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The role for independent equity research

Date 25/06/2002

Dr Shandi Modi
Chairman and Chief Executive Officer, IDEAglobal

When assessing concerns over the objectivity of financial market research, and equity research in particular, one is invariably drawn to the Internet revolution and the proliferation of online trading since 1995 -- a revolution which created a whole new community of investors, and a platform through which to service that community with institutional quality research. With retail investors (as well as institutional investors), ultimately suffering sharp balance sheet deterioration in 2000/2001, the subject of biased research is now very much an issue for Main Street, and indeed Congress. This article attempts to identify some of the key factors that compromise objective research, and assesses the role for independent research going forward.

Before turning our attention to the ethical challenges faced by sell-side research analysts, it is worth pausing to examine the role of research in the global and, in particular, the US economy. At its best, quality equity research provides a crucial conduit for the efficient allocation of capital. It has, no doubt, played its part in the surge in business investment, the technological advancement and the productivity improvement seen in the US economy since 1995. As Congressman Richard Baker, Chairman House Subcommittee on Capital Markets, points out, America does not have a choice in deciding whether to trust Wall Street again -- "We must", he says. However, Baker cuts to the nub of the issue when he outlines that, "the foundation of the free-market system is the free-flow of straight-forward, unbiased information". This sounds simple enough in theory. What prevents this happening in practice?

Without doubt, the Internet transformed the equity market landscape from 1995, sparking a surge in online trading, and of course access to/awareness of investment bank research, previously restricted to Wall Street and its institutional client base. Prior to 1995, who would have believed that working families with USD60,000 incomes and a net worth of less than USD50,000 would be making 800,000 equity trades a day? However, it is that very 'democratisation' of the trading process that has drawn to centre-stage the integrity of Wall Street research.

The concern of all parties involved revolves around the seemingly unending stream of 'Buy' recommendations. We've all seen statistics such as those of 2000, where less than 1% of brokerage house recommendations were 'sell' or 'strong sell'. Of course, to some degree, the growing pains of online trading dictate that the individual investor cope with Wall Street's code of 'Strong Buy', 'Buy', and 'Accumulate'. Investment language however, pales into insignificance as a concern, when compared to the ethical questions faced by analysts remunerated from the investment banking division, or indeed having direct ownership in pre-IPO stock.

Before we can convict Wall Street of serving multiple masters, we must first ask ourselves three questions. First, what precipitated the Street's descent to its current condition? Beyond this, in spite of the apparent conflicts, has Wall Street research benefited investors? Finally, what will it take to move Wall Street beyond its modus operandi?

"Wall Street, in short, has a credibility problem. Its boosterish ways are coming under renewed attack as individual investors learn the hard way that analysts -- the pundits who talk up stocks in the papers or on TV -- serve many masters as stock pickers, they often act like marketing agents, pushing stocks in which they have a stake, or would like one."

US News & World Report, 'Blame The Pundits'.
October 9, 2000

Prior to 1975, the securities industry was a landscape dominated by brokers. Wall Street had the Security and Exchange Commission to thank for this business model, with a fixed commission structure dictated by the government. Without price competition, brokers found that one of the keys to draw more business from their book of clients was to generate the best 'ideas'. With a focus on consistent transaction generation, Wall Street had a strong incentive to provide institutions and individuals with insightful research.

At commission rates averaging USD0.70 per share, firms could count on being paid for good recommendations, whether the company traded 15,000 or 15 million shares per day. Further, with lower servicing costs, providing recommendations to individual investors carried as strong an economic incentive as providing them to institutions, but with higher, government-mandated commissions.

The world changed for Wall Street on May Day, 1975. A Securities and Exchange Commission decree ended the period of fixed commissions after a 5-year phase out period. The 'Shangri-La' made possible by the SEC was no more. With over 60% of their revenues coming from the trading desk prior to May Day, Wall Street moved quickly to realign its interests. Its aim was simple, obvious, and understandable: to continue generating immense profits, in spite of ceding trading revenues to the proliferation of discount brokerages, and in spite of commissions plummeting to USD20 from USD300 per transaction.

Wall Street found its redemption in investment banking, which would soon be producing profits previously undreamt of. From 1975 until 2000, net proceeds from offerings underwritten by Wall Street soared from USD42bn to USD2.24tr. The Street's share of this lucrative business came to a spectacular USD7.3bn in fees in 1999 and 2000.

Unfortunately, Wall Street quickly found that credible, objective, unbiased research and investment banking relationships mixed like oil and water. It was a rare company that was willing to reward poor ratings with underwriting commissions. Indeed, the SEC has been at pains to point out the conflicts of interest faced by investment bank equity analysts, as follows:

  • The analyst's firm may be underwriting the offering
  • Client companies prefer favourable research reports
  • Positive reports attract new clients
  • Brokerage commissions
  • Analyst compensation
  • Ownership interests in the company

The 'Chinese Wall' claimed to exist between research and corporate finance was long ago stormed by the bankers in search of lucrative underwriting relationships. It doesn't take much insight to see the potential conflict in JP Morgan's memo (The London Times, March 21, 2001), explaining that analysts must seek comments from the relevant JP Morgan investment banker, before changing a stock recommendation. This mentality is not isolated to a single firm, as a Morgan Stanley internal memo (Wall Street Journal, July 14, 1992) declares: "Our to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice".

