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Two years of investigations, disciplinary actions and internal crackdowns have drastically changed the life of Wall Street securities analysts. Before the bubble burst researchers celebrated their unprecedentedly high stature and compensation; now the dominant emotion inside most research departments is panic. Greed has given way to fear.
“People are scared,” says a 13-year veteran sell-side researcher, who insisted that he and his firm not be identified. “That includes myself, my colleagues here, other analysts I know elsewhere on the Street. Even if you’re completely honest, you’re scared that everyone’s watching and ready to pounce on every little thing you say or do, whether it’s the regulators, the plaintiffs’ lawyers, the press or even your own compliance people.”
Fear can be a mixed blessing. On the positive side, the backlash against conflicts of interest -- which culminated in this year’s $1.4 billion proposed settlement between regulators and ten firms accused of publishing overly bullish stock research to win investment banking business -- is prompting analysts to go back to basics, producing more rigorous, intellectually honest research. This work is helping investors make money and, just as important, avoid losing it. But there are negatives. Some investors are carping that analysts have become even more afraid to take controversial stances -- especially bullish ones -- for fear of running afoul of regulators.
“Research has gotten markedly better,” says Peter Tuz, a portfolio manager at Chase Investment Counsel Corp., a Charlottesville, Virginia, fund management boutique overseeing about $2 billion. “The onus is off working for the investment bankers, and people are calling it as they see it much more frequently.”
One example of old-fashioned analytical rigor’s comeback is Kenneth Weakley of UBS. Last October the 37-year-old health care facilities analyst warned of problems with Medicare payments at Tenet Healthcare Corp., which he downgraded from hold to reduce. Bad news followed, including reports of a federal investigation into allegedly unnecessary surgeries by two doctors at one of the company’s hospitals in California. Shares of Tenet collapsed from 47 on the day of Weakley’s call to 14 in just two weeks. Now, with its shares still mired in the teens, Tenet’s Medicare payments and other financial practices are being probed by the Securities and Exchange Commission. Thanks to his clear-eyed analysis, Weakley jumps from runner-up last year to first in his sector in this magazine’s annual poll of the best brokerage firm analysts.
Another sharp nonconsensus call came from Steven Binder, who tracks aerospace and defense electronics contractors for Bear, Stearns & Co. Despite widespread investor euphoria over what seemed to be exponential growth in the U.S. defense budget, Binder concluded in January that growth in defense spending would not be remotely as robust as fiscal year 2003’s 19 percent. Investors profited from his timely bearish call on defense contractors, voting Binder, 45, the first-teamer in his sector for the fifth year running in the All-America Research Team.
Investors responding to the 2003 survey demonstrate a slightly better opinion of research quality than in recent years. Of those expressing an opinion, 28 percent said research had improved in the past year, compared with only 19 percent who said so in 2002. Asked to rate the overall quality of research on a 1-to-10 scale, with 10 representing the highest quality, investors who responded gave the sell side a 5.67 this year, up from 5.55 one year ago.
If their views of research shifted only modestly, investors’ opinions of individual firms changed dramatically, as they chose to shake up the ranks of America’s top research firms. For the first time in more than a decade, Lehman Brothers takes first place, culminating a dramatic march back from 13th in 1995 (see story, page 56). Lehman finished second in 2002.
Most firms have fewer ranked analysts this year than they did in 2002, owing to a number of factors. First, to reflect market changes, II reduced the number of categories in which it ranks analysts, from 77 to 71. Additionally, dozens of previously ranked researchers have left the profession, disenchanted by the regulatory backlash. Others have been let go as their firms tried to cope with drastically smaller budgets. In many cases, those experienced people were replaced with new analysts, or not at all. Smith Barney Citigroup, last year’s leader with ranked analysts in 53 sectors, sinks to fourth this year with only 34. At Merrill Lynch, which tied for second with Lehman last year, the number of rankings drops from 52 to 35, as its overall standing slips to third. Those that could limit defections, hire away ranked analysts or develop them from within perform comparatively well. Morgan Stanley, for instance, loses six team positions from last year yet still rises from fifth to second place. UBS surges from eighth place last year to fifth, just three places behind No. 2 Morgan Stanley, knocking Credit Suisse First Boston out of the top five. It gains 12 team positions.
Lehman, which eschewed cutbacks, loses only two of its 52 team positions from 2002. Its lead over Morgan Stanley -- 14 positions -- is the most commanding of any No. 1 firm in the survey since 1983, when Merrill bested First Boston by 43 to 27.
The widespread trepidation in Wall Street research departments, of course, is having other effects on analysts and the investors they serve. If some analysts appear to have been scared straight by the regulatory backlash and are unafraid to be vocally bearish when it’s called for, others have been what might be called scared bland. More than a few investors complain that as a result of enforcement actions and private lawsuits brought against analysts who were wrong during the bubble, researchers are increasingly loath to make controversial bullish calls. Some fear they’ll be accused of being shills for banking or the companies they cover.
“It’s true that sell-side analysts are more free to be bearish now, without the kinds of consequences they used to face,” says one analyst at a mutual fund complex. “But there are also an awful lot of them that are afraid to make a controversial or nonconsensus call if it’s bullish.”
Maybe so, but there’s at least one sign that analysts are managing to get it right despite these pressures. An analysis by Hoboken, New Jersey, research performance measurement firm Investars.com, using data provided by Reuters Research, shows that the average recommendation of sell-side analysts (excluding those at independent firms) handily outperformed the Standard & Poor’s 500 index in the third quarter of 2003.
