Amid Criticism, Wall St. Offers Analyst Guidelines
Not long after Kent L. Womack left brokerage firm Goldman Sachs to become a Dartmouth finance professor, he surprised his new colleagues with a 1996 study showing that Wall Street analysts’ “buy” recommendations were nearly worthless in generating profits for investors.
It was only a mild surprise, he said, because the academics had assumed such advice to be altogether worthless.
One of Wall Street’s perennial controversies--the quality and objectivity of analysts’ research and ratings of stocks--has become a hot topic again, in the wake of the collapse of many once highly touted technology shares over the last year.
Amid searing criticism from investors large and small, leading brokerage firms Tuesday proposed guidelines aimed at giving analysts more freedom to be totally frank about the companies they cover.
The guidelines precede hearings Congress will hold Thursday, focusing on several conflicts of interest that many Wall Street critics say taint analysts’ stock recommendations.
Rep. Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee on capital markets, said one focus of the hearings will be the apparent “grade inflation” that leads many analysts to call a stock a “hold” when they really mean “get out now.”
The hearings may resonate loudest with small investors. Though institutional investors say they have long been skeptical of Wall Street research, many individuals who were new to the stock market in the late-1990s may have been far more willing to take analysts’ touts at face value, experts say.
The basic conflict for analysts--practically as old as the concept of stock research--is in trying to provide unbiased advice on companies in which their own brokerages have a financial interest.
A major share of large brokerage firms’ profits is derived from fees earned underwriting stock offerings and performing other investment-banking services for companies. Whether it is delivered bluntly or subtly, Wall Street critics contend that the message to analysts is that you don’t bite the hand that feeds you by issuing negative opinions on the stock of a client or potential client.
Debate over analysts’ conflicts waxes and wanes with market booms and busts. It’s waxing now because of the excesses exposed by the collapse of the historic tech-stock bubble.
At the peak of the tech boom, analysts such as Merrill Lynch’s Henry Blodget and Morgan Stanley’s Mary Meeker became like rock stars with their seven-figure salaries and their predictions of ever-giddier highs for Internet stocks.
Today, after hundreds of billions of dollars of investors’ wealth has evaporated in the dot-com debacle, industry critics are focusing on the role analysts played in inflating the bubble--and on their seeming inability to warn that stocks might have become overvalued.
Data from First Call/Thomson Financial, tracking 25,000 analyst stock recommendations, show that analysts overwhelmingly rated their stocks “strong buy” or “buy” as the tech sector soared in 1999 and early 2000. Even as the stocks plunged later in 2000 and early this year, the percentage of ratings shifted to “sell” has remained minuscule--less than 1.5% of all ratings.
Those figures have helped spur state and federal regulators to launch multiple probes into Wall Street’s research and banking operations.
The Securities and Exchange Commission, the regulatory arm of the National Assn. of Securities Dealers and the U.S. attorney’s office in New York are investigating possible wrongdoing in the underwriting of hot initial public stock offerings in 1999 and 2000.
The New York attorney general’s office confirmed last week that it has launched an investigation specifically into analyst conflicts of interest.
And the SEC is investigating several companies for violation of 8-month-old Regulation Fair Disclosure, a rule that forbids companies from releasing significant financial news to analysts before disseminating it to the public.
Baker’s hearing Thursday may be the most public airing yet of the controversy over whether analysts mean what they say, and say what they mean.
In advance of what could be stinging criticism at the hearing, the Securities Industry Assn., the brokerage industry’s chief trade group, Tuesday issued a list of “best practices” it suggests members use to govern research coverage. The list, drawn up by 14 of Wall Street’s largest firms, recommends that analysts:
* Use “the full ratings spectrum”--including “sell”--in rating stocks.
* Should not report to their firms’ investment-banking departments.
* Should be paid based on how their recommendations work out, not on investment-banking deals or other non-research factors.
* Should not personally trade a stock while they are preparing research on it or “within a reasonable period of time” after issuing a recommendation.
* Should not “trade against” their recommendations--for example, selling personal shares of a stock that they have rated a “buy.”
* Should disclose any personal investments or business relationships (both the analysts’ and their firms’) with the company being rated.
The Assn. for Investment Management and Research, which trains and certifies analysts, this week added its own recommendation that analysts be barred from receiving share allocations in advance of IPOs of companies they cover.
Many brokerages contend that they already follow many of the Securities Industry Assn.’s proposed guidelines.
Still, Robert A. Olstein, a New York money manager who began his Wall Street career as a stock analyst, argues that the analyst profession needs to get back to basics.
Analysts, Olstein said, should use the fundamental tools of accounting and finance to calculate an appropriate value for a stock--and stop there. He decried the increasing use of “price targets,” or projections of a stock’s value as much as a year in the future.
It’s hard enough to figure out what a company is worth today without trying to factor in market psychology, the direction of the economy and the million other vagaries that might affect the stock market between now and next year, Olstein said.
In many cases, he added, price targets are just a catchy way to hype a stock.
But analyst ratings of stocks still generate the most heated debate.
Womack, the Dartmouth professor, found in his 1996 study that stocks with an initial “buy” rating--that is, the first time they were rated by a particular analyst--did about 2.4% better than the average stock in the first month after the recommendation. For ordinary investors, however, such gains would be eaten up mostly by commissions, he said.
“Sell” ratings, on the other hand, were not only rarer but far more valuable: Those stocks under-performed the market by 9.1%, on average, over the six months following the recommendation.
Womack theorized that because analysts stick their necks out when they say “sell,” they only do it when they are certain.
Womack followed up with a 1999 study illustrating the woeful effect that conflicts of interests appear to have on analysts’ IPO recommendations.
IPO stocks recommended by analysts whose firms acted as the underwriters performed horribly compared to those recommended by analysts from neutral firms: After one year, the neutral analysts’ picks outperformed the underwriting analysts’ picks by a stunning 18.4 percentage points.
Womack’s general conclusion is that investors do far better when their advisors don’t have any stake in the stock being recommended.
With that in mind, one Wall Street firm, Prudential Securities, is hoping to turn a competitive weakness into a marketing strength. A perennial also-ran in investment-banking, Prudential decided earlier this year to drop stock underwriting entirely and emphasize the independence of its research team.
Damon Silvers, associate general counsel of the AFL-CIO and one of the scheduled witnesses at the Thursday hearing, said that as their pension and retirement assets grow, American workers are increasingly dependent on honest advice from Wall Street.
The problems with analysts’ conflicts are approaching the point where legislation may be needed to rebuild the “Chinese wall” between the brokerages’ research and investment-banking departments, Silvers said in an interview this week.
Disclosure of conflicts is welcome, he added, “but there are some relationships so corrupting that no amount of disclosure will cure them.”
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Analysts’ Stock Advice Under Fire
Rep. Richard H. Baker (R-La.) holds hearings Thursday focusing on Wall Street analysts’ potential conflicts of interest in making stock recommendations. Controversy over the objectivity of brokerage research has soared in the last year as analysts overwhelmingly maintained “buy” recommendations on stocks amid the market’s boom--and as it busted.
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Sources: First Call/Thomson Financial, Bloomberg News
