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Playing the stock ratings game

Prudential Securities defies conventional wisdom by paring down its ratings system, but critics argue the change could end up hurting the people it was designed to help.

    Prudential Securities shook things up a bit this week when it defied Wall Street's conventional wisdom by paring down its rating system to three simple recommendations: buy, hold or sell.

    The new system might be simpler, but critics say it could end up hurting the very people it was designed to help.

    This might not seem like such a big deal on the surface. As one investor said, "Those should be the only ratings because those are the only three things you can do with a stock."

    These investment firms have become quite enamored of their dizzying array of ratings that all sound different from their competition but essentially say the same thing.

    What's the difference between an "accumulate" rating at one firm and a "buy" rating at another? Does a short-term "market perform" rating mean that retail investors should buy the stock, hold it or sell it? An "avoid" rating appears to be pretty clear, but does that mean shareholders who didn't avoid it in the first place should now sell?

    Prudential hopes to clarify matters some with this new straightforward approach.

    "It's really a joke," said Michael Shea, president of Prudential Securities' equity research division. "This inconsistency of ratings is a huge issue with investors of all types, and we decided to be the first to start cleaning up the practice."

    Under the new rating system, a "buy" recommendation means the firm believes a stock will deliver a minimum return of 20 percent in the next year. A "sell" rating, thus far rarely used by any institution, means the firm expects the stock to lose at least 20 percent of its value in the next year. Those stocks unlikely to move up or down at least 20 percent in the next 12 months will be tagged with a "hold" rating.

    Shea said the change will primarily benefit retail investors who may not be as sophisticated as money managers working for large institutions. While an institution would easily recognize a downgrade from a "strong buy" rating to a "buy" as a sign of possible trouble ahead, an average retail investor would only see the "buy" rating and, presumably, act accordingly.

    "We want much less gray area in our ratings," he said. "We want Mom and Dad to understand what we are saying. We realize we're still going to make mistakes with these new ratings, but hopefully this will help retail investors make more informed investment decisions."

    Too simple, more risky?
    Critics say the simplified rating system does just the opposite. They say the myriad ratings used by different firms help investors make more informed decisions because the ratings factor in the risk tolerance and time horizons of their individual clients.

    "Product differentiation is a significant part of our business," said Dan Scovel, an analyst at Needham. "Real life is never as simple as buy, sell or hold. I think this kind of simplicity is a great disservice to investors."

    Scovel points out that many stocks, particularly technology issues, can move up or down 20 percent in a day or even in a few hours. If a stock were to shoot up 20 percent in a week, would Prudential then downgrade the stock from a "buy" rating? And if it did, would that be providing any more value to investors than, say, a long-term "accumulate" rating at another firm?

    "A lot of stocks aren't worth assigning a 'buy' rating until there's a possibility of at least a 40 percent or 60 percent upside," Scovel said. "Our job is to accurately communicate the issues so investors can make informed decisions. Buy, sell and hold ratings don't factor in how much risk your clients are willing to take on or their investing timeframe."

    Brant Thompson, an analyst at J.P. Morgan H&Q, said Prudential's new system doesn't allow analysts to react to news or information that could have a significant impact on a stock's performance.

    "If you've uncovered some news that's going to really make a stock pop in a single day, you wouldn't have the ability to immediately upgrade the stock," he said. "In general, it's really difficult to compare one bank's ratings to another. Everyone has different methods."

    Conflict of interest
    This lack of uniformity in the analyst community will likely be one of many topics covered shortly, when a House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises meets June 14 to discuss how analysts could better serve investors.

    U.S. Rep. Richard H. Baker, R-La., who chairs the subcommittee, has taken a keen interest in the potential conflicts of interest that exist in Wall Street stock analysis.

    Baker wants investors to have "an undistorted view of the marketplace" and for all participants in a transaction to have "full disclosure of everyone's standing in the deal."

    Baker was unavailable to comment on the subcommittee hearing, but it's clear he's alluding to the soft touch analysts are known to show toward stocks that they helped bring public or companies with which they enjoy an extensive investment-banking relationship.

    It's no coincidence that, throughout the dot-com collapse, many of the analysts who tried to suggest the glass was half-full and held firm to "buy" or "strong buy" ratings as the stocks continued to plummet were the very same people who pocketed huge underwriting fees after taking immature, money-losing companies public.

    In their defense, analysts are often put in a no-win situation: They're expected to provide objective analysis of the stocks and companies they follow, but are largely beholden to these companies not only for information but future investment-banking deals.

