During market sell hell, analysts were angelic

Prudential Securities Inc. started promoting its independent research last December while downsizing its investment banking business and leads the Wall Street pack in “sell” recommendations.

But don’t get too excited.

Despite the market downturn this year, less than 3% of the recommendations made by the New York subsidiary of Prudential Insurance Company of America were “sell” or “strong sell.”

The percentage of “sell” recommendations made by brokerage analysts dropped off sharply after that, according to Zacks Investment Research Inc. in Chicago.

The independent stock market research company compiled for InvestmentNews a list of brokerage houses with the highest percentage of “sell” recommendations for the year as of April 1.

The scarcity of “sell” ratings is receiving new attention after a speech this month by Laura Unger, acting chairman of the Securities and Exchange Commission.

Ms. Unger highlighted conflicts of interest between brokers’ investment banking businesses and the overly favorable research recommendations for the companies covered by their analysts.

She called on the brokerage industry to do a better job of ensuring that analysts’ reports and recommendations are unbiased and especially making sure that all financial relationships with companies covered by the brokerage firms are disclosed.

Impartial research is especially critical to financial advisers, many of whom are increasingly putting clients in stocks rather than mutual funds. Brian Orol, a principal of Strategic Financial Planning Group LLC of Raleigh, N.C., is one such adviser. (He wouldn’t say how much in assets he manages.)

Impartiality needed

Over the past three years, Mr. Orol, who has been a financial planner since 1991, has moved from investing virtually all of his clients’ money in mutual funds to investing primarily in stocks and bonds, along with keeping cash reserves. He still uses funds for international and sector investments.

He says he made the switch to manage capital gains and to keep investment costs down. In addition, Mr. Orol says, “there’s such a proliferation of mutual funds. There are many, many excellent fund managers, but there are clearly more funds than there are excellent fund managers.”

Mr. Orol is concerned about the reliability and independence of analysts. “It’s very important that analysts can stay independent because planners rely on them for their expertise and their objective information. I certainly do,” he says.

Other changes in the advisory business highlight the need for more independent analysis. The Evensky Group, which has $350 million under discretion, is looking at moving from all mutual funds to a mix of mutual funds, exchange-traded funds and separate accounts that would include stocks in folios, says chairman Harold Evensky.

While the Coral Gables, Fla., advisory company does not use research for individual securities, it does rely on research for general market information, Mr. Evensky says. The reliability and objectivity of that analysis is an “extraordinary concern,” he says. If analysts were independent, “we would continue to see thousands of `buy’ recommendations and no `sell’ recommendations.”

Even small advisers who do not invest client money directly in stocks are concerned. Bryan Lee, president of Strategic Financial Planning Inc., a Garland, Texas, advisory business that supervises $8 million, says he leaves “all the stock picking up to third-party money managers.”

He thinks it is important that financial relationships between analysts and the companies they cover be adequately disclosed. “I want everybody to be on the same, level playing field,” he says.

“I don’t want another money manager having information that my money manager doesn’t have because I didn’t know that my money manager wasn’t best friends with the chief financial officer of IBM.”

Mitch Zacks, vice president of Zacks Investment Research, says it is difficult for brokerage houses to put up Chinese walls separating their research and investment banking departments.

“It is illegal [for an analyst] to tell someone on the trading desk what he’s going to say before he says it,” Mr. Zacks says. “Insider trading is very well policed. On the merchant banking side, it’s a much more nebulous concept. The SEC can’t police investment banking revenue being tied to the analyst.”

Mr. Zacks also believes Prudential and others trying to gain more independence will have a hard time changing the culture of analysts. “They realize they may not be working at Prudential the rest of their lives,” he says.

“If they say `sell,’ it creates long-term animosity between investment banking management and analysts. Investment bankers have a big hand in which analysts are hired.”

But Susan Atran, spokeswoman for Prudential Securities, disagrees. “What we’ve found is that there are many analysts out there who really welcome this emphasis on objectivity because it gives them more freedom. This is really what you’re paying them for, after all.

“Clients seem to really like it,” she adds.

Prudential Securities’ chief executive, John Strangfeld, de-emphasized the company’s ailing investment banking business when he took over last fall and earlier this year hired noted financial services sector analyst Michael Mayo, formerly of Credit Suisse First Boston. Mr. Mayo promptly continued his practice of issuing “sell” recommendations on several banks.

As commissions have dwindled in recent years, brokerage houses have come to rely increasingly on revenues from investment banking.

“It’s easy to throw stones at the brokers, but the institutions need to look in the mirror a little bit,” comments Chuck Hill, director of research at independent research company First Call/Thomson Financial in Boston. “You aren’t paying what you used to, so don’t expect the same quality.”

Mr. Hill says company surveys in the past year have not shown a correlation between the lack of investment banking business and a high number of “sell” recommendations.

A case in point is Bernstein Investment Research and Management in New York.

The company, which does not do investment banking, had higher-than-average recommendations, Mr. Hill says.