Stock Analysis Inflated Stock Ratings. Friday’s landmark settlement between major investment banks and securities regulators over inflated stock ratings could help investors get better stock-picking advice in the future.
But even before the settlement which fined Wall Street firms about $1.4 billion in connection with misleading research, Wall Street analysts had been toughening their ratings on stocks.
Last year, before the recent crackdown spurred by New York State Attorney General Eliot Spitzer, “sell” recommendations made up only 2 percent of the 26,000 individual recommendations by analysts at any given time.
But recent regulations from the stock exchanges and the Securities and Exchange Commission require brokerage firms to list the percentage of “buy,” “hold” and “sell” recommendations they make and show how many of those companies are investment banking clients.
Ever since the rules went into effect in September, half the major banks have issued “sell” recommendations 17 percent to 18 percent of the time, said Chuck Hill, director of research for Thomson First Call, which tracks analysts’ ratings and financial forecasts.
“All these things combined are a powerful incentive to say what you mean and mean what you say,” Hill said. “People are going to realize you’re one of the shills if all your investment banking clients are in the `buy’ category.”
Banks must also provide customers with a chart that tracks price movements of a stock against their firm’s rating of that stock.
Morgan Stanley, which changed its rating system in February, has issued “sell” ratings 20 percent to 22 percent of the time since March. Other banks that have significantly boosted their “sell” ratings include Credit Suisse First Boston, Salomon Smith Barney, Lehman Brothers, Goldman Sachs, Bear Stearns, JP Morgan and CIBC World Markets, Hill said.
Banks whose “sell” recommendations remain closer to 2 percent“still plowing along the old way,” as Hill put it include UBS Warburg, Banc of America, AG Edwards, Deutsche Bank, Prudential, US Bancorp Piper Jaffray, Thomas Weisel, Wachovia and Legg Mason.
But some critics say the ratings system is all that’s visibly changed so far.
The ratings are really aimed at portfolio managers, not ordinary investors, said Pat Dorsey, director of stock analysis for Morningstar, an independent investment research firm that uses a five-star rating system to grade mutual funds and stocks.
“These are individuals who are very concerned with their performance with relation to the S&P, because that’s how they get paid,” said Dorsey. “The whole `overweight’ and `underweight’ thing, they’re constantly fiddling with it. Does it make sense for the average individual investor? Not in the slightest.”
In addition, firms like Merrill Lynch have taken to including so much boilerplate in their reports about potential conflicts of interest that it’s difficult for investors to figure out where actual conflicts exist.
Wall Street’s biggest banks
Friday’s settlement could offer investors a way around that problem. One key provision will require 10 of Wall Street’s biggest banks to fund a total of $450 million in independent research from firms like Morningstar to provide to their customers along with their in-house reports.
In addition, the firms must take more steps to insulate research analysts from the undue influence of the investment banking process, such as banning analysts from participating in sales pitches and road shows to potential banking clients.
The investment banks are also studying other reforms. Merrill Lynch, which paid a $100 million fine earlier this year to settle Spitzer’s charges of misleading research, has created a research recommendations committee to oversee changes in ratings.
And Goldman Sachs, which paid $50 million in fines under the settlement, now has a board of outside directors reviewing its analyst compensation process and a former head of the Federal Reserve Bank advising analysts on potential conflicts of interest.
Taken together, these changes are making research more honest, said Stephen J. Crimmins, who is a partner with the law firm Pepper Hamilton and a former deputy chief litigation counsel of the SEC’s enforcement division.
“Now, if they say company XYZ is the greatest thing since sliced bread, people will be very interested to look down the page,” Crimmins said. “If they see 90 percent of your reports are `buys,’ and 97 percent of the investment banking clients of your firm are `strong buys,’ I think you blow your credibility.”
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