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A second opinion with every stock
Regulators soon will force brokerages to hand you, the customer, free stock research from independent shops. But old conflicts of interest may still be at play.
By Michael Brush
Every investor worries that the information he gets from his broker is biased in favor of the company or the big investors. Regulators are starting to level the playing field a bit.
Wall Street brokerage houses will soon be forced to hand their customers free stock reports from independent research shops.
The freebies -- meant to serve as an ongoing reminder to people using Wall Street research that its not all its cracked up to be -- are part of a fraud settlement being hammered out by prosecutors and brokerages caught red-handed pushing worthless stocks on investors during the market bubble.
A wider distribution of stock reports from independent shops such as Value Line or Argus Research, both of New York, will clearly help individual investors avoid the trap of being too gullible about Wall Street research.
Fraud cleanup requires more
But the fix, which will likely be approved before the New Year, falls short of all that needs to be done to clean up the shadowy world of Wall Street stock research.
The most glaring problem: Regulators punted when it came to forcing many of the basic changes that would make stock research unbiased.
At the top of this list: They backed away from making brokerage houses spin off stock analyst units. Wall Street research will always be suspect unless analysts are separated from the investment-banking divisions that bring in the lions share of the money at the typical brokerage. Otherwise, the temptation will linger for analysts to write rosy reports on companies -- in exchange for juicy investment banking business.
Because this problem still hangs in the air, regulators are now working out the details of a plan to make Wall Street brokerage houses distribute an alternate view on the stocks they cover.
Here are recent highlights of the plan, based on interviews with New York State Attorney General Eliot Spitzer, his staff, and independent research shops close to the talks. The plan, of course, is in flux because negotiations are ongoing.
Free research is not a bad deal
If you have an account with a Wall Street brokerage house like Merrill Lynch, whenever you get stock research youll also be given access to a few reports from independent stock analysts at places like Morningstar, Standard & Poors or Value Line -- the kind of shops that are likely to participate.
Each Wall Street brokerage will be told how much it has to spend on independent research. Then theyll contract with outside suppliers. Brokerage houses will assign someone in-house to oversee the distribution of independent research and confirm to regulators that the job is being done properly.
Regulators will appoint a well-known market veteran like Arthur Levitt, former Securities and Exchange Commission chairman, or Paul Volker, former Federal Reserve chairman, to help decide which independent research shops can participate. The plan will also set up an analyst database which will be made public so investors can review track records. Brokerage houses will have to distribute independent research for about five years. After that, the SEC may consider supporting the program.
The pitfalls in the plan
All in all, thats not a bad deal for individual investors who use Wall Street research, and Spitzer deserves credit for going after Wall Street and stepping in when market regulators dropped the ball. But here are some of the potential pitfalls in the plan to distribute independent research.
Some of the best independent research will be off-limits. Many independent research shops such as Green Street Advisors, Avalon Research Group or Sedoti & Co. work for a narrow base of clients who are willing to pay as much as $150,000 a year or more for reports, which they value because they are so exclusive. The clients would cancel contracts if that research gets widely circulated. So shops like these already know theyll opt out.
We would love to have the extra revenue, says Jon Fosheim, a principal at Green Street Advisors, which follows companies in the real estate sector. But we are reluctant to distribute our research to retail investors, because it might cheapen our work in the eyes of our institutional investors.
Next, some of the most effective independent research comes from so-called quant shops. They crunch numbers, measuring things such as valuation, earnings momentum and profitability. Then they boil down recommendations to a set of numerical ratings with little -- if any -- explanatory analysis. Since the reports are not full stock reports, securities regulators are rejecting their work, says Tom White of Global Capital Institute, a quant shop.
Its not fair to individual investors that so much unbiased research gets put off limits. But Spitzer says theres enough money to attract solid independent research firms. Indeed, the top stock picks of two potential candidates -- Morningstar and Value Line -- regularly beat S&P 500 index funds. Since 1965, a portfolio rebalanced once a year to reflect Value Line's top picks would have earned 14,000% excluding commissions and dividends, compared with returns of 1,203% for the S&P 500 index.
Independent researchers may come under the spell of Wall Street brokerage houses because they take their money. Thats why one independent research shop, the Washington, D.C.-based Precursor Group, says it will take a pass on selling reports to Wall Street brokerages under the settlement plan. If we participate, Wall Street will have leverage over us as independent researchers, says Scott Cleland, chief executive of the firm. We have no desire to compromise our research objectivity.
Value Line Chairman and Chief Executive Jean Buttner, whose company already sells research to Wall Street brokerages, doesnt think it compromises her firms objectivity. Spitzer notes there will be strict limits on how much money an independent firm could get from any single Wall Street brokerage. That will keep them from getting co-opted, he says.
Regulators arent forcing truth in advertising on Wall Street brokerage shops as part of the settlement. Investors using stockbrokers at Wall Street firms that do investment banking always run the risk of getting stock research tainted by a desire to drum up investment banking business. But the current settlement wont force brokerage houses to tell potential clients about this risk in advertisements, notes Cleland.
Spitzer responds that reforms are putting up new walls between analysts and investment banking divisions to reduce conflicts. He also notes that the performance database theyll be making public will let investors see which analysts have record of making good calls.
Since Wall Street analysts will still be too close to the investment bankers, some retail investors will continue to get duped by biased reports. Spitzer points out it isn't practical to separate the analysts from bankers, for several reasons, including:
- If analysts were spun off into a separate company, theyd still do most of their business with one brokerage house. So the potential for undue influence would remain.
- Next, investment bankers generate a lot of useful insights about a company when they carry out the work behind issuing shares or debt. Those insights inevitably get passed along to institutional money managers who participate in equity offerings. Spitzer says it wouldnt be fair to cut individual investors out of the loop by building too many barriers between the investment bankers and the analysts who write stock reports for retail investors.
- Besides, says Spitzer, regulators are taking some significant steps to build walls between analysts and the bankers -- like cutting any direct links between the volume of investment banking business and analyst pay.
But critics warn that reformers have left a system in place that will continue to produce biased stock research. Brokerages still want to make a ton of money from investment banking, and they know one of the ways you attract investment banking business is to have the right kind of research on a stock, says Pat Dorsey, director of stock research at Morningstar. Retail investors will still be getting opinions that are biased because of the investment banking conflict.
Spitzer concedes theres still a chance that sell-side research will be tainted, since analysts and investment bankers will continue to work for the same brokerage.
Bottom line: If you manage your own stock portfolio, its up to you to be savvy, not gullible, about Wall Street stock research and to seek out independent research on your own. Its really a matter of common sense, says Mark Hulbert, of Hulbert Financial Digest, now a subsidiary of CBS MarketWatch. The way to grow up as a human being is to not trust everything that is told to you, he says.
There are signs that investors are keeping this lesson in mind even as the horror stories of Wall Street misdeeds during the market bubble subside. Judging by the number of phone calls we are getting from people who are interested in our work, says John Eade, president of Argus Research, I think independent research is already a part of the solution.
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