Why Trust on Wall Street Always Needs a Qualifier

Morgan Stanley Dean Witter’s Scott R. Davis apparently wasn’t called to testify at last week’s House hearings on the ethics of Wall Street analysts.

It could be that his latest research report on the packaging industry just didn’t strike a controversial-enough chord with anyone on Capitol Hill.

“For Case-Ready Meat, Inflection Point in Sight,” read the headline on Davis’ June 4 report. In it, he wrote about the desire of some big food retailers, such as Wal-Mart, to have meat packaged at an off-site location and shipped directly to the stores, “without processing by an on-site butcher.”

This is a trend for beef and pork, and it is fueling strong demand for special packaging material that can extend the meat’s shelf life “from a few days up to several weeks,” Davis said.

The upshot for investors: There’s faster earnings growth ahead for packaging giant Sealed Air, which Davis rates “strong buy,” and possibly for rival Pactiv, which he rates “outperform.”

Davis’ report is mostly what investors find when they actually bother to read Wall Street analysts’ research--as opposed to simply asking for the sound-bite summary of whether to buy, hold or sell a stock in question.

Brokerage research is typically optimistic, often overly so. But investors can usually glean from the average analyst report some sense of the major trends in an industry, and/or how an individual company is positioned in its industry. For the most part, though, this isn’t terribly exciting reading. It hasn’t yet attracted the Pulitzer board.

In the wake of the crash of technology stocks over the last year, the search for the guilty has led many angry investors--and now angry members of Congress--to analysts’ door.

At best, they’re accused of being irresponsible in touting stocks and too slow to jettison ideas that don’t work. At worst, they’re labeled liars, cheats and full partners in an alleged brokerage-industry conspiracy to sucker investors into what become Roach Motel stocks--easy to enter, near impossible to exit without serious harm.

Tech stocks have become the collective lightning rod for criticism of the analyst profession, but the “problem” of Wall Street research is as old as the business of corporate finance.

How can you fully trust an analyst who writes favorably about a company that also may pay the analyst’s brokerage for investment banking services?

The potential for conflict is obvious and seemingly inescapable.

And yet, to suggest that analysts are utterly incapable of taking an objective view is to credit them, and their firms, with a level of diabolism that severely stretches the imagination.

Read enough Wall Street research--and I confess to having read plenty over the last 22 years--and your impression will be less one of deceit and conspiracy than of the drudgery of basic securities analysis.

Analysts crunch income-statement and balance-sheet data, talk to company and industry officials who may not tell them much they don’t already know, and make guesses about the future.

Until the Internet stock bubble of the late 1990s, which made stars of a relative handful of technology analysts, securities analysis for the most part was no glamour field. The one industry beauty pageant was Institutional Investor magazine’s annual All-America Research Team poll, which asked big investors such as mutual fund managers and pension fund directors to name the analysts they respected most in terms of individual industry coverage.

Could analysts’ work have been so severely compromised by the bull-market excesses of the late ‘90s that it now has zero merit?

Institutional Investor’s introduction to its 2000 All-America team roster, published in October, pretty well set the scene for the current storm over analysts’ ethics.

“[Big] investors, desperate to outperform their peers, beat their market benchmarks and shine before their bosses, insist on scads of timely insights and endless hand-holding” from analysts, the magazine wrote, describing the view from Wall Street.

The analysts, in turn, “must meet these ever-growing needs while juggling the demands of prickly chief executives [of firms they follow] and insatiable investment banking colleagues.

“And that’s in good times. When markets sour . . . the state of affairs can get downright ugly.”

In fact, Institutional Investor’s 2000 poll, which canvassed 2,500 money managers in all, found that the managers’ respect for analysts’ advice was middling at best. Asked to grade the overall quality of analyst research on a 1-to-10 scale, poll respondents gave an average grade of 5.9.

What’s more, 44% of money managers said they thought the quality of research had deteriorated over the previous 12 months.

Many money managers cited the same concerns that were aired at last week’s House hearing on analysts’ objectivity, or lack thereof: Analysts are beholden to their firms’ investment bankers; they rarely advise selling a stock; they’re brainwashed by executives of the companies they follow.

Though analysts are given significant credit for helping to pump up the great bull-market surge of the late ‘90s, it’s also clear that they became its victims as well.

“Sell” has always been a difficult word for an analyst to say or write, but never more so than at the height of the tech-stock mania. It’s easy to argue now that analysts should have spoken up about what became outrageous stock valuations. But at the time, anyone who said so was considered a fool, or out of touch with “new-economy” realities, or both. Who knew how large the inflating tech bubble could become?

Today, it seems obvious to all that analysts in general have been far too optimistic. But in the late ‘90s, today’s army of critics railing against excessive “buy” recommendations was barely a platoon. As long as the advice worked, few complained.

Still, it’s tough to feel sorry for Wall Street when it makes so many of its own problems.

Consider the mealy-mouthed stock rating systems that most brokerages require their analysts to use. At some firms there is no such animal as a “sell” rating--just an “under-perform” rating, which means a stock is likely to under-perform either the market overall or its industry peers, or both.

If that’s the case, why not sell it?

The “hold” or “neutral” rating also is a favorite refuge of analysts who probably would advise selling a stock if only it wouldn’t upset the company or the analysts’ own senior management on the investment banking side.

The Securities Industry Assn., the main trade group for brokerages, last week proposed guidelines that it hopes will remove the cloud over analysts’ credibility. One of those guidelines calls for analysts to be free to use the full spectrum of ratings on stocks they follow--including “sell.”

Another SIA proposal calls for brokerages to ensure that their analysts don’t report to investment banking executives. That the industry should even consider that a subject of debate, however, won’t help allay investors’ concerns about the credibility issue.

Since it’s clear that the potential for conflict of interest will be there so long as brokerages engage in both research and investment banking, investors ultimately have two choices: They can ignore Wall Street research altogether, or they can regard it for what it is and always will be--another opinion, hopefully educated, about the prospects for a company or an industry.

You read stock research, you consider its merits, you glean from it some intelligence you might not otherwise have come across, and in the end, you make your own decision about buying, holding or selling.

To ask more of even stock research that appears completely unbiased is to forget that analysts are human and make mistakes. To pretend that research has no value at all is to forget that analysts, too, can get lucky from time to time.

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Tom Petruno can be reached at tom.petruno@latimes.com.