"Underweight" Means "Sell," Doesn't It?


Last year, in the wake of Enron, WorldCom, and a host of other corporate scandals, Prudential Financial (PRU) decided to take the high ground. "You said you wanted objectivity from Wall Street" in evaluating stocks, Prudential declared in a marketing and advertising campaign to customers and prospective customers alike. "Prudential Financial is listening."

The message was clear: Other major Wall Street firms' research analysts might be pressured by investment bankers to pump out confusing or misleading research reports, but Prudential's researchers would be forthright and plain-speaking in their recommendations to retail investors.

Prudential may have been listening. But the firm still seems to be wrestling with the forthright and plain-speaking part. It appears that Prudential broke one of the NASD's first reform rules when it switched to a new stock rating system on Sept. 8.

"PRODUCTION ERROR." Instead of continuing to rate stocks under the terms buy, hold, and sell, the firm's analysts use overweight, neutral, and underweight. That's fine under the new rule. But firms must clearly explain to investors how the new ratings compare to traditional ones. "The idea was to make it clear when you were saying buy, hold, and sell," says Charles L. Hill, research director at First Call. Prudential would have to explain how the three new terms replace buy, hold, and sell somewhere in its reports after Sept. 8.

Prudential hasn't done that, however. After being questioned by BusinessWeek Online, a company spokesperson acknowledged the mishap, calling it a "production error" in the publication of its latest report. The firm says it will communicate the mistake to its clients on Sept. 11. And it will include what percentage of all its ratings should be under the categories of buy, hold, and sell in future reports, though it won't revise the reports that contained the error, the spokesperson says. Its analysts will still rate each company as an underweight, neutral, and overweight.

The NASD declined to comment on the mishap. But Prudential's error has another twist that muddles the issue further: The new NASD guidelines clearly state that, while companies need not use the terms buy, hold, and sell, whatever terminology they adapt still must convey those three classifications. That's the rule.

NOT WHAT IT MEANS. So how to explain Prudential's report on Unilever (UL) issued on Sept. 10? At the bottom of that report, it says only 4% of all of Prudential's stocks were rated sell as of June 30. Yet, 25% of them were rated underweight by Sept. 9. If Prudential treats underweight as a replacement for sell, that would mean the number of stocks that Prudential rates as a sell jumped by 21 percentage points in just three months.

Asked for a clarification, Prudential says it's a bit more complicated than that. Underweight really means a stock isn't expected to perform as well as other stocks in the same industry sector. For example, if the stocks in the tech sector are expected to double in price, but one stock will rise only 10%, an analyst might recommend it as an "underweight" even though an investor could still make money from it.

So it appears that underweight doesn't mean sell after all.

Prudential says it changed its research ratings to cater more to its primary audience -- money managers, who are better able to parse such information and manage portfolios of stocks in the same sector. But brokers still distribute its research to individual investors at Wachovia (WB), which purchased Prudential's retail brokerage operations in July.

DIFFERENT STROKES. Won't these revisions confuse small investors? Michael Jones, head of advisory services for Wachovia, says it isn't troubled by the Prudential ratings change. "We try to make sure our clientele doesn't place an emphasis on the buy, hold, sell, or overweight, neutral, and underweight ratings in research reports," Jones says. Wachovia routinely adds its own opinions to such data and then synthesizes it "into a definitive buy, hold, or sell" for clients, he says. Besides, Jones adds, "Institutional investors don't invest the way small ones do."

Jones has a team of nine people who pore over reports from Credit Suisse First Boston, Goldman Sachs (GS), Wachovia, Standard & Poor's, and Prudential to make stock recommendations. That may solve the problem for people who get advice from Wachovia's brokers. But individuals who seek out Prudential research on their own might want to consult a few more sources as well. By Emily Thornton New York


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