Last week, it was reported that Citigroup is considering formally separating the investment bankers from the analysts at its Salomon Smith Barney unit. Such a move would undoubtedly help the megabank reach a settlement with New York State Attorney General Eliot Spitzer, who has been looking into the web of conflict-of-interest and corruption issues at Salomon.
Wall Street goo-goos have long advocated a formal separation of the two functions. Insiders have always known, and Spitzer’s investigations have virtually proved, that stock analysts help drum up investment banking business by relentlessly pushing the stocks of their clients on a gullible public. Frequently, their compensation is tied to investment banking revenues rather than to the performance of the stocks they recommend. As a result of all the revelations, Wall Street analysts have seen their credibility sink about as far as the Nasdaq. So instead of merely rebuilding the Chinese Wall that was supposed to separate analysts and investment bankers, the argument goes, we should send the analysts to Formosa.
There’s a bit less than meets the eye to the Citigroup proposal. Most notably, CEO Sanford Weill will only take the bold step if all his major competitors agree to do the same. But there’s a larger question here. Would a complete divorce between analysts and investment bankers serve investors better? Unshackled from their investment banking clients, will independent analysts be more likely to call a sell a sell? And will they be more likely to be accurate than their conflicted counterparts?
Judging by the experience of a major Wall Street firm that voluntarily tried this reform a couple of years ago, the answer is a qualified yes.
In late 2000, before analysts fell into such disrepute, Prudential Securities moved to decouple its investment banking and analyst functions. The move by the unit of the giant Prudential insurance/financial-services conglomerate was more a recognition of market realities than a bid for virtue. Prudential Securities had long been an also-ran in the great Wall Street underwriting game of the 1990s. Its 1999 move to acquire Volpe, Brown, a San Francisco-based boutique company that specialized in technology IPOs, came about four years too late to do any good.
Unable and unwilling to compete for the dwindling share of business with the likes of Merrill Lynch and Goldman, Sachs, Prudential decided to jettison its high-priced investment bankers and keep its lower-priced analysts on board. After all, Prudential had a vast consumer and retail brokerage business. The move would both slash costs and send a message to individual investors that the analysts were there to serve them.
The theory, of course, was that Prudential’s analysts would spend more time researching stocks and less time schmoozing on the golf course with potential clients. They would function more like reporters than bankers. They’d also get paid more like reporters, too, since the revenues supporting them would come from asset management and brokerage fees and not from the more lucrative underwriting fees. There would be no Grubmanesque $20 million paydays for Prudential analysts.
Next, Prudential moved to simplify its ratings. Most brokerages used five ratings, ranging from the redundant (strong buy), to the amorphous (accumulate and hold), to the seldom-used and hence meaningless (sell). Starting in May 2001, Prudential began to rate stocks buy, sell, or hold. Without the investment bankers looking over the shoulders, Prudential analysts felt more comfortable urging clients to dump certain stocks. Indeed, they were encouraged to rate any stock that they believed might fall by one-fifth as a sell.
Even after the market meltdown of March 2000, only about 2 percent of the stocks covered on Wall Street were rated as sells. At Prudential, the rate was significantly higher. “Their sell ratings got up to 7 percent or 8 percent of the stocks covered at times,” said Chuck Hill, director of research at First Call.
Throughout 2001, Pru’s analysts distinguished themselves by making some noteworthy calls—especially sell calls. The Wall Street Journal dubbed Prudential Internet analyst Mark Rowen the No. 2 stock-picker on its Home Run Hitters Team for telling people to dump Amazon in February 2001, and to go long Digital River. Prudential downgraded Enron to a sell in October 2001, when the stock was still at 20, and analysts at the major investment banks that had done so much business with Enron were still suffering from ratings-lock. Last November, it put a sell sign out in front of Homestore.com after it warned about fourth-quarter results. Within three months, the company’s shares were halted amid allegations of fraud.
Indeed, because of its structure, Prudential is more likely to attract skeptical analysts. Banking expert Michael Mayo, who was dismissed from Credit Suisse First Boston for his tendency to speak up about lousy deals, has found a congenial home at the Rock. Last month, his sell rating knocked several points off of Citigroup. In the Wall Street Journal’s Best on the Street Awards last June, 10 of the 26 eligible Prudential analysts placed best in their sector, the highest percentage of any of the 20 largest brokerage firms.
Of course, independence is no guarantee of prescience. And as far as telling people what to buy, Prudential’s record is somewhat mixed.A month after it got out ahead of the curve on Enron, it boosted the stock to a hold. Oops. And in the last quarter of 2001, the stocks on Prudential’s recommended list placed 12th out of 15 brokers surveyed by the Wall Street Journal.
No other major investment bank has followed Prudential’s lead in separating analysts from bankers. But they are simplifying ratings and issuing more sell orders. New regulations imposed by the National Association of Securities Dealers compel analysts to disclose more details on the research reports they issue. For example, they must stipulate what percentage of their overall recommendations are buys and what percentage of each rating category is made up of investment banking clients, and create charts that show the stock’s price history and the firm’s recommendations. In addition, many brokers have moved to adopt a three-rating system. The predictable result has been that the large brokerage firms, previously so parsimonious in doling out sell ratings, have been dispensing them the way George Soros dispenses grants.
As a result, the number of sell ratings has proliferated. “Today, we have a number of brokers that have 20 percent or more of their ratings as sell,” said Chuck Hill of First Call. Salomon Smith Barney, whose name has become a synonym for “dishonest analyst,” now has 283 sells, 395 holds, and 346 buys, according to First Call. By contrast, Prudential seems downright bullish. According to First Call, of the 417 stocks that Prudential covers, only 10—that’s 2.1 percent—are rated as sells.
In a sense, then, the world has been turned upside down. The independent analysts seem comparatively bullish while the presumably conflicted analysts, who are supposed to be shilling for investment banking business, are dissing a large chunk of their inventory. Of course, analysts as a group in the past few years have proved themselves to be a pretty clueless lot. The fact that many of them have suddenly turned bearish only after the markets have plunged to multi-year lows doesn’t exactly inspire confidence in their abilities. That’s the bad news. The good news: If brokerage analysts are still too conflicted or lazy to be correct, and if Prudential’s analysts truly are superior stock-pickers, the market may be poised for a turnaround.