Value Investing, The Short & Long Of It AllDear Investors,

Wall Street always seems eternally optimistic about even the dodgiest of companies. Here is chart from FactSet showing that at the beginning of this year only 5% of the stocks in the S&P 500 (INDEXSP:.INX) had a sell rating from analysts.

Value Investing, The Short & Long Of It All

Why is Wall Street research so positive? The usual answer given is that there is a huge conflict of interest between the research analysts and the investment banking arms of large financial institutions.

When companies need access to the capital markets to issue stock or debt, or need “advice” and “expertise” about mergers and acquisitions, they turn to investment banks. In return for giving business to these banks, many companies want analysts to say positive things. It’s especially important if the company is issuing stock or selling debt. You need to hype up the investment so you have buyers. It’s hard to find buyers when an analyst in the research division is writing bad things about the company. Even if an analyst isn’t affiliated with a large investment bank, the analyst still needs access to company management to gather information for accurate quarterly earnings predictions. Here again, saying bad things about a company or saying investors should sell the stock is likely to get that analyst cut off from management.

This explanation is certainly correct, but I think it only partially explains the reasons for the lack of “Sell” ratings. For example, there are some truly independent research firms, such as ValueLine, that, to the best of my knowledge, do not depend on access to management for the research and writing of their reports. (I’ve never heard any ValueLine analysts ask questions during conference calls.)
I think there is another, often overlooked, reason for the lack of critical analysis and sell ratings. Before I detail my hypothesis, I want to show some examples of stocks, where every analyst should have known problems lurked beneath the surface.

The first is Questcor (NASDAQ:QCOR). Questcor is a pharmaceutical company that bought a drug developed in the 1950s from Aventis for $100,000. The drug was traditionally used to treat a rare condition, Infantile Spasms, also known as West Syndrome. Questcor obtained orphan drug status for their drug, which allowed it to raise the price from several thousand to several tens of thousands. It then began to market the drug for a variety of other uses, including as a second-line treatment for MS. In January of this year, the website wrote a scathing expose on the company and raised numerous red flags. Then in July, noted short seller Andrew Left posted a negative research report on Questcor on his website Both websites are widely followed on Wall Street.

The reports pointed out numerous problems with Questcor and the many very serious risks the company faced. The reports were made public for everyone to see, so you would expect serious analysts to look into the allegations (truly, they should have known about some of the risks before the reports if they were covering the company, as some risks were obvious). The analysts should have made investors aware of the risks. So what did they do?

According to Thompson/First Call three months ago (this is after the reports came out), the nine analysts following the stock all rated it a buy, with seven rating it a “Strong Buy” and the remaining two a “Buy.” While traditional Wall Street research is known to be biased and of dubious usefulness, you might expect more even-handed coverage from an independent source like ValueLine. ValueLine had a three-to-five-year price target of $70 to $110 on Questcor. ValueLine says, “Questcor Pharmaceuticals’ top and bottom lines should experience healthy growth over the next two years.” They go on to say “Questcor’s 3 to 5 year prospects are bright.” Finally, they end with this: “These shares are well suited for long term investors.”

Nowhere does ValueLine take time to mention the implausibility of Questcor’s business. Questcor bought the rights to a drug that was discovered in the 1950s from Aventis for a mere $100,000 and somehow turned it into a multibillion-dollar business. This was also despite the fact that the synthetic version of the drug was widely available in Europe and Questcor’s marketing practices were widely known to be very aggressive. The business defied basic economics: Either a competitor would emerge using the synthetic version, or insurance companies would crack down on reimbursements. ValueLine does not inform their readers of any of those risks, or even the main risk, which is that H.P. Acthar Gel® is Questcor’s only product. With news of Aetna limiting reimbursements for H.P. Acthar Gel® to only one condition and other insurers starting to follow suit, and the government starting an investigation of Questcor’s marketing practices, the stock now trades around $25.

Another example is Green Mountain Coffee Roasters (NASDAQ:GMCR). Green Mountain Coffee Roasters has been an ongoing accounting train wreck for years. The former criminal CFO of stock fraud Crazy Eddie’s turned accounting fraud fighter, Sam E. Antar, has been blogging about accounting problems at the company for years. About a year ago, superstar hedge fund manager David Einhorn gave a 100 plus page presentation detailing numerous allegations of poor business practices and possible accounting issues at Green Mountain. Again, all of the blog posts and the presentation were public. As usual, nobody listened.

Back on January 27, 2012, after a 30% drop in the stock price (to $51), ValueLine had this to say, “…at its current quotation GMCR offers above-average recovery potential for the pull to 2014-2016.” In fact, ValueLine slapped a three-to-five-year price target of $120 to $180 on Green Mountain. The comedy continues, as their report says, “The overall financial position is in good shape.”

Since when is having quarter after quarter of inventory growth outpacing sales considered “good shape”? Inventory and sales growth is something any analyst following a company should be tracking closely, and when inventory growth outpaces sales it is a very serious problem. Stale inventory is certainly not good for a food products company. There is simply no excuse for the ValueLine analyst not to point out the problems with Green Mountain’s inventory and previous accounting problems. Green Mountain now trades at around $25.

Why can’t even independent analysts write critically about companies? I think part of the reason is that if you do, everybody, and I do mean everybody, will hate you. I write negative articles about companies, so I know.

Below is a recent sampling of the nasty e-mails or feedback I’ve gotten from the articles I’ve written. These comments aren’t even close to being the worst (or funniest). (I regularly delete all my hate mail; I didn’t realize I might be publishing an article like this, so I didn’t save them.) Most of the truly awful comments on my articles have been deleted by site moderators. I’ve highlighted the parts of the feedback below that I think

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