Speaking their minds

February 11, 2002: 3:47 p.m. ET

Analysts at independent research firms don't think the latest proposals for analyst reform go far enough.
By Staff Writer Paul R. La Monica

NEW YORK (CNN/Money) - After years of watching Wall Street hype unprofitable Internet stocks and skip over ticking time bombs like Enron, regulators are finally fed up.

On Thursday, the National Association of Securities Dealers announced a proposal for new rules governing Wall Street analysts. Among the changes: analysts will have to disclose whether or not they own a stock they are covering, and they will no longer be allowed to report directly to investment bankers or have bonuses tied to participation in banking deals. (For more, click here.)

It's a step in the right direction. At most brokerage houses, investment banking pays the bills, and the analysts at those houses have to think twice before saying anything negative about the stocks of potential clients.

But the proposed rules, which must still be approved by the Securities and Exchange Commission, won't necessarily change the rules of the game. Even if the analysts don't have explicit incentives to promote banking deals, the implicit pressure will be ever-present.

Sean Ryan, co-director of research for Fulcrum Global Partners, an independent research firm that does not do investment banking, says that banning formal bonuses related to investment banking deals is pointless since most of the compensation is informal anyway. "The NASD and SEC may as well announce a decree banishing evil and establishing paradise," he says.

Research-only firms don't fear backlash
Of course, there are many top analysts at big Wall Street firms. But for solid unbiased advice on stocks, many top money managers will continue to rely on the small group of research-only firms.

"Given the absence of investment banking relationships, these analysts can be less delicate," says Frank Barkocy, an analyst with hedge fund group Keefe Managers and a former sell-side analyst who has worked for Merrill Lynch, Advest and Josephthal.

At Fulcrum, for example, analysts rate some 40 percent of the stocks they cover as "sells" (the firm has only two ratings, "buy" and "sell," while elsewhere on Wall Street, you'll find ambiguous ratings like "market perform").

Fulcrum was founded in May, 2001 by the former CEO of ING Barings to provide research to hedge funds and asset managers. Ryan, a former sell side analyst with Bear Stearns who resigned in 2000 after being chided for speaking out against several bank stocks, joined Fulcrum last year.

The analyst no longer has to worry about backlash from his employer and has sell ratings on both mortgage purchaser Fannie Mae (FNM: up $0.14 to $79.64, Research, Estimates), because he's concerned about increasing competition, and on Bank of America (BAC: up $0.65 to $61.25, Research, Estimates), because he thinks the market is not taking into account the bank's credit risk. Not one analyst tracked by First Call rates Fannie Mae less than a "buy," and of the 27 analysts following Bank of America, only one other rates it a "sell".

As for what Ryan does like, one stock he's been eyeing is credit-card lender Metris (MXT: up $0.37 to $15.33, Research, Estimates). The stocks of many credit card lenders, particularly Metris, have been battered on concerns about rising default rates from Americans who have overloaded on debt. As a result, Metris's stock now trades at just 5.5 times 2002 earnings estimates. But Ryan thinks any worries about defaults are more than priced into the stock.

Other renegades
Prudential, which has been making waves for some prominent sell calls lately (see "Bears love the Rock"), also does not have an investment banking arm. The firm was the only brokerage to issue a sell on Enron before it collapsed and also accurately predicted Kmart's bankruptcy.

Less than half of the firm's recommendations are "buys," according to Thomson Financial/First Call, with 196 buy ratings, 244 holds and 22 sells. Prudential only rates stocks buy, sell, or hold. Prudential officials were not available to comment for this story.

Another independent firm that does not hold anything back is Cleveland-based Midwest Research. According to data from Thomson Financial/First Call, Midwest Research was the third most bearish firm of research firms covering more than fifty companies.

"Our analysts make money by helping our customers make money. We have one customer: institutional investors," says Eric Bosshard, director of research for Midwest Research. "We don't waste time on road shows or running out ground balls for investment bankers."

Bosshard says that the firm's top picks currently include tool maker Black and Decker (BDK: up $0.85 to $40.37, Research, Estimates), consumer electronics retailer Radio Shack (RSH: up $1.07 to $28.02, Research, Estimates), and diesel engine manufacturer Cummins (CUM: up $0.67 to $39.13, Research, Estimates).