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To be fair, Wall Street was moving toward limiting potential conflicts of interest between investment-banking and research departments before the investigation into Merrill Lynch broke into public view. The Street just wasn't moving fast enough. Now, as state regulators led by New York State Attorney General Eliot Spitzer mount an aggressive investigation into allegations of tainted stock research, brokerage firms need to make some significant changes to the reports they issue.
Getting the Street to overcome its resistance to rapid change may be the hard part. However, major improvements don't necessarily have to be all that difficult to implement. Here's a pretty simple idea that could go a long way toward solving the problem: Firms should strip their reports of both recommendations and price targets.
REQUIRED READING. Doing so would leave analysts to do their job: provide insight into a company's earnings prospects, business strategy, and competitive position. Even better, it would require brokers and investors to actually read a report to find out what the analyst thinks.
In contrast to the recommendations and the price targets, the content of analyst reports (I typically read a dozen or so each week) is usually quite balanced, reflecting both a stock's potential upside and the risks it faces. If analysts didn't stamp their reports with a rating, they would still be able to get across their opinion on a stock. But the analysis could be far more nuanced and complete.
Clearly, the problem with brokerage-house research is mainly in the ratings (almost all stocks garner a buy or better) and the price targets. As has been well documented, analysts often feel pressure to issue positive ratings on companies they follow. Sometimes it's because their firm is trying to gain investment-banking business from that company. Another reason analysts write positive reports is to stay on good terms with management at companies they follow so they'll be kept in the loop.
Professional investors know that a buy rating doesn't mean much. What matters to them is when an analyst upgrades a stock (which means buy) or downgrades one (which means sell). Even if a stock drops from strong buy to buy, the message is still "get out now." Unfortunately, very few individual investors know this code.
THEORY VS. PRACTICE. As for price targets, they're considered virtually worthless by investment professionals (see BW Online, 4/25/02, "When a Stock's Rating and Target Collide"). In theory, targets should indicate a reasonable valuation level for a stock, assuming the company performs as expected in the next year. In practice, targets are really just another clue as to what the analyst truly thinks about a company. (Buy it, and it could double from here. Or buy it, and the best you can hope for is a few measly points.)
While professionals easily decipher the hidden signal in the price target, unsophisticated investors are too often seduced by the dollar sign. They see the target as a real prediction of future performance, only to be sorely disappointed. Some individual analysts at firms such as Robertson Stephens already eschew price targets in their reports. And many Wall Street outfits are experimenting with different ways to rate stocks. Prudential has a simple buy/hold/sell system (and is issuing a lot more sells these days).
Barry Hyman, chief investment strategist at money management firm Ehrenkrantz King Nussbaum, thinks Morgan Stanley has the Street's best stock-rating system. Its reports tell investors whether they should overweight (buy a larger position in the company than an index fund would) or underweight (purchase a smaller position). But while that lingo makes sense to professional investors, it's a bit opaque for most individual investors.
RADICAL CHANGE? Other reforms are under way. Facing a court order, Merrill Lynch has promised to improve disclosure in its reports. That's a step in the right direction, but it's not much to crow about. If the price targets and buy ratings are still there, most individuals will focus on those.
Spitzer's proposal that firms strictly separate their investment-banking and research divisions has sparked the most discussion. Such a radical change would require Wall Street firms to change their business models. Not only would it take time to implement but it also would eliminate only one kind of conflict of interest.
Even without investment-banking deals, brokerages would still have incentive to encourage their analysts to issue buy ratings. Their brokers would need something to wave in front of their clients to get them to buy stocks. Analysts, too, would continue to feel pressure to write positive reports to stay on the good side of management at the companies they follow. "I don't think separating investment banking and research really matters," says Hyman. "Those seeking positive research will seek it anyway."
COSTLY REMEDIES. Maybe so. But facing growing public outcry and increasing legal pressure, Wall Street can't just shrug its shoulders. On Apr. 23, state securities regulators formed a national task force, chaired by Spitzer and the attorneys general from New Jersey and California, to investigate possible securities-law violations. Criminal and civil charges can potentially result from these investigations. It now seems likely that firms will have to pay millions of dollars in settlements to individuals misled by tainted research.
Wall Street could stop putting out recommendations and price targets on stocks tomorrow. That simple move wouldn't resolve all the underlying conflict-of-interest issues -- or make up for past abuses. But it would offer individual investors some immediate protection. And it would go a long way toward Wall Street showing the public that it's ready to do more than just run for cover.
Associate Editor Stone follows Wall Street for BusinessWeek Online Edited by Douglas Harbrecht
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