Dec. 3 -- Anybody who followed the advice of Wall Street's top-ranked analysts, none of whom would say ``sell'' for a single company in the securities industry this year, is reckoning with subprime-like losses.
Merrill Lynch & Co.'s Guy Moszkowski, UBS AG's Glenn Schorr and Sanford C. Bernstein & Co.'s Brad Hintz maintained either buy or hold recommendations on Bear Stearns Cos. as it fell 39 percent in 2007, the most since the firm went public in 1985. Moszkowski and Hintz had buy ratings on Morgan Stanley while the stock shed 22 percent in New York trading. Moszkowski and Schorr advised holding on to Citigroup Inc. as it dropped 40 percent.
Shrinking fees from brokerage commissions mean fewer dollars for research and more pressure on analysts to hang on to paying customers such as hedge funds. While clients care little for ratings, they covet meetings with company executives -- audiences that favored analysts can deliver. As a result, ``sell'' ratings on Wall Street are even scarcer than four years ago, when 10 securities firms paid $1.4 billion to settle allegations by then-New York Attorney General Eliot Spitzer that they used research to improperly promote stocks.
``An analyst cannot issue a sell rating because he doesn't want to lose access,'' said Tom Larsen, a former Credit Suisse Group analyst who now runs research and helps oversee $6 billion at Somerville, New Jersey-based Harding Loevner Management LP. ``It's logistically cumbersome for the buy-side to arrange its own meetings with company management, so this concierge service is very useful.''
Research Fees
Analysts rarely said ``sell'' before the Spitzer settlement because they didn't want to jeopardize investment banking fees. Now, they're more concerned about maintaining good relations with company management. Only 7 percent of analysts' recommendations have been sell this year, down from 11 percent in 2003, data compiled by Bloomberg show.
Institutional investors are willing to spend more for meetings than ratings, according to a survey of money managers by Greenwich Associates, the industry consulting firm founded 35 years ago in Greenwich, Connecticut.
Investors surveyed said they allocated 19 percent of their commission dollars to pay for ``direct access to company management,'' up from 14 percent in 2003. Stock recommendations merited only 8 percent of commissions, down from 18 percent.
Money managers paid brokerage firms $10.3 billion this year to trade stocks, down from $13.4 billion in 2002, even as trading increased, according to Greenwich Associates. About 40 percent of those fees go to pay for research services, including conferences and trips that allow investors to meet corporate executives.
Analyst Disclosures
Investors ``place a pretty high premium on brokers that can do a good job coordinating access to the companies' CEOs, CFOs, treasurers,'' said John Feng, a principal at Greenwich Associates.
Hintz, 57, the third-ranked brokerage-industry analyst according to Institutional Investor magazine, said in an e-mail that his ratings aren't intended as trading advice and aren't influenced by any desire to mingle with company managers. Ratings from New York-based Sanford Bernstein indicate how an analyst expects a stock to perform relative to a market index in the year ahead, according to disclosures in the firm's research reports.
``We are not supposed to make trading calls,'' Hintz said. ``Just because a brokerage stock goes down over a short period doesn't mean it's an underperform.''
Moszkowski, 50, and Schorr, 40, declined to comment. Moszkowski is the top-rated analyst in the Institutional Investor survey, followed by Schorr. UBS spokesman Douglas Morris said the rationale for the ratings are included in the research notes, which ``speak for themselves.''
The `Hold' Ratio
Sell ratings should be less common than buy ratings because the equity market tends to rise over time, said Stefano Natella, who runs research at Zurich-based Credit Suisse Group, Switzerland's second-biggest bank. And research departments are more likely to choose to cover companies that are successful than to spend money analyzing businesses with dim prospects, according to Larsen of Harding Loevner.
Instead of saying ``sell,'' analysts have stuck with ``hold'' ratings that are less likely to antagonize the senior executives they're monitoring, Larsen said. The ratio of hold recommendations has climbed to 48 percent this year from 40 percent in 2003, Bloomberg data show.
While a ``hold'' might be enough to signal to institutional investors that a company is in decline, retail investors follow analyst recommendations literally, according to a study published in the Journal of Financial Economics in August.
`Tacit Understanding'
Authors Ulrike Malmendier, an economics professor at the University of California at Berkeley, and Devin Shanthikumar, an accounting professor at Harvard Business School in Boston, analyzed trading data from U.S. exchanges between 1994 and 2001. They concluded that institutional investors sell stocks downgraded to hold, while small investors react to buys and sells, but not holds.
``Companies can live with a hold recommendation,'' said Larsen of Harding Loevner. ``The tacit understanding by everyone, except possibly the retail investor, is that it's a less-harsh way to say sell.''
Traders who take analysts' ratings at face value are often the victims of bigger players, such as hedge funds, which know to discount the research reports, said Henry Blodget, a former Internet analyst at Merrill, the biggest U.S. brokerage, who was banned from the securities industry following Spitzer's investigation.
Little League
``The only type of investor who should ever consider buying an individual stock is a sophisticated investor,'' said Blodget, who's now head of Silicon Alley Insider Inc., a Web-based technology industry newsletter, and author of ``The Wall Street Self-Defense Manual: A Consumer's Guide to Intelligent Investing.'' ``A little league team is always going to get destroyed by the Yankees, it doesn't matter what field they play on, and that is exactly what happens when individuals try to compete with hedge funds.''
