Bears love the Rock

January 4, 2002: 2:13 p.m. ET

For analysts at Prudential Securities, 'sell' is not a dirty four-letter word.
By Staff Writer Paul R. La Monica

NEW YORK (CNN/Money) - When a Wall Street analyst downgraded discount retailer Kmart to a "sell" this week, there was a lot of hubbub about how rare it is for investment banks to be critical of a company.

And the Kmart (KM: up $0.62 to $4.71, Research, Estimates) �"sell" call was more than just critical. The analyst went as far to say that he would not be surprised if Kmart was forced to file for Chapter 11 bankruptcy in the next few months. Ouch!

But close followers of Wall Street should not be surprised. After all, the analyst in question, Wayne Hood, works for Prudential Securities. And while "sell" is still considered an obscenity by most analysts - only 2 percent of all recommendations on Wall Street are "sells" according to analyst tracking firm Thomson Financial/First Call -- Prudential has developed a reputation for making some head-turning, not to mention accurate, bearish calls.

Made the right call on Enron and Amazon.com
Consider this. Prudential was the only firm to downgrade Enron (ENE: up $0.02 to $0.66, Research, Estimates) to a "sell" before it imploded, doing so in October when the stock was still trading at around $20. Prudential analysts also made timely "sell" calls on Amazon.com (AMZN: up $0.35 to $12.25, Research, Estimates) and DaimlerChrysler (DCX: up $1.22 to $45.62, Research, Estimates) earlier in 2001.

More recently, Prudential downgraded the troubled real estate information company Homestore.com on Nov. 2 after it issued a warning about fourth quarter results. While five other analysts downgraded the stock that day, Prudential was the only one to slap a "sell" on Homestore.com (HOMS: Research, Estimates).

Turned out that call was on the money as well. On Dec. 21, the company announced that it was conducting an inquiry into its accounting practices and subsequently said it will restate 2001 revenues. Shares have not traded since December but once they do, it is likely that the stock, already down nearly 28 percent since Prudential told investors to sell, will take an even larger beating.

More bearish than your average bear
Officials at Prudential Securities would not comment for this story, citing concerns about the company's quiet period. Prudential Financial, the parent company of Prudential Securities, went public on Dec. 13. But people who watch analyst ratings for a living confirm that Prudential is certainly more negative than most on Wall Street.

Thomson Financial/First Call has a 1 to 5 rating system for analyst calls with 1 being a "strong buy" and 5 being a "strong sell". Chuck Hill, First Call's director of research, says the average recommendation for all analysts is 2.1 and that Prudential's average is 2.24. Why is Prudential more willing to pan stocks?

"Their research is squarely focused on the brokers working at the firm and helping retail investors. Everyone else's research is geared more towards institutional money mangers," says Mitch Zacks, vice president of Zacks Investment Management, a Chicago-based firm that tracks analyst estimates.

A big reason Prudential is able to be more blunt in its stock research is due to how different it is from most other Wall Street firms. For one, Prudential exited the investment banking business in December 2000. Therefore, the potential conflict of interest that can arise when an analyst rates a stock no longer exists. A big reason Wall Street brokerages are said to be so loath to issue negative commentary about a company is the fear that they will lose out on potential investment banking business such as equity and debt underwriting or merger advisory work.

Other Wall Street firms depend on investment banking
For example, investment-banking fees accounted for nearly 16 percent of revenue for Merrill Lynch in the first nine months of 2001. Goldman Sachs derived 24 percent of its revenue from investment banking fees in fiscal 2001, which ended in November. And nearly a quarter of Citigroup's total revenue in the first nine months of 2001 was from investment banking fees.� Citigroup owns Salomon Smith Barney.

Prudential on the other hand is a diversified financial services company that caters to the retail customer. One could argue that another reason investment banks are reluctant to disparage companies is that it would lead to less buying of their stocks and hence, lower commissions for the brokerages. That said, even the brokerage side of Prudential is not a huge piece of the overall revenue stream. In the first nine months of 2001, commission revenue from Prudential's private client group accounted for less than 5 percent of the company's revenue. So Prudential clearly can afford to be a bit of a maverick.

It also helps that Prudential changed its rating system in May, instituting three categories. Stocks must simply be rated a "buy", "hold" or "sell". Analysts are supposed to label something a "buy" if he or she thinks the stock will go up at least 20 percent over the next 12 months and issue a "sell" if they expect the stock to decline by 20 percent or more with "holds" being in between. Many other firms continue to have a confusing morass of ratings for stocks. What, for example, is supposed to be the difference between "accumulate" and "buy" anyway?

Not all "sells" have panned out
Of course, Prudential's "sell" calls are far from perfect. The firm actually upgraded Enron from "sell" to a "hold" in November. While certainly not as cardinal a sin as maintaining a "buy" on the stock, it's certainly clear now that Prudential probably should have maintained a "sell" as Enron fell another 93 percent since the upgrade.

Some bearish calls in the biotech sector have not panned out either. Prudential downgraded Biogen (BGEN: Research, Estimates) to a "sell" in October of 2000 and reiterated the "sell" in September. Biogen's stock is up 9.3 percent since the initial "sell" call. Prudential also downgraded Sepracor (SEPR: up $0.37 to $55.40, Research, Estimates) to a "sell" on April 24. But the stock wound up gaining 37.2 percent between that day and Nov. 9, when Prudential upgraded the stock to a "hold".

Nonetheless, Hill thinks that the big market rally since Sept. 21 has left many stocks ripe for a fall, especially in the technology sector. That said, more analysts should follow the lead of Prudential. "If analysts are really going to do their job we should start seeing more sells," Hill says.

Don't hold your breath, though. "Most firms are more likely to drop coverage of a stock they don't like rather than issue a "sell" or continually have it as a "hold" as the price declines," Zacks says. He adds that Prudential should be applauded for its straightforward approach.

That approach certainly won't make Prudential analysts many friends among the CEOs of the companies they follow. But it just might save the average investor lots of money.