IPO Investing: Understanding the Crumbling Chinese Walls of Wall Street
In 2003, ten of the largest Wall Street firms paid $1.4 billion to settle a government lawsuit. The charge? Misleading investors during the stock market bubble of the late 1990s. The Wall Street Journal reported: “[the settlement] centers on civil charges that the Wall Street firms routinely issued overly optimistic stock research to investors in order to curry favor with corporate clients and win their lucrative investment-banking business.”
Over a decade later, while there have been shifts in regulation, practically, little has changed. The SEC, the government body that regulates Wall Street, even has a page warning against following analyses that come from the same firms that underwrite an IPO. “The analyst’s firm may be underwriting the offering,” they caution. “If so, the firm has a substantial interest — both financial and with respect to its reputation — in assuring that the offering is successful.”
Investors would do well to be skeptical and take the time to understand analyst reports — they remain a linchpin on Wall Street, with guidance, estimates, and ratings influencing investor behavior. According to several studies, analysts who are affiliated with firms that underwrite IPOs are significantly more likely to rate those companies favorably, especially if the stocks do poorly in the secondary market and are in need of a “boost.”
The consistency of this is such that some investors have crafted successful strategies by understanding these trends — we’ve seen this first hand at Instavest, where a number of investments have been made to take advantage of analyst behavior for IPOs underwritten by their own bank.
Investing in a Conflict of Interest
Once such investor is Don Dion — whose money management business handled over $900 million in assets (he has since retired to only managing his family’s assets). Dion has focused on a particular part of this trend — the “quiet period.” When an IPO is filed, there is a 25 day period, during which the underwriting firm cannot publish reports about the company. Once they do though, “the report tends to be positive,” he says, “which tends to make the stock go up.”
Dion, one of the most popular investors on Instavest, buys shares of a stock about five days before its quiet period ends. Then, he sells on the day the report is released. He states the five day lag is because his strategy is common enough that it drives the price up in the few days before the quiet period ends. “We’re not the only ones who have figured this out,” Dion says.
Of his eight trades of this kind on Instavest in 2015, Dion made an average of 2.3% on his buy price. While that may not seem like a lot, his compound returns have been 9.6% over 127 days. He says he’s implemented the same strategy off the platform as well — due to the short hold periods, if the pace of success continues, it would yield nearly 30% annual returns.
“We’ve been doing this for 4 years,” Dion says. “We typically see a positive return 2/3 of the time.” He says that returns average around 2–4%. He pays attention to other factors, too, that he thinks make a difference. According to Dion, prestigious investment banks like Morgan Stanley or Goldman Sachs are more likely to produce a bump than a no-name firm. And a stock is also more likely to bump if it’s already above its initial valuation.
It might come as a surprise that this mini-phenomenon, which stems from an apparent conflict of interest that shouldn’t exist, is reliable enough for an investment strategy. But Dion is nonplussed. He discovered this strategy by reading academic research on how it theoretically should work, and why. Then, he got in touch with the researchers, and decided to run an “experiment” with his own money.
A History of Deregulation
In the banking sector, conflicts of interest began to be regulated during the Great Depression. The Glass-Steagall Act, passed in 1933, prohibited commercial banks from owning securities brokerage firms. The point was to separate commercial and investment banking, in order to prevent conflicts of interest which were believed to contribute to the 1929 economic collapse.
The 70 years that followed saw the slow deterioration of these regulations through loopholes and legislative reform.
In 1998 Citicorp — a bank holding company — wanted to merge with Travelers Group — an insurer. For that to be legal, Congress granted them an exception to what remained of Glass-Steagall, and the Bank Holding Company Act of 1956. Less than a year later, Congress passed the Gramm-Leach-Bliley Act, which overturned large parts of both acts, including the Glass-Steagall prohibition, “against simultaneous service by any officer, director, or employee of a securities firm as an officer, director, or employee of any member bank.” The explicit prohibition against fully merging the operations of a bank and brokerage disappeared.
One argument for Gramm-Leach-Bliley was that banking and investment functions were two sides of the same coin — people generally invested in stocks when the economy was good, and put their money in a savings account when it was poor. By doing both, financial firms could be resistive to economic fluctuations. Another argument was that many of these financial institutions had already managed to diversify their operations, offering both savings and investment opportunities to their customers.
But, when the tech economy plummeted in the early 2000s, it seemed to many to reveal a dark side to all this deregulation.
It was discovered that analysts of new tech stock had been using their authority to influence investment patterns to manipulate the market in their favor — or in favor of the firms they worked for. According to Lisa Smith, writing for Investopedia, “Big-name analysts were privately selling personal holdings of the stocks they were promoting.” Because of their firm’s loyalties, and sometimes because of their personal commission-based payment structure, some of these analysts had been directly pressured to publish positive analyses of companies, they personally believed to be poor investments.
Some analysts actually owned pre-IPO shares of the companies they were analyzing, thus stood a lot to gain if the stocks were successful. If they convinced enough of the public to invest, they could artificially drive the stock’s price up. If they sold their shares in that bubble, they could disproportionately profit off of a bad investment.
The Sarbanes-Oxley Act of 2002 came in the wake of these realizations. While it did not reinstate Glass-Steagall-like prohibitions, it tried to require firms strengthen “the wall” between analysts — who are supposed to be objective — and everyone else in the firm, including underwriters.
Despite the efforts of regulators, the Chinese wall of Wall Street has shown its cracks. But they’re visible enough for investors to take note and flip the script. “It’s not a controversial thing,” Dion says. “But you gotta have the money to do it, and you gotta do it right.”
End note: Trade data for ‘Returns: IPO Quiet Period Trading’ chart (full dataset and calculations may be requested by emailing email@example.com)
Period 1 [sold on day 8]: Return of 1.74%
- NYSE:BKFS (2.86%), NYSE:CHCT (1.39%), NYSE:PGND (1.46%)[principle divided equally]
Period 2 [sold on day 21]: Compounded return of 7.41%
- EVH (7.57%), GI (2.55%) [principle divided equally]
Period 3 [sold on day 42]: Compounded return of 8.39%
- NASDAQ:ALRM (2.27%)
Period 4 [sold on day 55]: Compounded return of 7.21%
- NYSE:TDOC (-4.11%)
Period 5 [sold on day 127]: Compounded return of 9.55%
- NYSE: PEN (3.66%)