By David Shook
In December, 2000, Prudential Securities decided to downsize its investment-banking business, all but eliminating it. Prudential Securities, a division of Prudential Financial (PRU ), informed investors that the ties binding investment banking and equity research made analysts salespeople as much as stock-pickers.
Rival brokerage firms all but laughed at Prudential's logic, and one could perhaps argue it wasn't such a noble gesture, since its investment-banking business didn't bring in much money anyway. However, in the wake of New York Attorney General Eliot Spitzer's offensive against biased research, Prudential's moves seem prescient.
That wasn't the extent of Prudential's overhaul. A year ago, it changed its equity-rating system to a simple "buy, hold, or sell" scale. Analysts have issued sell ratings on stocks they believe are likely to drop 20% over the next year. Prudential has a sell rating on about 5% of the stocks it covers -- making it more bearish than any other major Wall Street firm.
Some consider such bearishness risky, believing companies given sell ratings would retaliate by denying analysts access to top management -- and, consequently, insight into their inner workings. BusinessWeek Online reporter David Shook spoke recently with Stephen Buell, Prudential's director of global equities research, about the changes the company made and their impact. Buell declined to discuss specific allegations and charges against other Wall Street firms.
No other firms have announced plans to drastically reduce their investment-banking business as Prudential has done. But several, including Merrill Lynch (which agreed to pay a $100 million fine related to its analysts' misleading statements) and Salomon Smith Barney, have agreed to reform their investment-banking and research.
Buell admits analysts at Prudential take pride that the company instituted its reforms nearly 18 months before Spitzer pressured Wall Street to do likewise. Edited excerpts from Shook and Buell's conversation follow:
Q: Your banking analyst, Mike Mayo, testified before Congress in March that "companies themselves and their management teams are the best source of information, and bullish and conflicted analysts may have the best access to this information." While it's true Prudential's research is objective, because you have no investment-banking ties, does placing sell ratings on stocks hinder your analysts' ability to gather information?
A:By and large, companies have come to accept that in issuing a sell rating, objective analysts are talking about the stock, not the company behind it.
The environment is changing. Not just because of Reg FD [Regulation Fair Disclosure, the Securities & Exchange Commission ruling issued last year that says all companies must issue the same material facts about their prospects to every investor at the same time], but because companies are becoming more mature about this issue, and have come to appreciate the long-term relationship with the Street in light of this controversy over biased research.
Q: Have you seen much retribution from companies?
A:With these ratings, there have been scattered examples of reduced access for some of our analysts. I won't go into specifics. But this has been the exception, not the rule. The vast majority of negative reactions we've gotten from companies have been in the short term.
Companies have gotten used to the idea a sell rating doesn't mean we dislike a company. It may mean simply that we see the stock as overvalued. The whole idea here is to [destigmatize] the sell rating.
In the old days, a sell rating meant fraud, going out of business, evil management. That's not the message anymore. For us, it means that we see the stock of a perfectly good company moving down 20% rather than up 20% over the next 12 months.
Q: So relationships aren't destroyed by a sell rating?
A:No. The climate is changing. And the...reaction we've seen is the acknowledgement by companies of the valid role of the independent analyst.
Q: Prudential analysts no longer have to spend time creating business for a sister unit that handles investment banking. Has this made it easier for analysts to do an objective job?
A:This is one point not to be missed. The independence from banking [frees up] our analysts' time as well. That's the most important practical development of all this. Analysts whose sectors are actively banked [by an investment-banking arm of the same company] are often spending 30% to 50% of their time coming up with banking ideas, rather than investment research ideas.
Q: Why is it so important for companies to afford analysts face time? Shouldn't analysts be able to conduct sound, objective research by simply using the disclosure documents, quarterly conference calls, and other tools and information available to all investors from companies?
A:I spent my first 15 years in this business as a drug-industry analyst, and while I acknowledge that much of the value-added information can be obtained from external sources, the analyst must first develop a foundation in researching a stock.
Where do you start before adding value from external sources? You start with the company. What you get from face time with management is the differences in insight and nuances in character -- all the things that you cannot learn from reading the annual report. There is a mile of difference between what you can read and what you can get out of talking with management in person.
Q: You said Reg FD doesn't make it a completely level playing field -- that companies still have lunch and play golf with some analysts but not others. Why doesn't Reg FD prevent this?
A:The onus is on the companies to ensure that they don't disseminate material facts to certain investors and not to others. But there's a big difference between fact and musing.
If I'm talking to a drug-company manager about what he thinks over the next 10 years will be the hottest therapeutic category, he's not stating facts to certain investors. He's telling you his opinion. That's valuable. With that kind of information, the analyst can walk away with a much more informed opinion for investors.
Q: With easy-to-understand equity ratings and very little investment banking, how's business? Is Prudential Securities making money?
A:I can't comment on that. Pru Financial is publicly held, and the performance of Pru Securities is not broken out in the financials. But it's been 18 months. And no, this isn't an experiment. These changes are here to stay.
Shook is a reporter for BusinessWeek Online in New York
Edited by Patricia O'Connell