Is channel checking a form of insider trading?

Independent analysts who deploy ‘channel checking’ are striking back at federal prosecutors bent on painting so-called expert networks as a form of insider trading. What they believe is honest and difficult work is being branded the same as Ivan Boesky’s shenanigans.

Doug Thomas of JET Investment Research placed this mocking disclaimer on the top of his latest research note on Wabtec (WAB), a maker of brakes, switchers and other equipment for the rail industry. It has to be presented in its complete form to be fully appreciated:

Note: To the FBI, SEC, IRS, TSA and any other government organization it may concern (before you decide to raid the JET offices): This report is based 100 percent entirely on pure guesswork. The author used absolutely no channel checks in its preparation, unless you include the time he stood outside the PF Chang’s in Homestead (PA) counting the CSX freight trains roll by. In fact, our stock-picking methods rely exclusively on that old, tried-and-true strategy of throwing a dart (while blindfolded) at the stock quotes section of the local newspaper. From the day the firm was founded, we have consistently shied away from the use of any and all meaningful data points in favor of far better analytical methods, such as astrology. Any reliance on insider information (any kind of useful information, really) or even the surreptitious reading of management’s body language (the CEO grinning like a Cheshire Cat or the CFO repeatedly winking at me on my way out) is purely coincidental and played absolutely no role in our recommendation or opinion. At JET, we have never let the facts get in the way of a good story, and have always encouraged our clients not only to take our work with a big fat grain of salt but also to remember that, as a colleague once reminded me, "sometimes your best shorts are your longs."

Thomas’s frustration is shared by many of the independent boutique shops that sprouted up following former New York Attorney General Eliot Spitzer’s 2003 crackdown on what was deemed to be biased Wall Street research used to drum up investment banking business by the major firms. Many analysts struck out on their own then, and continue to do so now as traditional investment banks shed research units in the wake of the credit crisis thrashing. It’s a difficult business to sell your research without a major institution’s name on it.

"Doug Thomas is a highly-skilled and reputable independent analysts whose work I have appreciated throughout my career," said Gary Kaminsky, who used to manage $13 billion for Neuberger Berman. "Doing independent ‘channel checking’ is at the heart of research not influenced by investment banking influence research."

Kaminsky, who presented Thomas’s note on his show "The Strategy Session" today, believes the federal insider-trading crackdown being led by the U.S. prosecutor in Manhattan, Preet Bharara, is an attack on traditional methods used by any good analyst.

The challenge for the Feds will be drawing the line between good insight and insider trading. Is asking the manager of an Abercrombie and Fitch at a mall, "How’s business?" ok? What about the head of a trucking company that ships goods for Wal-Mart? One could argue Fidelity legend, Peter Lynch, was the first to popularize channel checking. In his book "One Up on Wall Street," Lynch directed individual investors to invest in trends discovered while at the mall. It’s a Pandora’s box that may need some regulation rather than prosecution, analysts and investors said.

To be sure, in this current dragnet, they will most likely find some analysts who call themselves "channel checkers," but instead get actual inside information from company executives and sell it to hedge funds under the guise of a ‘network’. But that shouldn’t lead to the destruction of all independent research.

If you’re curious, in his report, Thomas suggests buying Wabtec based on the company’s analyst meeting last week where management did not disclose specific figures, but was "clearly enthusiastic about improving trends in freight traffic and optimistic about their project pipeline in transit."

Maybe Thomas is just really good at reading the auras of management? Is that a crime?

For the best market insight, catch ‘Fast Money’ each night at 5pm ET and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC. 


John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team

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