Originally created 05/10/04

Despite more "sell" ratings, Wall Street banking clients don't bear brunt



NEW YORK - Before applauding Wall Street stock analysts for learning how to say "sell," take a closer look. They may not speak so freely when it comes to companies that buy investment banking services from their firms.

Despite the obvious increase in negative stock ratings since the peak of the bull market - not such an accomplishment considering they were almost non-existent back then - most of the harsh opinions are directed at companies that aren't clients. Friendly remarks are most often reserved for paying customers.

Sell recommendations and similarly worded opinions such as "underperform" and "reduce" now account for about 9 percent of all ratings on all stocks traded on U.S. exchanges, according to both Zacks Investment Research and Thomson First Call. That's ten times more than in 2000, when slightly less than 1 percent were negative.

But despite this belated realization that some stocks actually fall, analysts are not sharing the un-love evenly.

Among the nation's 15 biggest brokerages, the shares of companies who also happen to be investment banking clients account for no more than one out of 10 sell ratings issued by any one of the brokerages, estimated Mitch Zacks, vice president at Zacks. At some of these big investment firms, it's one in 25.

By contrast, about two-thirds of a big investment firm's banking clients are buy-rated, while the rest are deemed "hold" or "neutral."

Since the actual breakdown varies widely from brokerage to brokerage, individual investors are well-advised to consider the source of their investment advice.

And thanks to disclosure rules adopted two years ago, investors willing to put in the effort actually have some tools to help gauge for themselves whether the advice emanating from the research side is relatively independent.

Wall Street firms say they have changed drastically since charges of biased research provoked a $1.4 billion settlement with regulators. The scandal also prompted new rules designed to rebuild the crumbled wall that was supposed to insulate stock analysts from pressures to win lucrative investment banking business.

To test how much has changed, one can now view a detailed breakdown of any investment firm's ratings.

At Merrill Lynch, a prominent name in the controversy, there were 164 "sell" recomendations at the end of March, accounting for about 7 percent of the nearly 2,500 stocks rated by the firm. Among the sell ratings, a total of 28 companies or 17 percent had paid Merrill for investment banking within the past year.

By contrast, at Smith Barney, another target of the probe, 19 percent of the all ratings were a sell, for a total of about 440. And a third of that number, or 150, were investment banking clients.

Perhaps even more useful are disclosures of whether a brokerage or analyst owns shares of a stock being rated, or whether the research involves a company that has been an investment banking client in the past year or is seen as a prospective source of business in the coming months.

There are in fact some benign, reasonable explanations for why the reforms passed in 2002 would not completely eliminate the skew toward favorable stock ratings on investment banking clients. If, for example, a brokerage already has a negative rating on a prospective investment banking client, it might be difficult to win that business and so the brokerage may not even try.

Nevertheless, the uneven distribution of buy and sell ratings suggest that investors at least need to remain mindful of the conflicts of interest that can influence analyst ratings.

In other words, where there's money and human nature involved, it would be naive to expect rules and regulators to provide foolproof protection against the pressures on analysts whose firms profit from selling stock and other securities.

"One of the most important elements (of the reforms adopted) was a disclosure element as opposed to wall building," said Stellman Keehnel, a partner at the law firm Gray Cary who specializes in securities litigation. "When somebody is basically advertizing their own product, a lot of people would be skeptical if you would ever achieve total independence no matter how many Chinese walls they put up."

Unfortunately, like so many disclosures designed to aid investors, the paragraphs and tables revealing some of the valuable information are often ignored and easily overlooked in the blur of small-type at the end of research reports.

But compared with the alien terminology that tends to dominate corporate financial reports, these disclosures are presented in relatively straightforward language.

"Regardless of any correlation (between stock ratings and investment banking), it can be said that any reader of research can easily determine whether that research is being generated by an entity that has a relationship with the client being reported on, and that is a significant disclosure," said Keehnel. "So investors can exercise their own degree of skepticism, whether due or undue."