Dueling Fools
The Wise Guys
May 5, 1999

Merrill Lynch Bear Argument
by Bill Barker ([email protected])

The easy way to do this might be to just write a straight screed on the self-proclaimed poster-child for Wisdom. (Check out the use of the word "Wisdom" twelve times in this Merrill speech.) I could write about the obvious signs of panic in Merrill's "Human Achievement" advertising campaign; the "avalanche" of 900(!) female employees currently suing Merrill for sex discrimination; the threatened multimillion pound lawsuits in Britain against Merrill's Mercury Asset Management unit for its "disastrous performance" as a pension funds manager. Believe me -- I could go on for a looooooong time.

However, for all of the easy barbs, we're not dueling about whether you should do business with Merrill Lynch, but whether you might do well to invest in it. The sad fact of the matter is that the provision of substandard financial advice and expensive asset management has been and continues to be an enormously profitable business. Five years ago, when The Motley Fool first started, all the arguments about Merrill being overpriced and underperforming were trotted out time and again, but the message of the Fool has not yet carried very far. Merrill continues to have a lot of clients, it continues to manage a staggering amount of money, and over the last five years it has continued to be a great stock to hold.

The times they are a changin', though. How does the ol' "We can fool all of the people all of the time" full-priced brokerage biz look today? Let's quote a recent analyst report:

"We view online trading as a legitimate disruptive technology since it clearly demonstrates to retail investors the low marginal costs of executing trades, allows for pronounced customer empowerment in a way that many investors find emotionally stimulating, and potentially places at risk the expensive infrastructures of full-service brokerage firms.... The dominant issue for these new firms has been the channel conflict with their traditional broker forces. These firms are being challenged to find ways to build stronger product offerings so as to deflect potentially intense pressures on commission structures. Ultimately, we think these firms may have to reengineer their approaches to broker compensation."

Okay. The thing that you need to know is that this is the analysis [PDF document] of Merrill itself. Merrill is fully aware that its commissions can in no way be justified, but there's a big problem. It can't go about providing better service to its clients today, though one would think that would be a priority for an entity which proclaims that it "always get[s] the job done in the best interest of our clients." Merrill simply can't afford to follow up on its empty claims, because as it notes in its own analysis -- to do so would make its brokers mad.

"Hey," you're saying to yourself, "I'm sure that Merrill is perfectly willing to cut its brokers loose. No use destroying the business just so some salesmen can add new wings onto their vacation places at the Hamptons." And you'd be partially right to say that. I have no doubts that when the time comes, Merrill will dump its brokers faster than you can say, "Ranked 55th out of 55 mutual fund families over the last five years."

Yes, according to Barron's February survey of mutual fund families, Merrill has beaten out some stiff competition for the absolute worst track record in the mutual fund business. That's one of the reasons Merrill can't make its brokers mad. Look, nobody else can be bribed into recommending that anyone purchase Merrill's mutual funds, so Merrill's in a bind. As soon as the brokers have their precious compensation system changed, they'll cut and run -- taking clients with them, and blowing the whistle on Merrill's awful funds. So Merrill management and the broker force have each other frozen in a game of mutually assured destruction. I, for one, can't wait to see who pushes the button first.

Meanwhile another of the bulwarks of Merrill's Wisdom is getting set to crumble. As has been noted in a marvelous recent article by Michael Lewis, author of Liar's Poker, the financial scandal of the 1990s is the selective disclosure of material financial information by publicly traded companies directly to Wall Street financial analysts. Lewis notes, "Probably we have already arrived at the point where big investors would have no use for Wall Street analysts if the analysts weren't privy to inside information. But they are, and because they are they are actually important. Once a quarter, for a brief moment, they know something other people don't. But they shouldn't."

So maybe Merrill's analysts do have some slight advantage that they can currently provide for their institutional clients. However, since the advantage they have is, or should be, illegal, I just don't see Merrill's reliance on selective disclosure as a real "growth" business -- particularly with David Gardner now working on getting some changes effected from the inside of the system.

And once Merrill's analysts have no inside edge, why would anybody choose to use Merrill's outrageously overpriced investment bankers? Again, according to Michael Lewis, "Practically no one who uses the services of the most highly paid investment bankers believes they are worth what they are paid. Investment bankers belong to the blessed class of people who are paid whatever they can get away with charging." With the emergence of Wit Capital Group, Inc. and Friedman, Billings Ramsey Group offering IPO shares to clients directly through the Internet, the days of raising capital the super-expensive way -- the Merrill Lynch way -- are rapidly drawing to a close.

With essentially all its business as the most expensive middleman in the financial world under heavy fire, it's no wonder this is one of the most volatile stocks in the entire market. Just last year, on only the slightest touch of bad news, MER shares lost over 67% of their value in the space of a couple months. In a particularly amusing little bit of logrolling, fellow full-priced brokerage Salomon SmithBarney entitled its most recent "Buy" report on Merrill Lynch "Full-Service Retail Business Far From Dead." Nevertheless the rating was "Buy, High Risk." Buy a high-risk stock with little growth prospects that is trading at about double its historic price/sales norm and four times its historic price/cash-flow ratio?

Heck, even a Fool's got to be wiser than that.

Next: The Bull Responds