Research analysts were unreliable guides during the collapse of the subprime mortgage market. They failed to foresee about $66 billion of writedowns that led to the unprecedented departures of CEOs from Zurich-based UBS and New York-based Merrill and Citigroup in less than six months.
Merrill's Moszkowski and Sanford Bernstein's Hintz maintained buy recommendations on Morgan Stanley, the second- biggest U.S. securities firm by market value after Goldman Sachs Group Inc., while the stock fell 30 percent from its high in June. Schorr has had a hold rating since 2005, missing out on last year's 44 percent advance and this year's drop.
Hintz and Schorr downgraded Merrill to hold on Oct. 25, a day after the firm announced a $2.24 billion loss. By that point, the stock had lost 32 percent. Moszkowski doesn't rate his company.
`Big Call'
Schorr has kept his ``buy'' on Lehman Brothers Holdings Inc. as the stock declined 20 percent this year. Moszkowski downgraded Lehman to hold on Aug. 28 after it had dropped 26 percent; the stock has gained 15 percent since then. Hintz has had a hold on Lehman, the fourth-largest U.S. securities firm, since May 2006.
Hedge fund manager Colby Harlow, who oversees more than $100 million at Dallas-based Harlow Capital Management LLC, said he only uses Wall Street research reports as a way of gathering data on the firms he tracks and never follows the recommendations.
``These guys don't want to get out in front of the crowd and make a big call because if they're wrong they're out of a job,'' Harlow said. ``I don't use sell-side research because I want to have some kind of edge.''
Regulation FD
During the Internet boom, top-ranked Wall Street analysts were known for having exclusive access to industry executives. Jack Grubman, Institutional Investor magazine's top-ranked telecommunications analyst in the late 1990s, boasted that he was close to the management of the companies he covered, according to the 2006 book by Dan Reingold, ``Confessions of a Wall Street Analyst.''
The U.S. Securities and Exchange Commission passed Regulation FD in 2000 to curb the practice of selective disclosure of ``material information.'' While the rule curtailed the relationships Grubman advertised, company executives can still reveal useful tidbits to investors without running afoul of the law.
``Management can still give color that will help the investor understand what's going on,'' said Richard Lindsey, a former executive at Bear Stearns, the No. 5 U.S. securities firm, who now advises hedge funds and institutional investors at New York-based Calcott Group LLC. ``That's why the conferences and one-on-one meetings analysts arrange are so valuable to this day. Even when executives don't answer your question, what they don't answer tells you something.''
Slamming Doors
Analysts with the most bullish recommendations are typically the most accurate at predicting earnings, according to research by professors Shuping Chen and Dawn Matsumoto at the University of Washington in Seattle. That proves that companies provide more information to analysts who make favorable ratings, Chen and Matsumoto wrote in their paper published by the Journal of Accounting Research in September 2006.
``Since Regulation FD, investors probably rely more on direct contact'' with company insiders, Chen said in an interview.
For analysts, the punishment for a negative rating can be as swift and unmistakable as a door slamming shut, said Richard Bove, a Lutz, Florida-based analyst at Punk, Ziegel & Co., who downgraded the top five U.S. brokers to ``sell'' in July.
``At one of the companies I've been writing very negative things about for a while, the CEO absolutely refuses to talk to me anymore and I don't have access to that management,'' Bove said in an interview, declining to identify the executive. ``And if you lose access to management, you lose the ability to take them on the road and that reduces your commission income.''
`Dead Wrong'
Citigroup, the biggest U.S. bank by assets, was down more than 13 percent for the year when Deutsche Bank AG's Michael Mayo cut it to ``sell'' on Oct. 12. It fell 25 percent before Nov. 1, when Meredith Whitney at CIBC World Markets issued a sell rating that drove the stock down another 8 percent. Neither Mayo nor Whitney, both based in New York, responded to requests for interviews for this story.
Goldman analyst William Tanona waited until Nov. 19 to downgrade Citigroup to ``sell.'' The stock has slipped 2 percent since the note was published. Tanona, based in New York, didn't respond to an interview request.
The reductions by Whitney and Tanona probably were too late, said Harlow of Harlow Capital.
``I think if you look back in 18 months, these guys are going to be dead wrong,'' he said. ``They're going to have downgraded these stocks at almost the bottom of the cycle.''
Finding the Bottom
Rating cuts have a bigger impact during bear markets because investors are more easily spooked, according to professors Xia Chen and Qiang Cheng at the University of British Columbia in Vancouver, who are working on a paper on the subject. They have concluded that sell and hold recommendations have about twice the impact during periods when stocks are sinking.
``When markets decline, people are looking for where's the stock with the real problems, and research has more value at that time,'' Credit Suisse's Natella said.
Hedge funds that employ computer-driven trading strategies are known to exploit short-term movements in stock prices caused by analyst rating changes, said Ross Miller, a finance professor at State University of New York at Albany. Managers study the trading patterns after analysts change stock recommendations and program their computers to benefit from them, he said.
Trading the Blips
``Although there seems to be more attention paid to analyst reports these days, these tend to be temporary impacts on stock prices,'' Miller said. ``A lot of hedge funds will trade the blips triggered by such changes.''
As most analysts shy from issuing sell recommendations for fear of losing access to management, Punk Ziegel's Bove said he has actually benefited from being the odd man out. His unorthodox calls have brought his firm new clients, he said.
``Even though they put you in the penalty box, even though they'll call up and yell at you, whether it's the management or the client, ultimately if your stock selection proves to be correct, you're going to get paid for it,'' Bove said.
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