howard Rudnitsky is a former senior editor at Forbes. He can be reached at dvolts@world.net.att.net.