The brokers continue to favor those `buy' ratings

January 19, 2003|By JAY HANCOCK

LAST JULY, Baltimore investment house Legg Mason Inc. pasted a "buy" rating on the stock of homebuilder Dominion Homes Inc.

Maybe it was Dominion's good reputation and steadily rising sales and profits that earned Legg's seal of approval. Or maybe it was the solid Midwestern markets in which Dominion operates, or Dominion's efficient management.

Or maybe it was the $600,000 or so that Dominion paid Legg to sell Dominion stock to public investors last year.

It's "the dawn of a new day on Wall Street," crows Christine A. Bruenn, head of a group of state securities administrators, but the sun rose over New York's East River this morning on the same old conflicts of interest.

Despite the reform of the past year, Legg and other top stock-research houses still work for investment banking and money management clients who love "buy" ratings and hate "sells."

In a perfect world, analysts would grade companies on merit and not worry about outside influences. The proportion of "sells" would rise from single-digit percentages, where it has been forever, to something that doesn't suggest nine out of 10 stocks are OK, good or fabulous.

To try to shield analysts inside something like a pure-research tank, the Securities and Exchange Commission has banned them from being supervised by their banker colleagues or collecting bonuses on individual stock and bond flotations.

The SEC has also prohibited analysts from trading stocks they cover on days near the issuance of reports and barred them from promising favorable research as an incentive to snag stock-issue deals for their firms.

These rules, plus disclosure requirements on stockbrokers' investment banking business; ownership of rated companies; and distribution of "buy," "hold" and "sell" recommendations, were phased in last year.

The results so far: As of Jan. 7, the top U.S. stock-research firms had placed "sell" recommendations on fewer than 10 percent of the companies they follow while rating almost half the companies a "buy," according to data from Thomson First Call.

While that's a change from the 1990s, when Wall Street rated fewer than 3 percent of stocks as "sells," it's not a big change, says First Call research director Chuck Hill.

"The critical thing is whether a firm has a meaningful number of `sells' or whether they're still operating the way everyone was" in the 1990s, Hill says. "Some firms have understood the implications of this and moved to a more realistic distribution [of ratings] and others have not."

Companies in what Hill considers the realistic camp include Salomon Smith Barney, Morgan Stanley and Goldman Sachs, all of which deem at least 17 percent of their rated stocks as "sells" under aggregate data disclosed under the new rules.

In a pitiful case of self-flagellation, Salomon wins the born-again battle by branding 40 percent of its covered stocks as "sells."

On the other hand, firms such as Legg, Deutsche Bank, Prudential and Bank of America have slapped "sell" labels on 5 percent or fewer of the stocks they follow. Legg, for example, rates 4 percent of its stock "sells," 47 percent "buys" and 49 percent "holds," says First Call.

Are these analysts really bullish? Or just chicken?

Ira H. Malis, Legg Mason's director of research, notes correctly that firms with high proportions of what the SEC considers to be "sell" ratings don't really say "sell" except in fine print, and even then not for particular stocks.

These brokers say certain stocks may "underperform" or should be "underweight" in portfolios, and such euphemisms go over better with potential critics than the "buy, hold, sell" thermometer used by Legg and other firms, Malis says.

"There are ramifications if you rate something a `sell,'" Malis says. "The companies are not going to like to see a `sell,'" he adds, and for institutional investors who own the stocks, "you can anger them, too."

Which is the point. Even with the new rules, there are plenty of reasons for analysts to pull punches.

Of the companies that bought services from Legg in the past year and are graded by Legg analysts, 57 percent are "buys," Malis says, and 3 percent "sells."

He explains the high proportion of "buys" by saying Legg doesn't like to issue stock unless its analysts favor a company. Stocks of many firms that Legg did deals with last year have indeed risen, although Dominion Homes has not.

Even so, the lesson is that analysts aren't in an isolation chamber. Look carefully at the new disclosures on conflicts.

Buyer beware. Of course, that was good advice in the 1990s, too.

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