Investors need genuine help to avoid perils

Rampant conflicts remain in the Wall Street jungle

Dollars & Sense

May 26, 2002|By Janet Kidd Stewart | Janet Kidd Stewart,SPECIAL TO THE SUN

Despite a settlement that requires Merrill Lynch to pay a $100 million penalty and change many of its research practices, experts say it's still a jungle out there for investors: Conflicts remain rampant on Wall Street, and the financial markets, in many ways, remain perilous.

The investigation by New York Attorney General Eliot Spitzer that resulted in last week's settlement refocused attention on the close relationship at brokerage firms between research analysts and investment bankers.

Despite intense criticism in the wake of the tech stock collapse, investors remain buried in "buy," "strong buy" and "long-term buy" ratings; critics say many analysts are little more than hucksters for many stocks, out to help their firms win huge underwriting fees from the companies they cover.

The terms of the Merrill settlement, these critics say, won't eliminate these conflicts, even if they're adopted across the industry.

In the settlement, the firm conceded that some of its analysts had recommended stocks to the public while simultaneously criticizing the shares privately. Merrill agreed to cut direct links tying analysts' pay to investment banking fees collected in stock and bond offerings. The company also agreed to disclose investment banking relationships in research reports and hire a compliance monitor to oversee research operations.

On Wednesday, Salomon Smith Barney announced that it will change its pay system to mirror Merrill's.

Observers point to an array of Wall Street practices that still pose risks for investors: Eliminating direct pay links won't eliminate the pressure on research departments to help win investment banking dollars. Analyst recommendations are still overwhelmingly positive, and there are plenty of incentives to keep them that way. For its part, Corporate America still has a long way to go to improve financial reporting standards that can drastically affect share prices. And the forced arbitration system for handling brokerage complaints rarely returns much to customers, investor advocates say.

"There are still some serious challenges for investors," said Russ Kinnel, a director at Chicago-based Morningstar, who questions whether analysts working at any investment banking firm can be truly unaffected by the relationship.

Further, analyst recommendations remain predominantly bullish, notes Chuck Hill, research director for tracking firm Thomson Financial/First Call, though he believes that will change in the summer when new industry rules take effect requiring more disclosure on firms' ratings track records.

"Investors hadn't gotten the secret decoder ring that said `buy' means `hold' and `hold' means `sell,'" Hill said.

The good news: The new disclosure requirements scheduled to take effect in July will allow investors to see a firm's investment banking relationships and its overall buy rating percentages on research reports. Wall Street experts, however, warn that individual analysts still will face pressure not to be overly harsh on specific stocks.

More important, experts said, investors can take steps to minimize or sidestep many of the risks that remain, and there is a wealth of information available to them at no or low cost that was once the exclusive domain of the investment houses.

"Investors are more aware of the need to question these research reports and not take them as God's truth," said Marc Beauchamp, executive director of the National Association of the North American Securities Administrators Association, an alliance of state regulators.

Investors should pay closer attention to the narrative portion of research reports and less to the bottom-line "buy" or "sell" ratings, he said.

Moreover, investment banks aren't the only shop in town anymore where an investor can read equity research. Prudential, Fidelity and Charles Schwab all have research functions, in addition to independent houses such as Morningstar. And in the wake of congressional and regulatory investigations into analyst conflicts, there is mounting evidence that investors will create a demand for such services.

Observers note that free sources of information are available on the Internet that were previously difficult for investors to access quickly.

"You can listen in every time a company has a conference call," thanks to fair-disclosure regulations, notes Kathy Shanley of Gimme Credit, the independent bond analysis firm.

She urges investors to do their own research using these tools, rather than reading analyst reports.

Chicago portfolio manager Edward Studzinski of Harris Associates, a self-described "natural skeptic," scours insider buying and selling data to see if company executives truly believe what they're saying about their company's prospects.

Many observers hope investors will bring similar skepticism to all types of advice they receive and will continue to question remaining conflicts.

"Even with the new regulations, we still have the problem of retaliation against an analyst if he or she writes a negative report," said Jack Coffee, a Columbia University professor and noted securities expert. "People do get fired for issuing negative reports."

Janet Kidd Stewart writes for the Chicago Tribune, a Tribune Publishing newspaper.

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