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Analyst hearing could change Wall Street

Pressure from Congress, an industry trade group and the press may already be affecting analyst behavior as two underwriters downgrade a recent IPO.

When Morgan Stanley and Goldman Sachs downgraded Loudcloud this week it was an unusual move--both were underwriters for the company's much ballyhooed initial public offering.

These downgrades--which came after the developer of Web infrastructure services gave a gloomy outlook--wouldn't have been notable if it weren't for the pressure Wall Street analysts are facing from Congress, the press and their own trade group. Congress is holding a hearing this week, alleging that analysts are hurting investors through grade inflation and bias toward companies they underwrite.

In the middle of the dot-com boom, underwriters weren't so quick to downgrade one of their clients. In fact, most analysts kept "strong buys" as companies saw their market capitalizations crumble. The greater the investment banking fees, the more likely a "buy" rating would stick.

What changed their tune this week?

Perhaps it was the accusations of bias and bad press. Perhaps it was the Securities Industry Association's (SIA's) issuing of "best practices" for analysts. But the Morgan Stanley and Goldman Sachs downgrades of Loudcloud were an example of exactly the kind of behavior the securities industry is looking for--analyst reports that focus on the company's fundamentals.

The analysts at Morgan Stanley and Goldman Sachs weren't available for comment, but their actions are a signal that analysts' practices may already be changing.

During the heady days of the tech bubble, researchers who for years labored in obscurity became instant celebrities. A pronouncement from one of the more prominent analysts could send a stock to ridiculous heights (consider Henry Blodget's now legendary $400 Amazon price target).

But now that stocks have crumbled and many investors have lost their shirts, people are looking around for someone to blame. Aside from the congressional hearing going on, the New York state attorney general's office is investigating feasibility of analysts having conflicts of interest.

The reaction from politicos was predictable.

"I am deeply troubled by the evidence of the apparent erosion by Wall Street of the bedrock of ethical conduct," said U.S. Rep. Richard H. Baker, R-La., the chairman of the House Subcommittee on Capital Markets, which launched the hearing. Baker said the financial media will also be held accountable in the hearing.

Some participants at the hearing, who were called as witnesses, urged Baker's subcommittee to refrain from turning the hearing into a witch hunt. Analysts maintain that investors still have a responsibility for their own money. They argue that investors played along as long as they were making a fortune in the stock market.

James Glassman, resident fellow at American Enterprise Institute, was a witness on subcommittee's panel and said investors can't completely blame analysts for their losses. He urged "restraint" in two ways. First, "Analysts should not be seen as a scapegoat for the market decline." Second, he said, government should resist any attempts to regulate Wall Street.

Predictably, SIA President Marc Lackritz defended analysts and said investors have a responsibility for their losses too. "We ask investors be informed and educated," he said. If investors don?t want to do the required homework to pick a stock, they should invest in mutual funds or get expert advice, he said.

The winding road to status quo
Part of the problem is that small individual investors were never intended to be the recipient of these reports, witnesses said. Decades ago, researchers sold their reports to private clients. Individual investors who had the clout to get that data were generally wealthy and experienced in buying and selling stocks. The research department used to be funded by brokerage commissions. Once commission revenue dwindled, the investment banking department picked up the tab and the research became widely disseminated through the media.

Flash forward a couple of years, and everyone in America decides they need to go build up their portfolio. The brokerage firms and the media were more than happy to jump in and help, sending analysts out to chat on TV and publishing recommendations on the Internet.

Simply put, Wall Street's morning calls--brokerage research roundups and sales advice--got a lot more play than they ever would have otherwise. While the recommendations were still technically intended solely for the benefit of their private clients, individual investors began to listen.

One of the latest SIA recommendations is that analysts' compensation be completely divorced from investment banks' actions. Witnesses at the congressional hearing said that would make perfect sense.

Let's make a comparison between an investment bank and a media company. Consider analysts as the news staff, doing research and publishing their findings, and investment banks as the advertising staff, generating the money. Do you want the reporters' salaries dependent on how well a specific advertiser does? Of course not; the potential for conflict is enormous. But as long as analysts' pay is tied to bringing in investment business, the temptation will be there.

Same as it ever was
According to research from a team at the Harvard Business School, the Internet stock hype had little to do with analysts and their inflated ratings.

The study, published in the spring 2000 issue of Contemporary Accounting Research, looked at the performance of stocks that issued IPOs or secondary offerings. But what's most interesting to note about this study is that the date period covered is 1981 to 1990, when the Web was barely a dream.

Analysts that participated in the companies' offerings predicted 19.6 percent growth. Unaffiliated firms gave predictions of 15.8 percent growth. In other words, investment-banking work breeds optimism.

It turns out that over the subsequent three to five years, the companies' actual earnings growth was only 5.6 percent--far lower than either set of predictions.

In addition, companies with affiliated research saw their stocks decline 23.8 percent, on average, while companies with unaffiliated research saw their stocks drop an average of 11.8 percent.

"Given how long it's been going on, why haven't investors learned?," said Amy Hutton, associate professor of business administration at the Harvard Business School and one of the authors of the study. "This is the thing that perplexed (me). Why haven't investors learned to ignore analysts? Why did they continue to listen to them?"