The Cost of Trust :: The Value of Due Diligence

It's been as many as eight years, but the top execs at AOL have settled with the SEC for their part in the company's stock-inflationary financial reports for the period 2000 through 2002. It'll cost them $8 million collectively, but I have no doubt that that represents a drop in the bucket in comparison to what investors lost as a result of their fibbing.

Eight execs, including CFO Michael Kelly, conspired to overstate online advertising revenue expectations by more than $1 billion. With online ads representing a key part of AOL business at the time, this exaggeration represented a significant factor in the company's valuation at the time. With higher valuations, the stock and option-holding executives were able to collect millions of dollars at the expense of lowly investors who got stuck holding the bag when reality fell far short of the lofty expectations.

Analysts hold an incredibly powerful position in the capital markets; they hold a fiduciary responsibility to the firms they represent and, ultimately, the investors who use their advice as an input to their investment decisions. While it's hard to place blame exclusively on the analysts in a case such as this, where their sources were apparently lying, $1 billion is not a small sum. An amount as large as this must be relatively easy for a dedicated analyst to substantiate. They have access to the company's executives, who they interview regularly, and have superior access to information otherwise.

As an investor, it's important to learn from this experience. Analysts are a wonderful source of information, but they're likely more valuable in the negative direction than they are in the positive direction. Analysts, in one form or another, are rewarded for spotting winners more than they are for spotting losers. Consequently, we lowly investors must be sceptical of any positive news and seek to perform our own due diligence to whatever extent possible. Think of analysts, like your broker, as a salesperson; you wouldn't buy a $10,000 toy solely on the advice of a kid at BestBuy - you would likely do some research first. Don't treat your investment decisions any different.