By Gary Weiss
Brokerage firms have a serious problem: No matter how much they might finesse it, a large and vital portion of their business is tied to the level of public enthusiasm (or, nowadays, lack thereof) for buying stocks. So it's easy to dismiss Charles Schwab Corp.'s (SCH ) new Equity Ratings as a marketing ploy that capitalizes on the analyst woes plaguing its competitors. Every week, Schwab will issue grades to more than 3,000 stocks, with the top 60 heralded for customers on the Schwab Web site. The stockpicking will be done by computer, without the fouling human touch. Or as Schwab puts it, "free from investment-banking and commissioned-based sales conflicts."
Translation: Wall Street research has lost whatever credibility it may have once possessed, and here comes Schwab to the rescue--of its own flagging revenue stream. Well, such cynicism is justified, but only up to a point.
Sure, there's a heavy, if not dominant, marketing component to the Schwab Equity Ratings, which were announced on May 16 and have a starring role in Schwab's new advertising campaign. Grading stocks is not new--Value Line Inc. (VALU ) has done it for years--and brokerages have their own overenthusiastic, buy-hold-never-sell stock-rating systems. Schwab is cleverly playing off public dissatisfaction with Wall Street research. And by doing so, the firm is engaging in a classic soft sell--gently prodding its customers off their duffs to buy stocks. "The lists are intended to provoke thinking--just to get our clients thinking," says Jerry Chafkin, a Schwab executive vice-president in charge of the new ratings.
At a time when investors have ample reason to think about anything but buying stocks, that's a smart strategy. It's also a reasonable enough investment tool. The general idea--objective, computer-driven research--certainly makes sense. If Wall Street research is not to be trusted, how else does an investor pick stocks? Advocates of efficient market theory believe a throw of a dart is as good a method as any. They may be right. But other market mavens, notably author and former Fidelity Magellan fund manager Peter Lynch, believe that investors should focus on stocks they know, and do their own research.
The Schwab rating system is a kind of middle ground. It offers customers an old-fashioned stock-screening mechanism, as do many other firms and Web sites. But such screens are a perilous method of stockpicking if the criteria are not properly selected. So Schwab is taking the idea a step further by doing a weekly screen for its customers, using 24 criteria involving mainly fundamental factors such as earnings and cash flow, plus analyses of analyst upgrades and downgrades. Chafkin says the aim of the ratings is to give investors a tool to use if they decide to alter their portfolios, not to encourage them to buy stocks. And, he says, the list is not expected to change dramatically from week to week. He also warns against using the screens to cherry-pick stocks.
Schwab's rating system is a refreshing counterpoint to the hype that is routinely generated by Wall Street houses. The list criteria were designed by quantitative analysts who came on board from Chicago Investment Analytics, which Schwab acquired in November, 2000. Under the supervision of Chicago Investment co-founder Greg Forsythe, now Schwab's director of equity research, the computer will cull weekly through a list of nearly every stock with over $75 million in market value that isn't a real estate investment trust or a limited partnership.
The top 10% will be rated A and the bottom 10% will be rated F. The biggest category of stocks--40% of the lot--will always be rated C. Forsythe won't discuss the results of backtesting the new system because of regulatory constraints. But he says a model portfolio of 100 stocks, using the same basic approach as the ratings system, beat the market by 4.6 percentage points in 2001 and 6 points in the first quarter of 2002.
The top stocks on the list are diverse. The latest A-listers include such widely held companies as Anheuser-Busch (BUD ), Kellogg (K ), and Mattel (MAT ), as well as less well-known names such as Commercial Metals (CMC ), Sanderson Farms (SAFM ), and Walter Industries (WLT ).
But the system sneers at some widely held stocks, including a few that have lately generated a lot of Street interest. General Motors Corp. (GM ), up 34% this year in a bad market, gets a C rating (great momentum, mediocre fundamentals and valuation). Is bedraggled IBM (IBM ) a buy? So say three-quarters of analysts covering the stock. But its momentum is cruddy, says the Schwab ratings, so it gets a C. Ditto for AOL Time Warner (AOL ), while Citigroup (C ) draws a B, and Merrill Lynch, Schwab's beleaguered rival, gets a C.
And Schwab? Well, the firm, of course, does not rate its own stock. But its stockpicking system will only get an A from Schwab's shareholders if clients are roused from their stupor--and start generating commissions.
Senior Writer Weiss covers the Street.