(Still) Pity the Poor Little Guy

Wall Street's research deal will ease egregious conflicts, but small investors remain far from protected

Harvey Silver doesn't trust research analysts. Just before the bull market came to a screeching halt in 2000, the 70-year-old retired health-food distributor in Forest Hills, N.Y., started to triple-check every recommendation they make. He pores over 15 financial publications every month. He surfs the Web for independent research. Then he digs into mutual-fund reports to see whether the pros have big positions in his chosen stocks. "That's a pretty good endorsement," says Silver, whose portfolio is up 6% so far this year. "You can piggyback off the mutual funds."

More investors may soon have to do the same as Silver despite the global research settlement regulators reached with 10 investment banks on Apr. 28. Although it aims to clean up Wall Street's questionable research, the deal is no panacea. Main Street investors are staring at a future papered with skimpier reports on fewer companies as banks continue to slash their research departments or push research abroad to places such as India. Even before the settlement, Wall Street houses had cut their collective coverage back to 4,300 companies from 5,500 two years earlier, according to Thomson First Call Corp. Worse, there's a risk that in the future, research reports will be late and filled with conventional wisdom as banks try to avoid controversy at all costs.

Of course, putting an end to bankers using analysts as marketing shills is a huge plus for investors. So is the new onus on firms to disclose regularly full details of their past stock recommendations. "To the degree that information is available to investors, it will give them a way to shop for research based on its quality," says Barbara Roper, head of investor protection at Consumer Federation of America.

However, nobody has yet figured out how to finance top-notch research without subsidies from banking. Dispirited investors and money managers are unlikely to pick up the slack by paying more. A few top Wall Street execs believe that eventually, their firms may have to stop issuing research altogether. Although in a minority, they question whether it's worth publishing their own reports when they have to hand out independent research to retail clients for free. They would rather have analysts join their sales teams or trade hot tips with fat-cat money managers. If that happens, the stock market will be even more rigged against the small investor than before.

For now, banks plan to churn out as much research as they can with as few people as possible. Already, some have axed 40% of their research staff since 2001, and more layoffs are on the way. While they are firing in New York, some, such as J.P. Morgan Chase (JPM ) Co., are hiring in India, where math whizzes will build valuation models for a quarter of the cost in the U.S. "I think the analyst's job will be divided into two," says Manu Bammi, chief executive of New York-based research outfit SmartAnalyst Inc. "Quantitative work will move to India, while the subjective work of the analyst will remain in the U.S."

Independent research companies are raring to go head-to-head with a weakened Wall Street. Under the settlement, the 10 banks have to pony up $430 million over the next five years to buy outside research to give to clients along with their own. Outfits such as Standard & Poor's (MHP ) -- like BusinessWeek, a division of The McGraw-Hill Companies -- hope to exploit that opportunity. S&P is hiring extra analysts to cover more companies and bulking up the five-page stock reports it aims at retail investors. It brags it now covers 1,160 U.S. stocks -- more than Merrill Lynch (MER ) & Co. or Morgan Stanley (MWD )

Similarly, Chicago-based Morningstar Inc. is widening the universe of stocks it follows. By yearend, it plans to hire 10 more analysts so it can cover 700 stocks, vs. 500 now. "The possibility of winning some of the settlement business is a factor in deciding to expand our business and grow our analyst staff," says CEO Joseph Mansueto.

Still, it's unlikely that independents can fill the yawning void on Wall Street. They look at many of the same stocks, so collectively, their coverage will stay narrower than the Street's for some time -- and small companies will get short shrift. "Smaller companies have lost proportionally more analysts than the large companies," says Charles L. "Chuck" Hill, research director at Thomson First Call. Furthermore, many companies still reserve privileged access to their top management to analysts from big Wall Street firms. Companies must treat analysts the same when releasing important news, but they don't have to give independent analysts equal access when sharing general insights.

Firms that depend more on computer models for stock ratings aren't handicapped by a lack of access. And many have made the top of rankings of stock picks at Netologic Inc.'s Investars.com, which tracks how stock recommendations fare. So the so-called quants are muscling in, too. Thomas White, president of Best Independent Research LLC in Chicago, a consortium of five firms that use both quantitative and fundamental research, has been redesigning his reports. Once, they were destined mainly for big institutions such as pension funds; now, he's making them more appealing to individuals. "This has been a large front-end expenditure for us before we even see a dime of revenues from the settlement," he says.

Some boutiques populated by former big-firm analysts may also provide research to their erstwhile employers. In February, ex-Merrill natural gas analyst Donato J. Eassey formed his own firm, Royalist Independent Equity Research Ltd. in Houston, which gives money managers access to research on energy stocks for an annual fee of $130. Eassey is considering getting his firm's reports distributed by investment banks. "If the banks actually provide quality research reports to their clients, we've got as good a shot as anybody," he says.

Other independents are skeptical about how much scope the settlement will give them. The doubters point out that banks have bought some independent research for years and figure they will count the cost of that as part of their contribution to the $430 million pot. "I'm not sure this will be the bonanza many independent firms think it will be," says David T. Henigson, treasurer at Value Line (VALU ) Inc.

Some boutiques find they can't justify charging money managers high prices for research that millions of retail investors will get for free. Moreover, big institutions will still want to get research before anyone else sees it. "The settlement perpetuates the myth that investors can get something for nothing," says Scott Cleland, CEO of Precursor Group and head of Investorside Research Assn., a group of independent research firms.

To stifle opposition from big-money clients, some firms may give individual investors shorter, dumbed-down reports that get straight to the point. That tactic would once again put individual investors at a disadvantage. And it's a lousy way to rebuild the trust of investors like Harvey Silver.

By Emily Thornton, with Lewis Braham, in New York, and Manjeet Kripalani in Bombay

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