TCS Daily

Analyze This

By James K. Glassman - April 15, 2002 12:00 AM

For the past 10 months, the attorney general of New York, Eliot Spitzer, has been investigating Merrill Lynch & Co. Although he hasn't charged anyone with a crime, he has accused the firm of misleading customers by hyping stocks to win investment-banking business; Merrill's advice, he claims, is "tainted" by conflicts of interest.

Mr. Spitzer has turned up e-mails that he says show that analysts, using colorful words like "crap" and "dog," were more pessimistic about some stocks in private than in public. Mr. Spitzer's proposed solution is to force Merrill to pay big fines and spin off its research department as a separate business, and sources say he has expanded his investigation to nearly a dozen other firms. He admits his aim is nothing less than a restructuring of the financial industry.

Mr. Spitzer isn't the only politician angry at analysts. Congress is threatening new laws, and the Securities and Exchange Commission -- under political pressure itself -- has pressured the National Association of Securities Dealers and the New York Stock Exchange into writing new regulations that would force analysts to make excruciatingly detailed disclosures of their holdings and their performance and to bar firms from linking analyst pay to investment banking.

While it's important to unmask crooked analysts and it's good for the public to understand that firms have conflicts, the current hysteria is ultimately bad for markets -- especially for small investors. New regulations will inevitably load new costs onto firms and diminish their resources -- not to mention their desire -- to provide clients with strong analysis. And the attacks by Mr. Spitzer -- and the gang of state attorneys general who will inevitably follow -- will help slipstreaming plaintiffs' attorneys file huge lawsuits. Giving investment advice could turn out to be just as risky as manufacturing silicone breast implants, and firms may simply stop doing it.

Every bear market requires a scapegoat, and this time the chosen victims are stock analysts. Why didn't they see Enron coming? Why didn't they tell clients to bail out of sooner? Why didn't they know the Nasdaq would crash? The obvious answer is that even experts make mistakes and that markets are utterly unpredictable in the short term, but that's a theory that lacks an appealing conspiracy, so reformers have seized on the notion that analysts have conflicts of interest since they work for companies that also provide investment-banking services.

Do such conflicts exist? Of course. But conflicts abound in every nook and cranny of society. Politicians themselves are pulled in different directions by their contributors, their parties, their families. But, in the end, they try to surmount the conflicts and make sound judgments. They have to -- because those judgments are held up to intense public scrutiny.

Likewise stock analysts. Their work is out there in the public arena; their records are closely examined. Publications like The Wall Street Journal and Institutional Investor make lists of analyst all-star teams. Research firms like Zack's and First Call devote enormous effort to tracking analyst recommendations. If analysts make their choices not on the basis of company fundamentals but because they are swayed by investing-banking considerations, these biased judgments will produce poor performance. The proof is not in the anecdotes, but in the broad results.

Fortunately, there's a study that looks at such results. A year ago, a group of four California economists -- Brad Barber, Reuven Lehavy, Maureen McNichols and Brett Trueman -- published in the peer-reviewed Journal of Finance the most extensive research on record of the performance of stock analysts. It showed that analysts do an exceptionally good job picking winners.

The researchers examined "over 360,000 recommendations from 269 brokerage houses and 4,340 analysts" between 1985 and 1996, classifying consensus rankings on individual stocks into five categories. They found that the highest-rated stocks produced average annual returns of 18.8% while the lowest-rated returned just 5.8%. The market as a whole over this period returned an average of 14.5%.

Mr. Barber and his colleagues then controlled for "market risk, size, book-to-market, and price momentum effects" and concluded that a portfolio composed of "the most highly recommended stocks provides an average annual abnormal gross return of 4.13% whereas a portfolio of the least favorably recommended ones yields an average annual abnormal return of negative 4.91%." In other words, an investor who bought the top-rated stocks and shorted the lowest-rated stocks would beat the market by about nine percentage points a year. This performance can only be called astonishing.

Despite the Barber research, there's no doubt that some analysts are biased and that some firms put heavy pressure on their research departments to support investment banking. How to discipline such practices? The best way is through tough reporting. Analysts operate in public; the numbers are there; journalists and other analysts should count them and publicize them.

The answer is certainly not crazy, nitpicky new NASD regulations that would, for example, require every analyst report to include "a chart that depicts the price of the subject company's stock over time and indicates the points at which a member or member organization assigned or changed a rating or price target." Is this a good idea? Maybe, but it's no business of the regulators to require it. Investment firms themselves already have good incentive to provide charts and graphs if their clients want them.

Nor is Spitzerism the answer. If crimes were committed, let him prosecute. But his designs are far more grandiose -- and perplexing for the attorney general of a state trying desperately to keep investment firms from moving elsewhere. He wants to subject analysts to what John Coffee, a Columbia University professor of corporate law, called "ceremonial humiliation" at public hearings, but his ultimate goal is some sort of "global resolution" to restructure the industry.

In the end, all of this exaggerated emphasis on analysts is misleading for investors and dangerous to markets. A positive recommendation from an analyst should only be a small element in the process of deciding whether to buy a stock. That's the message investors need to hear. Instead, Mr. Spitzer and members of Congress who should know better, like Rep. Richard Baker (R., La.), are indicating to investors that their losses in recent years are the result of biased analysts rather than simply a decline in corporate profits during an economic slowdown.

The lesson to investors from the politicians is that, if it weren't for the sleazeballs, every constituent would be raking in piles of dough in the stock market. What investors need to understand is that stocks go up and down and that history shows that the market declines, on average, every three or four years. For a stock to fall, no scapegoat is required.

A version of this article first appeared in the Wall Street Journal.

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