Perhaps, however, all this bias is to the benefit of investors. Many investment bankers contend that strong ratings on their universe of clients are warranted, as they take only the strongest companies as clients. Indeed, the Securities Industry Association points out that Wall Street provides coverage of only 2,400 of the 14,500 securities listed and that a selection bias already exists. Further, their relationship to the firm provides them with better information upon which to develop their outlook.

Unfortunately, the evidence of recent years points to a rather different conclusion. A study by Michaely and Womack of Dartmouth University published in 1999, examining the early part of the 1990s, titled 'Conflict of Interest and the Credibility of Underwriter Analyst Recommendations', proves intriguing. The researchers found that:

  1. Analysts from firms with underwriting relationships do in fact issue more buy recommendations -- on average 50% more than analysts from other brokerage firms.
  2. Stock prices of firms recommended by lead underwriters fall, on average, in the 30 days after a recommendation is issued, while prices of those recommended by non-underwriters rose.
  3. Long-run post-recommendation performance of firms that are recommended by their underwriters is significantly worse than the performance of firms recommended by other brokerage houses. The difference in mean and median size-adjusted buy and hold returns between the underwriter and non-underwriter group is more than 50% for a two year period beginning on the IPO day.
  4. In the death knell to the underwriting strength argument -- "The mean long-run return of buy recommendations made on non-clients is more positive than those made on clients for 12 out of 14 brokerage firms. In other words, it is not the difference in the investment banks' ability to analyze firms that drives our results, but a bias directly related to whether the recommending broker is the underwriter of the IPO".

The evidence against analyst recommendations rests not only in academic studies. The web site,, ranks investment banks by the actual returns investors may have enjoyed had they followed their coverage. The site shows 15 of the 19 largest US brokerage firms producing negative returns, in a period in which the S&P 500 was up 58%.

The final question we must ask is whether Wall Street's self-regulatory code will be enough to end the conflicts of interest or whether government intervention is required.

At present, it appears the bankers have yet to budge. Despite the precipitous drop of 60% in the Nasdaq average, and over 20% in the S&P 500, investment banks maintain sell ratings on less than 2% of issues under coverage. Even with valuations still at historic highs, the average number of buy recommendations on each Nasdaq 100 stock is near 15, with sells below 1. In mid-2001, 72 stocks in the Nasdaq 100 had no sells.

It seems that, despite the painfully apparent lessons of recent history, investment banks have been unwilling to depart from their proven business methods. While many objective and independent analysts have found compelling returns in independence, Wall Street is having trouble distancing its research from banking.

In a 2001 speech, Acting SEC Chairman Laura Unger reported that in "a recent survey of 300 CFOs, one out of five CFOs acknowledged that they have withheld business from brokerage firms whose analysts issued unfavorable research on the company". As long as CFOs continue to pull underwriting business from firms that give unfavourable reviews of their companies, investment banks have no choice but to continue utilising research as quasi-promotional material. Given the choice, no one cuts their own pay cheque.

Indeed, the Security Industry Association's 'Best Practices For Research' guide, released two days prior to Congressional hearings on analyst bias, did not appear to make a material impression on Congressman Baker, and raises concerns as to whether Wall Street's ethical shake-up can be left in the hands of a self-regulatory body. Perhaps the most severe measure would be a government mandated separation of investment banking from research and trading operations. By forcing Wall Street to put a price tag on its research, either in the form of soft or hard dollars, truly independent research firms would be on the same level as their investment banking counterparts.

Free markets being what they are, the ideal solution might seem unlikely. But the world is different now from what it was a year or two ago. The 1990s bull market dramatically increased individual investor participation rates. Enormous apparent wealth creation was followed more recently by dramatic and painful wealth diminution, which was not, as in the past, limited to a small section of the populace. The wealth increase and subsequent loss has been felt directly by a broad spectrum of society. The breadth and depth of these losses bring issues of potential conflicts 'within the club' to a higher political level than ever before.

Regulation of capital markets is today at a watershed. Over the last decade, the players have, consciously or unconsciously, conspired to project a positive face to their businesses at all costs. Corporate managements, focused on stock option profits, determined to exceed earnings forecasts. Research analysts, pressured to support underwriting initiatives, promoted corporate clients without exception. Indeed, auditors, focusing on lucrative consulting opportunities, bent over backwards to accommodate the schemes of large corporate clients. The Enron fiasco appears to be the latest manifestation of this problem.

To take a more constructive viewpoint, we can but hope that such crises create opportunities for fundamental improvements in the way 'things have always been done'. Clearly, the fiduciary obligations of auditors must be affirmed. If the consulting business suffers, so be it. The fiduciary obligations of management must be affirmed. If there must be more than USD100bn of earnings restatements, so be it. And perhaps for the first time, the fiduciary obligations of ratings agencies and research analysts will be affirmed and codified.

The dictionary defines research as 'the hunt for facts or truth'. Research analysts, regardless of where they work, must be seen as having an obligation to disclose material findings of fact, whether positive or negative for the corporate relationship. If they seek to be influential, they must assume accountability for the thoroughness and objectivity of their analysis. They too have an obligation to deliver 'full, true and plain disclosure' to their investing clients. If they fail to seize voluntarily this opportunity to elevate the integrity of their profession, the investing public, and their elected representatives, may thrust it upon them. And so they should.

Investor impatience with biased, self-serving research is at breaking point. The growing awareness is that investment research that is not independent, is not research.