    It's quite a selling point to show a private company that not only can you deliver a huge valuation, but that you'll also maintain a positive spin on the stock long after the confetti from the IPO party has been swept away.

    Prudential's Shea said his firm will no longer lead any initial public offerings, a small step toward creating more objectivity in his research department. However, he did say his firm would help comanage an offering if it were appropriate.

    "We believe this will help us eliminate most of the conflicts between our research department and our clients," he said.

    Looking for the motive
    This quid pro quo approach to investment banking and stock analysis raises some very serious questions not only about the objectivity of a particular analyst, but also the motivation behind every deal, upgrade and association a brokerage firm makes.

    Just this week, Salomon Smith Barney initiated coverage of Cabletron Systems with a "buy" recommendation and a 12-month price target of $30 a share. If analyst Alex Henderson is to be believed, the stock will shoot up 67 percent in the next year.

    This enthusiasm surely couldn't stem from the fact that back in February Salomon Smith Barney helped underwrite the initial public offering of Cabletron's Riverstone spin-off.

    In his research note, Henderson said Cabletron is "well positioned in two of our favorite parts of the communications-equipment universe, the enterprise and metro markets."

    For the moment, take Henderson's comments and price target at face value. Cabletron has staged a remarkable turnaround in recent quarters, consistently meeting or beating analysts' profit estimates.

    The problem here is the appearance of prejudicial treatment. No one could prove that Henderson wouldn't have initiated coverage of Cabletron had his firm not been involved in the Riverstone IPO. Then again, investors shouldn't be so naive as to believe the Riverstone connection didn't play some role in this rousing endorsement.

    The vast majority of sell-side analysts contacted would not speak on the record about the rating systems or the inherent conflicts between the research departments and the investment-banking divisions.

    "That's one of the idiosyncrasies of this job," Scovel said. "To do your job well, you have to make everyone happy all the time. But in the end, all an analyst has is his or her credibility to fall back on. When that's gone, you're finished."

    They also conveniently forget to mention that upgrades and downgrades create a lot of volume. These transactions, made by investors small and large, all generate commissions.

    A case for no ratings
    It's hard to believe that other houses will follow Prudential's lead unless some regulatory body steps in and requires all firms use a universal rating system.

    There's no way an enormous firm like Goldman Sachs would jettison its vaunted "recommended list"--a branding tool that not only tells investors to buy the stock, but also tells the company that Goldman values it as a client--to make life easier for the small-potato retail investor, a curious creature that doesn't really exist in Goldman's world.

    The timing of Prudential's attempt to bring some sense to the ratings game is also highly suspect.

    Had it rolled out this newfangled approach back in May 1999, few would have even paid attention, and those who did would have mocked it.

    Picture the poor Prudential analysts trying to determine whether or not a stock such as Yahoo or America Online was going to improve 20 percent in a year. Those stocks were rising and falling 20 percent in a couple hours. By their own definition, they would have been forced to use all three labels for these stocks simultaneously.

    Now that the IPO market has dried up and venture capitalists have closed the vault, brokerage firms are looking for new ways to differentiate themselves from the competition and allegedly provide more value to their clients.

    This new system will make life much easier all right, but only for Prudential analysts. They'll no longer have to make the stomach-turning decision to upgrade an overvalued stock that's blown past their own price targets in order to keep up with the shortsighted bulls calling the shots at other firms.

    Everyone laughs at the Amazon story now, but in its heyday, there wasn't a single brokerage firm on Wall Street that didn't rate it either a "buy" or "strong buy" and maintain a ridiculous price target that most analysts wouldn't have dared assign to even the likes of Microsoft or General Electric.

    For retail investors, this buy, sell or hold philosophy is just another layer of confusion to overcome. It's all or nothing for this type of thing. Until everyone uses the same guidelines, it's just another shade of gray.

    Do us a favor
    If Prudential and other houses want to do retail investors a real favor, they should adopt another universal policy: abandon the rating systems altogether.

    They should just provide the research and analysis they're already providing and leave it up to the investors to decide what's worth buying and what should be dumped.

    If investors can't discern the investment potential of a particular stock from reading an unlabeled research report, these guys aren't doing their jobs. Disclose your relationships with the company in each and every report you publish and let people draw their own conclusions.

    Retail investors need information and context, not a meaningless label designed to generate trades and serve as a terribly inadequate measuring stick for the media and other analysts to pass judgment on.

    Investors don't care which analyst or firm is the first to recommend or bash a stock. That's nothing more than gift wrap. They only care how the research analysts come to those conclusions.