Wednesday, January 2, 2008

Wall Street Analysts Avoid the “B” word

If you were off drinking egg nog martinis in Saint-Tropez in late December, you may have missed “Settling for ‘Hold’” - a very informative piece of commentary from Bloomberg’s David Wilson. (click here for full story.)

Wilson first relies on Bloomberg’s own database of research to present his case. Most notably, he points out:

  • Just 43 percent of the calls made [in December were] buy ratings or equivalents, including ``overweight,'' ``outperform'' and ``accumulate,'' according to data compiled by Bloomberg. The percentage is the lowest since these numbers were first tallied a decade ago.

  • Sell ratings and comparable calls have amounted to 5.7 percent. That's less than half the peak reached in July 2003, when brokerage firms were reeling from then-New York Attorney General Eliot Spitzer's investigation of Wall Street research.

  • Analysts are retreating into the relative safety of ``hold'' recommendations, telling investors who own shares to keep them and those who don't to avoid buying them. The number of ratings in this category surpassed 50 percent for the first time in October and rose to 52 percent this month.

Wilson goes on to make an important point. He says, “Analysts' growing reluctance to say ``buy'' on companies, including securities firms, is understandable. U.S. stocks more than doubled, as measured by the Standard & Poor's 500 Index, in the five years ended Oct. 9. They have since gone through a so - called correction, or a more than 10 percent loss.”

We agree that collectively, it is understandable that analysts have been reluctant to say ‘buy’ and that the overall sentiment of the market led the ‘abundance of ‘hold’ calls. However, we also think that the reluctance of analysts to seek out new ‘buys’ sheds light on the fundamental problems inherent in the Wall Street research model.

When analysts are siloed off to exclusively cover specific companies, they are pigeon-holed into making some sort of call on those names, rather than seeking out new names that are more primed for investment. If the sector the analyst covers doesn’t do well, their position may become obsolete within their firm. This is precisely the problem – an analyst who is on the front lines is most qualified to see trouble in the sector or company he covers. He should be rewarded for identifying coming problems and threats - not punished by his firm, or stonewalled by a company he downgrades. The model is inherently flawed.

We’re not suggesting we have the solution for fixing the way research is handled, but we do believe that the industry is long overdue for an overhaul. The current model is not scalable, and does not lend itself to improving the quality of research.

A Ray of Hope

One encouraging sign reflected in Wilson’s story was uncovered in research conducted by Greenwich Associates:

Stock recommendations dropped to 8 percent of commissions from 18 percent during the period, the Greenwich, Connecticut-based research and consulting firm found.

This finding suggests that good information and new insights and ideas – not straight stock recommendations - are gaining ground as the benchmark for quality research. This is not particularly helpful to research desks at large brokerage firms, where stock recommendations will continue to govern coverage until ‘the powers that be’ come to their senses – but for independent analysts and research firms, like StreetBrains, this shift can be capitalized upon immediately by increasing the information channel, and scaling back on stock recommendations.

In our experience, PMs are plenty qualified to pick stocks, and don’t really need many recommendations from outside sources. What they do appreciate are new insights and valuable information upon which to base those picks.