Trust the stock analysts? Observers aren’t so sure

Alan Clendenning

Friday, May 31, 2002 | 9:54 a.m.

NEW YORK -- The way New York's attorney general sees it, Wall Street analysts will make more objective stock recommendations now that Merrill Lynch & Co. has agreed to stop rewarding its analysts for luring investment banking clients.

Only days after Eliot Spitzer announced his settlement last week with Merrill Lynch, Salomon Smith Barney and Credit Suisse First Boston said they would also adopt the new analyst pay guidelines.

Observers agree that other major Wall Street firms will probably follow suit, but warn that investors should still be skeptical when it comes to analysts' stock recommendations.

Theoretically, analysts working for firms that come to terms with Spitzer will be paid only for the quality of their research.

But the problem is that brokerages get so much revenue from investment banking fees for arranging mergers and new stock offerings that there will always be an indirect link.

"When it comes time to dish out the bonuses there certainly is a possibility, shall we say, that the investment banking guys sit down with the compensation committee or whoever and say, 'Hey, here's the analyst who has really been helpful to us,"' said Chuck Hill, director of research for Thomson Financial/First Call.

Spitzer disagrees, saying the reforms coupled with investors' greater awareness of potential conflicts will keep analysts honest.

"Analysts are under the microscope," said Spitzer spokesman Darren Dopp. "They simply won't have the opportunity to get away with it."

He said the reforms, which include monitors at the brokerages, will eliminate the conflicts.

"It's a kind of scrutiny that hasn't happened before," Dopp said. "The kind of cavalier attitude (from the past) won't fly anymore."

In his investigation of Merrill Lynch, Spitzer uncovered e-mail messages from analysts privately disparaging stocks that they publicly gave positive ratings. He claimed the brokerage misled investors because it wanted investment banking business from the companies whose stocks were touted.

Spitzer originally wanted Merrill Lynch and other firms to spin off their research departments, but that demand quickly evaporated after brokerages objected, saying the work the analysts do doesn't pay for itself.

Brokerages that provide analyst services give the research away as a side benefit to clients investing with their firms. But the brokerage's investment banking clients want their stock recommended by the analysts.

"I don't think you can ever totally rebuild the fire wall between investment banking and research until the brokerage firms can again get paid in a meaningful way for their research," Hill said. "That's the real problem."

Some critics say analysts will still be under pressure to give decent stock ratings to important investment banking clients because of fears they might lose their jobs if they don't do so.

"At the end of the day, they will still realize they receive a subsidy from investment banking," said John Coffee, a securities law professor at Columbia Law School.

And analysts will still be allowed to go on so-called road shows, where they team up with investment bankers to persuade financial backers to buy up new stock offerings.

Still, Coffee says the settlement is significant because analysts will feel some pressure to make their stock calls as they see them.

And this comes on top of a wave of investor distrust spawned by the inability of the industry's most intelligent stock watchers to predict Enron Corp.'s spectacular collapse.

"The audience no longer wants the analyst to tell him what the next Yahoo! is, he wants to know what the next Enron is," Coffee said. "When the audience is more skeptical, the research is more skeptical."

Others think Merrill Lynch and the other brokerages that adopt the settlement's terms will get a bargain, even if all end up paying a multimillion dollar settlement. In its settlement, Merrill Lynch agreed to pay $100 million.

But any penalties won't come close to approaching the billions the firms made during the stock market boom of the 1990s, when analysts became media superstars and helped propel shares higher and higher, said Robert Aliber, an economics and finance professor at the University of Chicago Graduate School of Business.

"What this indicates is it's incredibly profitable to use analysts to hustle investors and when you're caught the penalty is modest," he said. "It seems to me it paid off immensely in cost and benefits for Merrill Lynch."

The controversy over alleged analyst conflict of interests could actually end up prompting the growth of independent, fee-based analyst firms, said John Bogle, founder and former chairman of The Vanguard Group of mutual funds.

"I think it's very difficult to deal with the conflicts as long as (analysts) are working in the same firm with investment bankers," he said.

Aliber said no one will know whether analysts will change the way they rate stocks until the stock market recovers.

"I think we'll have to wait for another bull market to see how it plays out," he said.