Brent Sheather: Heads the advisers win, tails you lose

A defining feature of the modern financial world has been the huge growth of the investment advisory business, principally delivered to mum and dad via the advice of financial planners, banks and stockbrokers.

Their mission is to convince people that whatever they are selling will provide high returns at acceptable levels of risk.

Generally this involves two straightforward and rather basic marketing strategies:

* Overstate expected returns.

* Understate risk.

Obviously the best time to execute such a plan is whenever the asset class or product for sale is fashionable, at which time people are generally happy to accentuate the positive and ignore the downside.

The finance industry refers to intermediaries selling to mums and dads or institutions as the "sell-side". Institutions - like super funds and insurance companies - which typically buy assets are commonly referred to as the "buy-side".

Historically, sell-side research efforts have been viewed quite critically by the buy-side people and the media.

Unfortunately, not all of this criticism is undeserved and you don't have to go far to find local examples of bad advice - Feltex, Metropolis bonds and technology funds come readily to mind.

Whether these disasters were exacerbated by the sell-side or should have been picked up by the buy-side depends on your perspective.

Whatever the truth, sell-side research can occasionally be good for a laugh, particularly when the subject of the research pays much higher commission than usual and/or is an investment banking client.

One such piece of fun is a document entitled A Guide to Stockbroker Economics by Andrew Smithers, of independent UK economics group Smithers and Co.

Although Smithers writes primarily for institutional investors, he offers some pearls of wisdom for mums and dads dealing with the sell-side, be they financial planners, banks or stockbrokers.

Firstly, Smithers warns that there is a vast difference between the economics propounded by economists and that contained in the writings of stockbrokers.

Smithers, whom readers should note is an economist, is not at all surprised by this because he knows that economists are in pursuit of truth and stockbrokers of commissions.

He might have added that financial planners are in pursuit of commissions, master trust fees and monitoring fees - as are fund managers, bank managers and just about everyone else.

The name of the game is to convince the buyer to move along the risk-return curve - taking higher risks in the hope of achieving higher returns. Accordingly the first principle of sell-side economics is that "all news is good news".

An example is changes in profits and interest rates, which often rise and fall together. In times of recession, intermediaries point out that falling interest rates will drive up share prices. But they don't say that falling profits, which also happen in times of recession, will push down share prices.

Conversely, when economies are booming, the sellers of financial services emphasise stronger profits and ignore the higher interest rate. Very convenient - and good news, too.

The second major theory of sell-side economics is that whatever you are selling is always cheap.

Smithers observes that in the case of the stock market one can argue that it is always cheap if one refers to "meaningless measures of value such as the bond yield ratio".

"By using whichever one of these absurdities gives the most bullish answer the market can always be valued as good value".

Therefore, theories like the efficient market hypothesis (EMH), which suggests that the stockmarket is always correctly priced, pose a threat to the "stocks are always cheap" philosophy in that the EMH says "stocks are cheap because the outlook is poor" and conversely "stocks are expensive because the outlook is good".

This sort of heretical thinking, while necessary to get qualifications, can get you into a lot of trouble in the real world, so is best ignored.

Smithers writes, "High optimism goes with high markets and good turnover. It is therefore extremely bad for business to be pessimistic when markets are expensive".

This is true, unfortunately, for both fee-based and commission-driven intermediaries. While "bearish" times are obviously bad for commission, in the same way, most people will not pay a monitoring fee to see their cash on deposit.

So while one or two local financial planners have been known to say "your stockbroker will never tell you to sell", they might also have added "your financial planner can't charge you a monitoring fee when your funds are on deposit".

It is a far better strategy for the intermediary to join the "invest for the long-term" team, which means mum and dad's savings always stay fully invested and paying these fees even if it will likely take 20 years to get their money back.

Smithers says "data-mining" is the key technique for nearly all sell-side economics. Data-mining is the process of starting with the conclusion you want and finding the data to support it.

The first rule of data-mining is choosing your base date: if you start your graph at the right point it can support any argument.

According to Smithers, "the most successful piece of data mining yet devised is the bond yield ratio, which was solely based on this principle of base date selection. This has no theoretical or pragmatic justification. It can only be supported by data mining."

To illustrate he shows in the top chart the relationship between bond and earnings yields from 1977 to 1997, from which it is "clear" that as interest rates go down, so does the earnings yield of the stock market.

The earnings yield is the inverse of the PE ratio so what the graph says is simply: when interest rates go down, stock market valuations rise.

The "sell-side" can thus use this graph when interest rates are falling to support the argument that "lower interest rates mean higher share prices".

So far, so good. But, take a look at the second chart. Goodness me - this shows that sharemarket valuations rose at the same time as rising interest rates. Smithers concludes with the observation that statistics will always confess if tortured sufficiently.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.