Is Wall Street Out to Get You?

• Email
• Share
• Print

In 2003, 10 top investment banking firms coughed up a collective $1.4 billion in penalties for fraudulent stock research.

They were also publicly reprimanded for issuing research reports from mid-1999 on that were either fraudulent or made unwarranted or exaggerated claims with no evidence to back them up, and for inappropriate spinning of hot IPOs.

The Wall Street firms thus honored were:

• Bear Stearns (NYSE: BSC)
• Credit Suisse First Boston
• Goldman Sachs (NYSE: GS)
• Lehman Brothers
• JPMorgan (NYSE: JPM)
• Merrill Lynch (NYSE: MER)
• Morgan Stanley
• Citigroup Global Markets, f.k.a. Salomon Smith Barney (NYSE: C)
• UBS Warburg
• U.S. Bancorp Piper Jaffray (NYSE: USB)

This was a joint enforcement action by federal and state regulators and industry groups, including the SEC, New York's attorney general, and the National Association of Securities Dealers (NASD). The culprits were required to:

• Separate the stock analysis and investment banking sections of their firms.
• Provide at least three independent research reports at no cost to their clients on each stock covered.
• Publish their analysts' historical ratings and price target forecasts.

If you don't know who the patsy is, it's you
According to a recent study jointly done by Harvard Business School and UC Berkeley and published in the Journal of Financial Economics, small investors were the most vulnerable to biased analyst recommendations from 1993 to December, 2003. The authors concluded that small investors trust analysts too much and are naive about the potential conflicts of interest that exist within Wall Street firms.

Large institutional investors, in contrast, take analysts' "buy" recommendations with a large pinch of salt, and often treat "hold" recommendations as a signal to sell. They discount what analysts say, especially if those analysts are affiliated with investment bankers.

As a result, the study found that small investors' returns were significantly lower than those of large investors over periods of six to 12 months.

Without naming names, the study also reports that up to 95% of analyst recommendations were positive or neutral. Not surprisingly, it finds that independent analysts with no investment banking affiliations are more willing to issue "sell" or "strong sell" recommendations.

Have they improved since then?
Barron's has updated this study using nearly 2,600 sell-side analyst recommendations over the past four months for the 30 Dow Jones component stocks. Positive-to-neutral recommendations represented 96.1% of the total -- confirming the study. Similarly, for 39 IPOs valued at or above $500 million since 2003, 94% of the recommendations were either neutral or positive.

Unfortunately for the small investor, the Barron's update indicates that nothing has really changed since the SEC acted against top Wall Street firms four years ago.

Yes, they now provide independent research to clients, publish their ratings track records, and claim to have de-linked stock analysis from investment banking. But that's because they have to. There's nothing forcing them to stop issuing predominantly positive ratings, particularly for their investment-banking clients.

What should you, the small investor, do?
First: Stop trusting analysts without at least triple-checking their views against the third-party research they are required to provide for free.

No matter how successful or reputable the analyst, his recommendation should be just one data point in your total evaluation of a stock's prospects. In using any analyst recommendation, insist on:

• A Regulation FD (for "fair disclosure") of his ownership or position in that stock.
• Knowing the firm's investment banking or other financial links with the company.
• Understanding how the analyst's compensation is linked to investment banking.
• Knowing whether his firm trades in that stock.

Also check the firm's ratings distribution -- it is obliged to provide you with this information.

Second: Use ratings that are clearly independent, such as those from Charles Schwab (Nasdaq: SCHW) or Morningstar. Schwab's purely quantitative equity ratings system uses a set of four grades -- fundamental, valuation, momentum, and risk -- to assess nearly 3,000 stocks. The grades range from A to F and are set up so that no more than 70% will receive A, B, or C ratings.

Similarly, Morningstar uses its Star ratings system on more than 1,900 companies to signal whether its analyst thinks a stock's risk level, width of moat, and price compared to fair value make it a 5 Star (buy) or a 1 Star (sell). It also provides a fair-value estimate for each stock, along with buy-below and sell-above limits. Currently, of the stocks that get Morningstar ratings, 85% get three stars or higher.

As a small investor, you always have to watch out for your own interests. Luckily, you have the tools you need to do so.

Related Foolishness:

• Invest Like a Pro
• Lehman Dodges a Bullet
• Can the Super SIV Save the Day?
• Banking Lessons Learned