Research for the masses

Last week we examined the unhappy case of Merrill Lynch, which is now the subject of an inquiry by New York State securities regulators and prosecutors. Evidence presented by the state has called the integrity of Merrill’s stock market research into question, and news that the probe has been extended to other major New York investment firms reinforces the impression that many analysts were employed purely as cheerleaders for paper their own firm was trying to place.

The Financial Times’ Barry Riley put these words into the mouth of his fictional market commentator Mortimer Duhm: “We can blame the intermediaries and advisers, but we should not be surprised when they turn out to be greedy.” No, especially in the greed-is-good world we (until recently) inhabited. It is already fairly clear that the financial services firms had developed a compensation regime that perfectly reflects the firms’ own financial success.

But it seems fair to blame them for being wholly uncritical of much of the nonsense that massively capitalized companies fed them in conference calls. For example, analysts testifying at U.S. Senate hearings into the Enron bankruptcy said they had relied on audited financial statements from the company. Yet they had also sat through presentations on Enron’s topsy-turvy world of unconsolidated subsidiaries, strangely booked loans and even more strangely booked revenues without challenging management’s story. Greed happens, but only when it is married to basic competence is it excusable.

The test of the financial services business and of industries that need to raise capital will be making sure the interests of the houses converge with those of the investors they are supposed to serve.

We argued last week that the guidelines the houses offered up over the past year — to restrict trading by analysts in stocks they cover, and to disclose corporate-finance relationships with companies that were the subject of reports — slid past the main problem, which was that compensation has been based on the firms’ profitability, and profitability was determined by the firms’ success in shovelling paper out the door. Retail business became simply a means to the real prize of a string of large financings.

Yet it is in the creation of institutional and retail trading business that those same corporate finance deals prosper: and when there are financial rewards for overestimating earnings, setting lunatic target prices, and maintaining ratings that defy common sense, those are the kinds of things that will be done.

A number of observers have suggested that “buy-side” advice will expand to provide a counterweight — or at any rate that it should. This may serve the members of large pension funds and the holders of mutual fund units, but the institutions will have to pay for this good advice, and will be disinclined to share it with the public.

Henry Kaufman, who ran the research department at Salomon Brothers in the 1980s, has suggested that large houses should not provide research to clients but keep the reports strictly in-house. That would remove two definite conflicts between the interests of the firms and their investing clients: first, the use of analysts’ reports to attract financing business, and second, the ability of houses to anticipate market moves based on forthcoming reports.

He suggests that the reduced cost of providing research at the houses would lead to another decline in trading commissions, which would leave investors some spare cash to buy research off the shelf from institutions and from independent research firms.

Kaufman’s prescription may be sensible, but it may also be unrealistic. First, well-advised, buy-and-hold investors don’t create a lot of commission revenue anyway. Second, in-house research is likely to be just as expensive as the present kind, so the savings may be minimal.

Third, a retail investor looking for a good place to put a few thousand is likely to find that money spent on research reports eats up far too much of his investment capital. Investors, after all, drove brokerage commissions down with their shift to discount and on-line accounts, where brokers’ advice was not available: their message to the houses at that time was that an experienced independent investor did not need to be led by the hand.

It is unfortunate so many let themselves be led by the nose instead.