Schwab: Breaking the Code of Silence

Brokerage Giant Charles Schwab (SCH ) studiously avoided giving clients its own advice on individual stocks for its first 28 years. For the past six months, Schwab has been doing just that, every week, via report cards on over 3,400 stocks. If you hold one of Schwab's 8 million accounts, or if you're thinking of opening one, you've got to wonder: Are Schwab's stock grades worth following more than the Wall Street "research" that has turned 2002 into the Year of the Deadbeat Stock Analyst?

We should see soon enough. Jerry Chafkin, Schwab's man in charge of investment advice, told me the firm is busily creating a Web site to publicize continuously how well or poorly the Schwab Equity Ratings pan out. The site is due to appear by May at the latest, when the ratings scheme marks its first anniversary, and perhaps sooner. "We're willing to be held accountable for our research," Chafkin said.

This would seem a small step for humanity, except such open performance reporting of brokerage-firm advice is hard to come by on Wall Street, even if you have subpoena power. "It was surprisingly difficult for us to gather the data necessary to objectively measure analyst performance," New York State Attorney General Eliot Spitzer told a group of analysts at a Nov. 12 dinner. "After spending hundreds of hours listening to investment banks and their lawyers lecture about the efficiency of the marketplace, I'm still disappointed to learn that they withhold" data the market needs.

Schwab's method of rating stocks was developed by Chicago Investment Analytics, or CIA, a quantitative research boutique it bought in 2000. Each weekend, CIA crunches 24 data items for each stock, from the strength of a company's free cash flow to sentiment among short-sellers. CIA then ranks the stocks on probable performance over the coming year. By Monday morning, it assigns grades: The top 10% get As, the next 20% get Bs, the middle 40% Cs, the next 20% Ds, and the lowest 10% are Fs.

Naturally, there's nothing infallible about all this. While Schwab isn't disclosing the model's exact makeup, it resembles in varying degrees many others, most notably StockScouter, which is available for free at Microsoft's MSN. On any given stock, different systems will give you various readings. For ExxonMobil (XOM ), for instance, I found Schwab gave it a C and StockScouter a middling 6 out of 10. But Value Line Investment Survey gave ExxonMobil its second-lowest score, while Standard & Poor's (part of The McGraw-Hill Companies, as is BusinessWeek) gave it five stars, tops in its qualitative STARS system.

Schwab still makes such contradictory advice from S&P and others available to clients. Yet it is highlighting its own ratings, and the firm also is running two mutual funds, Schwab Core Equity and Schwab Hedged Equity, based on them. The latter fund not only buys high-rated stocks but also sells short the low-rated ones. The strategies have been in place only a few months, so it's too soon to judge them. As for the rating system overall, Schwab so far is saying only that in the first six months the market returns of its A stocks are ahead of Bs, Bs beat Cs, and so on. Yet once the firm begins posting the performance of its ratings on the Web, the stark question will be: Which other brokers will dare to account openly for their picks and pans?

By Robert Barker

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