What’s Wrong With Spitzer’s Solution to Analyst Bias?Published: November 06, 2002 in Knowledge@Wharton
New York Attorney General Eliot Spitzer, the Securities and Exchange Commission and about a dozen of the largest Wall Street firms are close to settling on a billion dollar solution to the controversy over analyst bias that has raged since the dot-com meltdown two years ago.
But will the settlement really resolve the conflicts of interest that caused some analysts to tout stocks they knew were no good? Is there a better approach that would solve the dilemma of how to pay for research? And, for that matter, is there still an analyst-conflict problem, or have publicity and other recent regulatory remedies already done enough?
Experts on the financial markets disagree over how bad the analyst problem is today. But few find much good to say about the Spitzer approach.
While details of that approach have not been disclosed, its outlines are clear from numerous reports citing people involved in the talks: Together, the big firms would contribute $200 million in each of the next five years to a fund that would pay for securities research by independent analysts. The firms would distribute the independent research to investors alongside the work of the firms’ in-house analysts, who could continue to be financed by investment banking operations.
“It seems sort of bizarre,” says Wharton finance professor Andrew Metrick. “The government is … forcing a specific organizational structure on research, and it’s not clear that this is necessary, yet.” Adds Wharton finance professor Jeremy Siegel: “You want to know the truth? There’s too much research coming out of Wall Street. I don’t think we want to subsidize it.”
Under Spitzer’s plan, what the big firms would get in return is protection against liabilities and penalties they might otherwise face from regulators. In addition, they could be protected from civil suits brought by investors who felt they had been defrauded when biased research recommendations led them to buy questionable stocks.
That may not turn out to be a very valuable tradeoff, according to Wharton finance professor Marshall E. Blume. It will shelter firms from liability without producing anything of real value to investors, he argues. Since there’s no evidence that analysts’ reports can help investors beat the returns they can get with simple index funds, they have no real need for analysts’ reports. “It looks like a billion-dollar drain.”
“I don’t think there was much of a problem,” Blume added. “It’s clear that we had an Internet bubble, where people tried to get rich quick. And there were people in the public domain who were recommending these dot-coms. But I’m not sure it was the research reports that did it. I’m sure some people bought the dot-coms because their neighbor bought the dot-coms the week before and made some money.”
Siegel points out that given the negative publicity analysts have received over the past two years, investor demand for unbiased research may automatically lead to better solutions. Investors might decide they are willing to pay for independent research, and Wall Street firms may see value in finding their own ways to remedy perceived biases. Indeed, Citigroup has announced plans to split off its Salomon Smith Barney brokerage, severing the link between the investment bankers and analysts.
That long-standing connection has been at the heart of the controversy. Currently, it is widely thought that individual investors will not pay for the analysts’ reports they receive from full service brokerages. Most Wall Street analysis, therefore, is funded by investment banking operations, which use the research reports to help market new securities issues for client companies.
In addition, some research is provided on a fee or subscription basis by firms that specialize in research and do not have investment banking operations. Many mainstream Wall Street firms also provide professional money managers with research in a “soft dollar” arrangement – in exchange for fees earned conducting the managers’ securities trades.
The Spitzer approach appears to recognize that there may be no practical alternative to using investment banking revenue to subsidize research. Critics of that model say analysts are hesitant to criticize stocks of companies that are investment banking clients, or could be. Academic research has shown that analysts are less accurate in forecasting performance of investment banking clients than non-clients.
The most severe criticisms of the Spitzer settlement come from those who complain it fails to deal with this conflict. “It’s a severe trust problem,” says Scott C. Cleland, chairman of Investorside, a 14-member association of independent research companies, and CEO of The Precursor Group, a boutique research company in Washington, D.C. “Because 95% of investment research today is funded by investment banking businesses, less than 5% of investment research is financially aligned with investor interests.”
