Equities: Serving Which Master?

Brokers have long understood analysts’ divided loyalties.

If you are a Merrill Lynch broker and followed the advice of Henry Blodget in 1999, chances are you made money for your clients. But when the bubble burst and he continued to recommend the Internet darlings that made him famous, you probably lost money for your clients. Ditto for devotees of Morgan Stanley's Mary Meeker and Salomon Smith Barney's Jack Grubman.

This begs the question: Do retail brokers really follow their firm's analysts? Now, of course, many brokers say that in fact, no, they don't depend on their own firm's stock recommendations much. Indeed, many brokers say, all sell-side research should be taken with a grain — or a bag — of salt.

“I was on a conference call with a Goldman Sachs analyst last fall,” says a broker who actively buys and sells individual securities for his clients. “He couldn't have been more enthusiastic about Enron. He was really pounding the table for that stock. The thing had really cratered, but he was saying it was the buying opportunity of a lifetime.”

The broker wasn't necessarily accusing the analyst of conflict of interest, though Goldman over the years helped structure deals for Enron. He did not buy any Enron stock for his clients. “I know the guy [the Goldman analyst] is smarter than I am, but I just didn't buy his story. Analysts have become parrots of company management.”

A few brokers did say they used to have greater faith in their own firm's equity research, but others say they've been skeptical all along. “I had one former branch manager at Merrill Lynch who used to say his favorite stocks were all ‘holds,’” says one East Coast-based Prudential broker. “As soon as a stock became a hold that was the time to buy it.”

This winter, more sticky situations have emerged involving conflicted analysts who weren't providing much in the way of balanced recommendations. In fact, most now believe that analysts were merely cheerleading to attract investment-banking business for their firms. Predictably, there have been several (largely unsuccessful) investor suits against analysts, including one against Henry Blodget that actually cost Merrill $400,000 to settle. Now, two former Smith Barney brokers are suing their own analyst, Jack Grubman, for his overly optimistic recommendations, a story Registered Rep. broke last month.

Recently, the NASD and NYSE together proposed new rules for securities firms that will make analysts disclose their firm's banking relationships, setting limits on the degree to which investment bankers can control analysts' reports and recommendations, and placing new limits on analysts' stock ownership and trading.

Independent Thinking Is Not Rewarded

Enron has become the poster child for the problem. Many analysts maintained a “buy” rating on the stock while Houston burned. Chung Wu, a Houston-based broker, was fired from UBS PaineWebber due to “unauthorized correspondence” last August, correspondence that, by the way, told his clients — Enron employee-shareholders — to sell Enron stock. Wu, now at A.G. Edwards, wouldn't comment, but asserted in his U-4 filing with the NASD that pressure to fire him came from Enron. A PaineWebber spokesperson has said in published reports that the correspondence, and not its content, was responsible for Wu's firing.

The conflict between investment banking and retail brokerage extends to encouraging retail brokers to continue telling clients to buy stock despite the broker's better judgment. Several brokers said that they don't feel pressure from their firm if they're telling clients to sell a particular stock, but that they'd be in worse shape if they simply waited around for researchers to lower their recommendations.

“There's never a chance you'd get in trouble for selling something,” says one West Coast-based Merrill Lynch broker. “If you sell a 1/1 buy-buy stock, you might get questions about it, but you don't get in trouble for it, especially if you're here a number of years.”

To supplement her own firm's research, she generally uses other research, including what's available at competing wirehouses. Other brokers said a similar thing, pointing out the variety of resources available on the Web. A few also said they share research with other brokers at other firms.

Generally, they say, they ignore price targets and buy recommendations, because of the short-term focus that's promoted in sell-side research. “Most of it has gone to the CNBC style of investing,” says one West Coast-based Morgan Stanley producer. “And that's the hot stock of the day.”

If anything, brokers say they view their in-house strategy recommendations with more gravity. The recommended division of assets between stocks, bonds and cash through quantitative or strategic research is worth more to them, they say, because it helps them build a model portfolio.

“We mostly use the strategists, just to get an idea of what the overall complexion of economy and markets, but not as much the actual industry analysts,” says one East Coast-based Prudential broker. Where brokers find specific stock analysis most valuable is through the vast data points and details that can come out through lengthy research reports produced by their analysts.

This, they say, has significant value, even if the analysts until recently were in hock to their investment banking departments as revenue producers. One Smith Barney broker quipped that “it's the nature of the business — they're not paid to blow bad news,” but countering quickly that its one reason why many brokers are moving into managed money, which in many cases removes the decision of buying and selling stocks from the broker and to a money manager.

It's one way for a broker to protect himself, because without skeptical research providing ballast, their judgment is the only thing that remains.

“I know where my bread is buttered, and it's not here,” says the Morgan broker of his analysts. “They used to be the be-all end-all, but they're not any more. They proved they were just watching their butts.”

Meanwhile, the NASD is proposing rules to separate between investment banking and research, something that was less of an issue until investment banks started purchasing broker/dealers (Salomon Brothers and Smith Barney; Morgan Stanley and Dean Witter). With the exception of Prudential, which has jettisoned investment banking altogether, major firms are attempting to put controls in place to separate analysts and bankers.

The analyst cult, of course, waxed and waned with the 1990s bull market, which made everyone — analyst, banker, broker, shoe salesman — into a genius.

Still, firms have generally been protective of their analysts first and intent on preserving their existing relationships with corporations, which provide more revenue than any one broker. For a rep, the last several years have been a heady education. “Now, my best guidance is if I'm driving by the Best Buy, and seeing if the parking lot is full or not,” says a PaineWebber broker.

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