A shortfall in Street smarts
10:54 EST Wednesday, Apr 17, 2002
Michael Den Tandt
TORONTO (GlobeinvestorGOLD) – Given that the dot-com bubble was among the worst disasters to befall financial markets, and seeing how it was exacerbated by egregiously flawed brokerage research, it's no surprise that Wall Street is now beset by calls for reform.
But there's something a little disingenuous, maybe even a wee bit self-righteous, about the tenor of some of the criticism being leveled at Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and others.
Is it really possible that all these congressmen, senators and attorneys general didn't understand, until a few months ago, that brokerage research was created to market stocks? It's always been that way. Possibly, it always will be that way.
Investment banks and brokerages are founded on underwriting, and to a lesser extent on commissions from trading stocks and bonds. Research is an adjunct: it's not something that could ever be profitable in its own right, given the huge salaries that brokerage analysts command.
According to the Wall Street Journal, New York Attorney General Eliot Spitzer - the man who's now investigating Merrill Lynch and other brokerages for conflicts of interest - has already floated the idea of forcing Merrill to spin off its research arm, making it a separate business unit.
The response from Merrill? Won't work, because research revenue doesn't justify a self-contained business. The best that might happen, according to the Journal, is that brokerages may be forced to create separate boards of directors for their research arms, to insure their independence.
But all of that misses the point: Brokerage research wasn't designed to be independent. Its purpose, in terms of the business model, is to market stocks underwritten by the firm.
It would make sense, then, to simply rename the investment banks' research arms “equity marketing,” and leave it at that. After all, there's nothing unethical or dishonest about marketing a product, as long as it's clearly labeled as such and makes no claim to objectivity.
The National Association of Securities Dealers laid out the limitations of brokerage research, in very plain-spoken fashion, in a series of public releases last February. The most interesting of these documents, available on the NASD's website (www.nasd.com) and entitled NASD Guide to Understanding Securities Analyst Recommendations, outlines in five short pages why brokerage research on its own is not enough.
If a firm's investment banking revenue depends on bullish research, or if the analyst's compensation is tied to investment banking revenue, or if the analyst is subjected to pressure from institutional holders of a given stock, or if he or members of his family owns shares in a given stock, the analyst may have a bias, the NASD points out.
Not to mention, we might add, that in a traditional brokerage, there's systemic pressure on a stockbroker to generate commissions by spurring purchases of stock. Selling may generate the same commission as buying, but every crafty broker knows that clients who “go to cash” often stay in cash. That's why you'll often see recommendations to “switch” from one stock to another, rather than just plain sell.
Of course, this won't be enough for most investors - nor should it be.
But as the NASD points out, the brokerage report can be a useful addition to other sources of research.
Ideally, a do-it-yourself investor should tap several independent sources of analysis, as well as brokerage research. There are stand-alone research firms out there, serving mostly institutions, but whose work is also available to the public for a fee. There are also numerous Web sites, both free and subscription-based, that offer analysis, this one included.
Reform of the brokerage industry is healthy and necessary, but most of what ails the industry can be resolved through greater honesty. Wholesale structural changes to the business are simply not practical.
And please, let's have an end to the hair-tearing and hand-wringing by public officials who ought to have known all about the underpinnings of Street research, long ago.
Michael Den Tandt joined the Globe and Mail as Investment Editor in October of 2000. |
