Still the Street's "Fundamental Problem"

First Call's Chuck Hill says the deal to clean up equity research still leaves analysts beholden to investment bankers

Chuck Hill is the director of research at First Call, Wall Street's main compiler of analyst projections and keeper of the closely watched -- and increasingly controversial -- "consensus earnings estimate" figures. From his perch at the Boston-based outfit, a subsidiary of Thomson Financial, Hill has watched over the Street's conflicts-of-interest scandals with the slightly detached eye, if not a fully objective one, of a veteran teacher. While somewhat world-weary, Hill remains firmly in his students' corner, rooting for research analysts to do better.

Hill doesn't think the $1.4 billion settlement unveiled by securities regulators on Apr. 28 spells an end to conflicts of interest that have tainted brokerage-house research (see BW, 5/12/03, "Will It Matter on Wall Street?"). But he's hopeful that ongoing oversight and additional regulation will work over time.

In an interview with BusinessWeek Online Associate Editor Amey Stone, Hill shares his insights on how Wall Street research has changed for the better, what individual investors should look for when reading today's research reports, and where the ongoing reforms are taking First Call's own business model. Following are edited excerpts from their conversation:

Q: Wall Street firms' abuse of individual investors was detailed in the settlement with securities regulators. Were you surprised at the extent of the abuse?


Everybody was well aware of how bad things had gotten. But the shocker was that firms were paying other firms to do research on companies they were underwriting. I don't think many of us knew that was going on, and I don't know how it was kept so quiet. For those firms to do something at such a great risk relative to the potential reward just doesn't make sense to me.

Q: Do you think we've seen the worst of the scandals?


We're not done hearing about this, and there are probably still a few more scandals out there. Research is just part and parcel of the main problem, and more regulation is needed to restore the public's confidence in American business. It will take a little more time to right the ship, but it will get righted.

Q: New requirements call for firms to tie analysts' pay to the success of their stock picks, raise dividers between investment-banking and research departments, and provide individual investors with independent research. Will this prevent future abuses?


It will help, but it won't do the whole job. The terms of the settlement, along with National Association of Securities Dealers (NASD) rules, and the Sarbanes-Oxley Act, are all part of a package of reforms that I think is working. More needs to get done, but over time, investor confidence will be restored.

Q: When it comes to conflicts in research, what still needs to be done?


What bothers me about the settlement is that it doesn't really address the fundamental problem, which is that a good chunk of analysts' pay will still be tied to investment banking. It puts out a bunch of "thou shalls" and "thou shalt nots" that will to some degree rebuild the Chinese Wall between research and investment banking -- but not to the height it should be.

You have to assume an analyst's performance will still be judged in good part by what he or she does for the investment bank. There won't be e-mails, but there's bound to be some kind of communication between research and investment banking somewhere -- conversations in the hall, perhaps.

Q: So research will still be tainted by conflicts of interest?


Let's not paint all analysts with the same brush. Some who are doing a superb job work for big investment-banking houses. But junior analysts today still have to ask themselves: How do I become a top analyst if I still have to play ball with investment banking?

Q: Of all the reforms, which one do you think is having the best results so far?


The NASD rules on research recommendations passed last Sept. 9 are a great example of how to regulate properly. It required firms to disclose in every report the percentage of its buy, hold, and sell recommendations, and what percentage of companies in each category the firm has done investment-banking deals with. Firms must also provide a three-year stock-price chart that marks where previous recommendations and price targets were made. Simply by more disclosure, not through "thou shalls" and "thou shalt not," they've given firms an incentive to do the right thing.

Q: How should individual investors interpret this new information?


If you see that only 2% of a firm's recommendations are sell and all its investment-banking business is done with companies rated buy, you're going to realize what kind of a shill [it is.]

Most firms have moved away from that, though. The firms that get it have between 15% and 35% of their recommendations as sells. Today, an average of 10.6% of all recommendations are sells, but I think that number will move up as more firms catch on.

Q: What else should individual investors keep in mind when reading Wall Street research?


The most important point to realize right now is that it's still in transition, so they better read the footnotes to find out where a firm stands. A hold in one firm may be very different than a hold in another. If 15% of the firm's recommendations are sells, than a hold probably really means hold. If only 2% are sells, than a hold probably means sell.

Q: Will investors choose to ignore Wall Street research in favor of independent research?


So far, we've found that there's no real difference between independent research and Wall Street research when it comes to the quality of recommendations or earnings targets. Clearly, there was a problem with the recommendations being skewed so heavily to the optimistic side -- and much confusion about terminology. But the independent firms mostly played along with the terminology set by the brokerage firms and also issued very few sell ratings.

Q: What do you make of all the independent firms popping up, hoping to supply the independent research demanded by the settlement?


The settlement puts a pot of gold out there that some people are going to go after. What worries me is that if you're a really good analyst, the bucks will still be better if you sell your research directly only to the top institutions rather than allow it to be distributed for free to retail investors. I'm afraid that a lot of fly-by-night stuff is going to be distributed to individuals.

Q: How will First Call handle an influx of shoddy research firms? Don't you already reject outliers from your consensus estimates?


We would never throw anyone out for being an outlier! What we do is exclude estimates if they aren't done on the same basis as most of the other analysts [for example, if one analyst includes a real-estate sale in operating profits, while most of the others exclude it as a one-time gain].

However, in terms of independent research boutiques, we have kicked out some -- if we find out it isn't doing good fundamental research. Often firms spring up that are trying to manipulate stocks. We need to maintain some selectivity.

Q: Given all the conflicts revealed at Wall Street firms, is the consensus of analyst estimates as relevant as it once was?


The consensus estimate remains just as relevant. And our clients still want that number.

Q: Some industry observers have been very vocal recently about criticizing the quarterly consensus numbers, arguing that they emphasize short-term results and don't accurately reflect the range of opinions on stocks.


Some critics have said we should provide a range of analyst estimates, which we do. That being said, is the market still overreacting when some companies miss estimates? Sure. Is there too much emphasis on the short term? Yes. But should the consensus estimate be ignored? No.

The question investors need to ask is why a company failed to meet the consensus number: Was it a temporary thing, or is it an indication that something is starting to change for the company longer term?

Q: So the conflicts of interest in research haven't hurt First Call's business?


Well, we've lost some clients that no longer exist. Some may have cut back on getting all the bells and whistles. But it remains necessary for any institutional investor to have a basic First Call service or the equivalent.

There may actually be new opportunity for research firms like First Call to take a closer look at what the analysts are doing -- to identify the good analysts and see what they're saying and supply this in some form to retail investors. The SEC has indicated that would qualify as independent research under its new program. You may see firms like ours provide some of that kind of research.

Edited by Patricia O'Connell

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