Commentary: The Myth of Independence

Unbiased research? It's more elusive than you think

To say that Laura Weil, the chief financial officer of American Eagle Outfitters Inc., was apoplectic early last year is an understatement. She had just reviewed a report on her company from an independent stock research firm, the Center for Financial Research & Analysis (CFRA), which usually gets high marks for its work. She found no less than 10 factual errors, some serious. The report wrongly gave earnings and revenue numbers in billions rather than millions. It had the wrong dates for American Eagle's fiscal year. And it reported higher debt than the company actually owed. What's more, the report said that many easily found numbers from 10Q reports filed with the Securities & Exchange Commission as well as the company's annual report were "not available." Says Weil: "It was like they had a high school kid doing the report."

Weil complained and CFRA, which is run by Howard M. Schilit, a respected accounting expert, ultimately corrected much of the report. It may have been a one-time event for CFRA. But, Schilit says, "It's never an excuse when something's not 100% correct, but there can be human error in anything." He notes that the analyst didn't usually cover retail and that he, along with his supervisor, "are no longer with CFRA."

Regulators and investors are making an enormous bet that independent research -- supposedly untainted because it has no links to investment banking -- is the cure-all for a conflict-of-interest-riddled Wall Street. But it's not. Independent research, too, can have problems and conflicts of its own. Shoddiness is just one of them. Independent analysts' pay is sometimes linked to the amount of trading commissions they generate for their firms, much in the same way Wall Street analysts' compensation often depended on how much banking business they brought in. And with new research shops hanging out shingles every day, there are questions about their lack of track record and expertise.

For at least the next five years, independent research will loom large on Wall Street. During that period, 10 big investment banks, including Merrill Lynch & Co. and Salomon Smith Barney (C ), must shell out around $430 million among them to buy the stuff as part of their April settlement with New York Attorney General Eliot Spitzer and the SEC over tainted research. They must make the outside research available to clients along with their own. Independent consultants will decide which researchers to employ.

The instinct behind the settlement was sound. Good independent stock research can add value to stockpicking. Value Line, Morningstar, and Standard & Poor's (MHP ) (like BusinessWeek, part of The McGraw-Hill Companies) (MHP ), among others, are widely recognized for their probity, accuracy, and credibility. Other reputable outfits are jumping on the gravy train. Both Thomson Financial and Reuters Group, which now owns Multex Inc., an earnings researcher that offers indie analysis, recently announced they would sell stock research.

But all is not what it seems throughout the world of independents. Some of the biggest indies are not quite as unattached as they might appear. Even the respected Sanford C. Bernstein & Co. is owned by Alliance Capital Management, which runs numerous mutual funds and institutional money. Prudential Financial Inc. (PRU ), meanwhile, which exited investment banking late in 2000, is also a big mutual-fund player. Newer outfits can also face potential conflicts of interest, or at least be short on quality. For one thing, analysts at upstarts or small firms can be astonishingly inexperienced. Often fresh out of school, they take low-paying jobs at small independent firms to learn the ropes. "That can leave to question the credibility of their research," says Charles L. Hill, Thomson First Call's director of research.

Often, the more trading commissions indie analysts generate for their firms' broker/dealer arms, the more bacon they bring home. Soleil Securities Corp., an independent research firm started late last year by Wit Capital founder and dot-com entrepreneur Andy Klein, is basing analysts' compensation on how much trading volume and commissions they generate. Critics say this type of model potentially encourages analysts to make overly bold statements about a company, or report unsubstantiated rumors, to gin up business.

What's more, analysts who aim their research primarily at traders are still apt to issue more "buys" than "sells." That's because only those who already own the stock -- a limited audience -- will be apt to sell, while there's a far bigger universe of potential buyers. And buys outnumber shares sold short even in this choppy market, by more than 30 to 1 on average. An Aug. 6 study for BusinessWeek by Thomson/First Call, the earnings research firm, shows that most Wall Street investment banks are issuing far more "sell" ratings -- from 15% to 25% of their total ratings -- than large independent researchers -- 10% or less. Says Soleil's Klein: "There may be lots of games [analysts] could play to get a quick break here or there. But researchers are going to go out of business if they don't help their portfolio managers make money over time, and that's our goal."

Stale or recycled research can be a problem, too. Like the Wall Street investment banks that give the first call on research to big trading clients, many indie firms sell their reports to hedge funds and other institutions first. That's fine. But after the smart money has traded off the information, the report -- or at least the "buy" or "sell" recommendation -- is often then released to the public, by which time it has little value. "[The Wall Street settlement] is creating a short-term market distortion where independent researchers can profit and where investors still don't matter," says Scott C. Cleland, CEO of the Precursor Group, a Washington-based independent research firm.

Critics fear that when they pick outside researchers as part of the settlement, Wall Street investment banks will tend to favor those who are more bullish on stocks and less harsh on investment banking clients. And that's despite the "independent consultant" who's supposed to do the picking. "Their funding will be indirectly dependent on fees generated from IPOs [initial public offerings] and other stock offerings by investment banks," says James M. Sheehan, an adjunct scholar at the Competitive Enterprise Institute, a free-market think tank in Washington.

In addition to startups, existing indie firms are looking to cash in on the fast-growing market for untainted research. Steadily trying to gain market share, they are issuing more frequent reports on more companies, say critics. Schilit's CFRA is adding to the number of companies it covers, say critics. Sidoti & Co., a respected small-cap researcher, now covers 300, vs. about 100 two years ago, and says by the end of 2004, it expects to cover 600. Are they sacrificing quality for quantity? No, insists Schilit. "If anything, our ability to uncover accounting problems has improved dramatically in the past few years because of the enhanced tools and screens we use," he says.

Perhaps. But investors shouldn't be lulled into thinking that independent research is the holy grail for stockpicking. Some academics who study financial markets question whether stock research has much value at all, given the amount of information bouncing around the markets. Untainted research is obviously preferable to the flawed kind, but it's no silver bullet.

By Marcia Vickers

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