The Spitzer approach leaves conflict in place and fails to address what will happen after the five years are up, Cleland adds, suggesting that regulators would get better results by eliminating the barriers that make it difficult for independent analysts to operate. Independent firms like Precursor serve mutual fund and pension fund managers. In order to charge fees to these clients, these firms must be registered as broker-dealers, and to get that they must receive regulatory approval to serve as investment bankers, even if they do not engage in investment banking. The expense of doing this makes it hard to start new independent-analysis firms.
Cleland estimates there are several dozen independent analysis firms as well as several hundred one- and two-person shops. He declined to discuss fees, but industry observers say independent analysis firms typically charge institutional clients thousands of dollars a month.
Individual investors can get analysts reports from several independent research firms. Valueline.com charges about $600 per year, Morningstar.com about $100 per year, and MultexInvestor.com about $10 to $300 per report for analysis by mainstream Wall Street firms. Typically, though, analysis from such services is not as extensive as that which is funded by the standard investment banking model.
Individuals who use full-service brokers often have access to the firm’s analyst reports. Under the Spitzer proposal, brokers will still be free to use those investment banking-funded reports to urge small investors to buy or sell. But Spitzer believes that supplying the independent analysis alongside the in-house product should curb bias.
Most of the criticism of the investment banking approach centered on the imbalance between analysts’ “buy” and “sell” recommendations. At the height of the dot-com bubble in the late 1990s, buy recommendations outnumbered sell recommendations by 100 to 1. Later, internal e-mails unearthed by Spitzer showed that Merrill Lynch analysts acknowledged that some stocks they were urging investors to buy were no good.
More recently, though, the buy-sell recommendations have been about even. Obviously, that’s partly because many stocks are less attractive in a bear market. Also, many analysts may have changed their ways under scrutiny from regulators, investors and the press.
Kent L. Womack, finance professor at Dartmouth’s Tuck School of Business, says the buy-sell disparity was never as serious as many made it out to be. Professional investors – the primary market for analysts’ reports – have long known they needed to consider the element of salesmanship in these recommendations. Just as consumers know to be somewhat skeptical of the commercials they see on television, so do professional investors know how to “de-bias” information they receive from analysts, he notes.
While small investors may not be as adept at de-biasing, they have a viable alternative – to buy stocks through mutual funds managed by people who can see through analysts’ puffery. Fund companies also employ their own analysts.
Womack says his research has shown that analyst bias is most severe in reports on initial public offerings, which, by their very nature, cover new companies about which most investors know little. Analysts’ recommendations on established companies tend to be much better, he points out, largely because biased reports stand out when there are more analysts watching.
While analysts may be overoptimistic in forecasting future stock prices and urging that investors buy, they are much better at forecasting earnings. Hence, the reader who ignores the buy-sell recommendation and focuses on the earnings estimate and discussion of the company can get real value from an analyst’s report, even if it is funded by an investment banking unit, Womack says. Indeed, he adds, surveys show that money managers are much more interested in an analyst’s knowledge of the industry he or she covers than they are in the buy-sell recommendation.
Rules put in place earlier this year may do much to remedy any bias problem, making the Spitzer approach unnecessary, Womack adds. Last May, for example, the SEC approved new analysts’ rules proposed by the National Association of Securities Dealers and the New York Stock Exchange.
The rules prohibit analysts from offering investment banking clients favorable research in exchange for the business. They also impose “quiet periods” during which analysts are barred from issuing reports on investment banking clients engaged in initial public offerings and secondary offerings.
In addition, the rules prohibit investment banking units from supervising analysts and restrict communications between investment bankers and analysts. And they prohibit firms from tying analysts’ compensation to specific investment banking transactions and require that firms publicly disclose business relationships with companies covered by analysts’ reports.
“Give it some time,” Womack says. “I’m sure more than half of the problem is already solved just by getting so much attention and the increased disclosure. Why upset the apple cart completely before you’ve had a chance to see if what you’ve already done has done the trick?”