Wall Street analysts talk the new reform talk
By Per Jebsen
NEW YORK, April 4 (Reuters) -- Wall Street analysts, who are usually hard-pressed to name a company they don't like, are rediscovering their inner selves -- as newfound proponents of objective stock market research.
They have been spurred by anger over investors' losses following the technology stock market bust and Enron Corp. (ENRNQ - news) scandal, which highlighted analysts' conflicts in analyzing companies while helping their banker colleagues compete for finance business.
The changing approach is apparent in a series of reforms announced by top investment banks over the past year which gained momentum after the Enron scandal broke.
The industry also soon will be required to adopt extensive disclosure and other rules concerning their research and investment banking practices. Some have been rolling out the reforms even faster than regulators required.
Firms such as Merrill Lynch & Co. (MER - news) and Credit Suisse First Boston (CSGZn.VX) have implemented policies including prohibitions on stock ownership of covered companies.
Just last week, Lehman Brothers (LEH - news) analysts provided a striking example of the new sensitivity in a report on life insurer Prudential Financial Inc. (PRU - news), which owns brokerage Prudential Securities.
The analysts, Eric Berg and Stewart Johnson, rated Prudential shares a lukewarm ``market perform'' -- yet gave a rousing endorsement to Prudential Securities' new emphasis on arm's-length stock research.
``Consider the steps taken by Prudential, many beyond what has been done by the competition, to position itself as a provider of genuinely independent advice,'' they wrote in their March 27 note.
Prudential's steps include giving up most of its securities-issuance business, simplifying stock ratings, and hiring controversial analysts who are unafraid to speak their minds, they wrote.
``Individual investors view hard-hitting reports by researchers such as outspoken (Prudential) bank analyst Michael Mayo as unambiguously independent,`` Berg and Johnson said.
Curtailing investment banking ``eliminate(s) even the slightest feeling by investors that the interests of corporate issuers of securities might take priority over investors' interest,'' the Lehman analysts said.
Simplifying stock ratings ``is an effort to eliminate milquetoast intermediate ratings such as the meaningless 'near-term accumulate'.``
The assertions are ironic and poignant. Investment banking, after all, remains integral to Lehman. In praising Prudential, the analysts acknowledge that Wall Street firms such as their own suffer from a credibility gap -- that tech analysts, once heroes, are ``reviled by the investing public.''
Mayo, moreover, spent three years working for Lehman. Later, he was unable to get a job at top investment firms until hired by Prudential. His crime: while at CSFB, he had broken a then-Wall Street taboo with a very public yet prescient ``sell'' recommendation for banking stocks.
AVOIDING WOBEGONITIS
In February and March, Morgan Stanley (MWD - news) announced it had simplified its ratings system and -- surprisingly -- that it had assigned 22 percent of its covered companies the lowest rating, ``underweight.'' Before, Morgan Stanley, like almost all other Wall Street firms, had put just a tiny fraction of companies in the bottom rank.
Morgan Stanley wants to avoid ``Wobegonitis,'' according to Steve Galbraith, its chief U.S. investment strategist. The reference is to a Garrison Keillor novel about fictional Lake Wobegon, where all children are above average.
``It is wholly in the Street's interest to tighten up analytic standards today,'' Galbraith said in a March 26 client note. ``Should investor confidence in our markets tip overboard, it won't be just the customers who don't have yachts.''
During the dot-com boom analysts had predicted ever-rising stock prices for their favored companies. Then, as energy trader Enron slid into bankruptcy, analysts supported management by recommending the stock almost to the bitter end. Both events eroded trust in Wall Street's collective judgment and helped lead to the new regulations, unveiled in February, that will impose increased disclosure and other requirements.
Embracing tougher stock rankings is a smart move, according to Henry Hu, a professor of banking and finance law at the University of Texas in Austin.
``More serious ratings are absolutely inevitable,'' he said. ``You might as well get a leg up on competitors by being among the first.''
The current preponderance of ``strong buys'' and ``buys'' resembles the controversy academia, where colleges, including, most notably, Harvard inflate grades so nearly all students receive ``As'', said Hu, a Yale graduate.
Tough research calls are not unusual, Lehman and Morgan Stanley would argue. Each firm's research department has had well-publicized run-ins with top management and venture backers.
Lehman's critical analysis of Amazon.com Inc. (AMZN - news) debt inspired the ire of powerful Silicon Valley venture capitalist John Doerr, who sits on Amazon's board. Morgan Stanley's questioning of accounting practices at Qwest Communications International Inc. (Q - news), the No 4. U.S. local telephone company, provoked the wrath of that company's chief executive.
PAYING THE BILLS
Investment firms have an incentive to broadcast their support for independent research so that they appear to be ahead of the curve as the new regulations approach -- and also because of the possibility that Washington might impose more draconian solutions.
``Independence is tough really to ensure on a regulatory basis ... so there may be a need for separation, and that may be more key than the rating systems,'' said John Davidson, president and chief executive officer at PartnerRe Asset Management, which oversees $4 billion in assets.
As long as Wall Street analysts ultimately depend for their big paychecks on the success of investment banking, enthusiastic experiments in telling it like is -- and irking company management, which can always send its business to more pliable banks -- may prove short-lived.
``The research arm has every incentive to be honest and so forth,'' said University of Texas's Hu. ``The problem is that they're not the fee generators.'' Wall Street makes its money through commissions and fees for selling shares and for advising on deals. Research is offered as an enticement for preferred customers.
``In general, you would think that the analysts would want to be franker, but the investment bankers who are generating lots of fees would prefer them to be less frank,'' he said. |
