Wall Street Stock Research: Soon, Less Independent

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The last time we realized the financial system had sold us out—this was way back in 2001/2002—one of the results was a half-a-billion-dollar settlement with Wall Street's stock analysts. As you might recall, investment banks had a bad habit of issuing overly rosy opinions of companies, particularly the ones the banks were courting for other sorts of business. Twelve companies, including Merrill Lynch, Bear Stearns, Citigroup, Goldman Sachs, Lehman Brothers, J.P. Morgan Chase and UBS agreed to pay a collective $432.5 million for research to be produced by dozens of independent, outside companies and distributed to the banks' own customers, as a counterweight to their internal opinions. This money, designed to be disbursed over the course of five years, spurred on an industry of independent stock research.

The checks stop this summer.

What will happen to independent stock research? It is an important question to ask, especially at a time when the ethics of financial firms are again front-and-center. Dozens of independent research companies—by some estimates, 60 to 70—have been selling their work to investment banks over the past five years. Under the terms of the settlement, the banks then make that research available to individual investors and the bank employees, like brokers, who advise them. The biggest providers of research to the global settlement are, by most accounts, S&P Equity Research, Morningstar and Argus Research—all decently sized (and, in S&P's case, quite large) companies. (Read "How to Know When the Economy Is Turning Up.")

But dozens of other firms selling research are much smaller, and have come to depend on the nearly $90 million a year the investment banks have been plowing into the system. When that money stops, "you're going to see a lot of these smaller firms either consolidate or dry up and go away," says James Gellert, CEO of the ratings and research outfit Rapid Ratings International, which sells its research through the settlement.

A handful of investment banks may continue to buy and pass along independent research—either because they know it helps their clients, or because they see it as a marketing tool. By and large, though, the banks never went to great lengths to advertise the availability and value of the research to customers—like, say, Charles Schwab does. That's partly because most customers at firms such as Merrill Lynch deal with intermediaries like brokers. Still, "while the retail investor may not have been accessing that research directly, investment professionals were consuming it and then presenting it to their clients," says Michael Mayhew, chairman and director of research at Integrity Research Associates, a firm that tracks and evaluates research outfits. When the settlement money stops, he says, "retail investors will have less information. That's absolutely clear."

Many of the firms themselves are already moving away from retail research. Thomas White International, which created a research consortium with four other firms to win settlement dollars, will go back to its main business of managing assets for institutional investors. Ross Smith Energy Group, a Canadian outfit that follows the oil and gas industries, is getting into investment banking. Three companies—Argus, Independent International Investment Research and Pipal Research—have joined with the London Stock Exchange to provide coverage of smaller firms willing to pay for it. Rapid Ratings is finding a hearty new revenue stream in doing analysis for companies that want to know about the financial positioning of the firms they do business with. (See 25 people to blame for the financial crisis.)

The drive to diversify doesn't only flow from the end of the global settlement. The independent research industry is influenced by plenty of other forces, too, especially a constant onslaught of new competition. "There are low barriers to entry, and with a lot of people on Wall Street out of work, it's pretty easy for an analyst to say, let me try my hand at that," says Mark Fichtel, a former president of the New York Mercantile Exchange and one of the Securities and Exchange Commission consultants who picked which independent research shops to use in the settlement.

And drifting away from retail research doesn't necessarily mean giving up on research line altogether. As institutional investors, particularly hedge funds, have taken a beating in the market and been forced to trim costs including staff, the demand for outside research has in some quarters actually increased. "There are different kinds of independent research," says Argus president John Eade. "As the settlement winds down, the focus is shifting away from ratings and reports to evolving forms, like expert networks and primary sources—meetings with our analysts, our institutional clients and different CEOs and CFOs we've gotten to know." But that analysis isn't making it into the hands of individual investors or their brokers.

So the bigger question may be, will the global settlement have any lasting impact—or do we lose something significant when the money for independent research stops in July? By some measures, the bias of investment-bank stock research has, in fact, changed since the late 1990s and early 2000s. Back then, only about 1% to 2% of the companies covered by banks carried a "sell" rating, according to research-tracker Investars. These days, that figure falls more in the 15% to 20% range—an indication, one might argue, that analysts are making tougher calls on the companies they cover. That probably has a lot to do with a slew of new rules that separate stock analysts from their firms' investment banking operations—not just the money for independent research per se. And those rules aren't ending.

An upcoming paper in The Review of Financial Studies finds that since the global settlement, research from investment banks has, in certain ways, become less biased. An analyst is no longer more likely to issue a "buy" rating when his firm is doing investment banking business with the company he's covering—as used to be the case. "It's leveled the behavior on the optimistic side, and that seems like a good result," says Leonardo Madureira, a finance professor at Case Western Reserve University and one of the paper's authors. Analysts, though, are still much less likely to issue a "sell" rating on a company their firm has another connection to. That goes to show how difficult it can be to achieve impartiality. And with the end of mandatory independent research, there's one less engine pushing in that direction.

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